    [Senate Hearing 107-948]
    [From the U.S. Government Publishing Office]

                   ACCOUNTING REFORM AND INVESTOR PROTECTION
                                    VOLUME I

                                                            S. Hrg. 107-948

                             ACCOUNTING REFORM AND
                              INVESTOR PROTECTION

    =======================================================================

                                    HEARINGS

                                   before the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                          ONE HUNDRED SEVENTH CONGRESS

                                 SECOND SESSION

                                    VOLUME I

                                       ON

           THE LEGISLATIVE HISTORY OF THE SARBANES-OXLEY ACT OF 2002:
     ACCOUNTING REFORM AND INVESTOR PROTECTION ISSUES RAISED BY ENRON AND
                             OTHER PUBLIC COMPANIES

                                   ----------

                       FEBRUARY 12, 14, 26, AND 27, 2002

                                   ----------

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

    87-708              U.S. GOVERNMENT PRINTING OFFICE
                                WASHINGTON : 2003
    ____________________________________________________________________________
    For Sale by the Superintendent of Documents, U.S. Government Printing Office
    Internet: bookstore.gpr.gov  Phone: toll free (866) 512-1800; (202) 512�091800
    Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001

                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      PAUL S. SARBANES, Maryland, Chairman
    CHRISTOPHER J. DODD, Connecticut     PHIL GRAMM, Texas
    TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
    JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
    CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
    EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
    ZELL MILLER, Georgia                 CHUCK HAGEL, Nebraska
    THOMAS R. CARPER, Delaware           RICK SANTORUM, Pennsylvania
    DEBBIE STABENOW, Michigan            JIM BUNNING, Kentucky
    JON S. CORZINE, New Jersey           MIKE CRAPO, Idaho
    DANIEL K. AKAKA, Hawaii              JOHN ENSIGN, Nevada

               Steven B. Harris, Staff Director and Chief Counsel
                 Wayne A. Abernathy, Republican Staff Director
                      Martin J. Gruenberg, Senior Counsel
                           Dean V. Shahinian, Counsel
                       Stephen R. Kroll, Special Counsel
                           Lynsey Graham Rea, Counsel
                            Vincent Meehan, Counsel
                            Sarah A. Kline, Counsel
                      Judith Keenan, Senior Policy Advisor
        Alexander M. Sternhell, Staff Director, Securities Subcommittee
                    Linda L. Lord, Republican Chief Counsel
                  Stacie Thomas Morales, Republican Economist
                    Michelle R. Jackson, Republican Counsel
         Geoffrey P. Gray, Republican Senior Professional Staff Member
                      Mark F. Oesterle, Republican Counsel
                    Katherine McGuire, Republican Economist
             Michael D. Thompson, Republican Legislative Assistant
       Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                           George E. Whittle, Editor
                    Irene Whiston Carroll, Assistant Editor
                       Frank E. Wright, Assistant Editor
                        Kevin D. High, Assistant Editor

                                      (ii)

                                C O N T E N T S

                                  ----------

                                    VOLUME I

                                  ----------

                           TUESDAY, FEBRUARY 12, 2002

                                                                       Page

    Opening statement of Chairman Sarbanes...........................     1

    Opening statements, comments, or prepared statements of:
        Senator Shelby...............................................     3
        Senator Miller...............................................     4
        Senator Enzi.................................................     4
        Senator Corzine..............................................     6
        Senator Hagel................................................     7
        Senator Stabenow.............................................     7
        Senator Bayh.................................................     8
        Senator Carper...............................................     8
        Senator Johnson..............................................     9
            Prepared statement.......................................    55
        Senator Schumer..............................................    10
        Senator Dodd.................................................    11
        Senator Akaka................................................    56

                                   WITNESSES

    Arthur Levitt, Chairman, U.S. Securities and Exchange Commission,
      1993 to 2000...................................................    14
        Prepared statement...........................................    56
    Richard C. Breeden, Chairman, U.S. Securities and Exchange
      Commission, 1989 to 1993.......................................    16
        Prepared statement...........................................    58
        Response to written questions of Senator Hagel...............    94
    David S. Ruder, Chairman, U.S. Securities and Exchange
      Commission, 1987 to 1989.......................................    20
        Prepared statement...........................................    69
        Response to written questions of Senator Hagel...............    94
    Harold M. Williams, Chairman, U.S. Securities and Exchange
      Commission, 1977 to 1981.......................................    23
        Prepared statement...........................................    75
        Response to written questions of Senator Hagel...............    95
    Roderick M. Hills, Chairman, U.S. Securities and Exchange
      Commission, 1975 to 1977.......................................    26
        Prepared statement and exhibits..............................    78
        Response to written questions of Senator Hagel...............    95

                                  ----------

                          THURSDAY, FEBRUARY 14, 2002

    Opening statement of Chairman Sarbanes...........................    97

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................    98
            Prepared statement.......................................   141
        Senator Stabenow.............................................    99
            Prepared statement.......................................   141
        Senator Enzi.................................................    99
        Senator Bayh.................................................   100
        Senator Crapo................................................   101
        Senator Bunning..............................................   101
        Senator Shelby...............................................   113
        Senator Carper...............................................   113
        Senator Akaka................................................   114
            Prepared statement.......................................   142
        Senator Miller...............................................   128
        Senator Corzine..............................................   129
        Senator Johnson..............................................   142

                                   WITNESSES

    Paul A. Volcker, Chairman, International Accounting Standards
      Committee Foundation; Chairman, Arthur Andersen's Independent
      Oversight Board; Former Chairman, Federal Reserve System.......   102
        Prepared statement...........................................   143
    Sir David Tweedie, Chairman, International Accounting Standards
      Board; Former Chairman, United Kingdom's Accounting Standards
      Board..........................................................   107
        Prepared statement...........................................   147

                  Additional Material Supplied for the Record

    Letter from Paul A. Volcker, Chairman, International Accounting
      Standards Committee Foundation; Chairman, Arthur Andersen's
      Independent Oversight Board; Former Chairman, Federal Reserve
      System to Chairman Paul S. Sarbanes, dated May 17, 2002........   159
    Editorial from The Wall Street Journal by Paul A. Volcker,
      Chairman, International Accounting Standards Committee
      Foundation, dated February 19, 2002............................   164
    Memo from Sir David Tweedie, Chairman, International Accounting
      Standards Board; Former Chairman, United Kingdom's Accounting
      Standards Board on Funding of the UK Accounting Standards Board   166
    Article from Sir David Tweedie, Chairman, International
      Accounting Standards Board; Former Chairman, United Kingdom's
      Accounting Standards Board, dated January 2002.................   168

                                  ----------

                           TUESDAY, FEBRUARY 26, 2002

    Opening statement of Chairman Sarbanes...........................   181

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................   183
        Senator Miller...............................................   184
        Senator Enzi.................................................   184
        Senator Stabenow.............................................   186
        Senator Allard...............................................   187
            Prepared statement.......................................   234
        Senator Shelby...............................................   187
            Prepared statement.......................................   234
        Senator Corzine..............................................   188
            Prepared statement.......................................   234
        Senator Schumer..............................................   219

                                   WITNESSES

    Walter P. Schuetze, Chief Accountant, U.S. Securities and
      Exchange Commission, 1992 to 1995..............................   189
        Prepared statement...........................................   235
    Michael H. Sutton, Chief Accountant, U.S. Securities and Exchange
      Commission, 1995 to 1998.......................................   193
        Prepared statement...........................................   239
    Lynn E. Turner, Chief Accountant, U.S. Securities and Exchange
      Commission, 1998 to 2001.......................................   196
        Prepared statement...........................................   243
    Dennis R. Beresford, Former Chairman, Financial Accounting
      Standards Board, 1987 to 1997..................................   201
        Prepared statement...........................................   258
        Response to question raised by Senator Miller................   270

                  Additional Material Supplied for the Record

    Article by Walter P. Schuetze in Abacus, a Journal of Accounting,
      Finance, and Business Studies, ``What Are Assets and
      Liabilities?'' dated February 2001.............................   271
    Article by Walter P. Schuetze, 2001 RJ Chambers Research Lecture,
      dated November 27, 2001........................................   288
    Letter from Walter P. Schuetze to Senator Charles E. Schumer,
      dated March 25, 2002...........................................   296
    Letter with attachments from Lynn E. Turner, Director, College of
      Business, Colorado State University, dated March 1, 2002.......   302

                                  ----------

                          WEDNESDAY, FEBRUARY 27, 2002

    Opening statement of Chairman Sarbanes...........................   341

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................   342
        Senator Miller...............................................   343
        Senator Corzine..............................................   362

                                   WITNESSES

    John H. Biggs, Chairman, President, and CEO, Teachers Insurance
      and Annuity Association-College Retirement Equities Fund (TIAA-
      CREF)..........................................................   343
        Prepared statement...........................................   373
    Ira M. Millstein, Co-Chairman of the Blue Ribbon Committee on
      Improving the Effectiveness of Corporate Audit Committees;
      Senior Partner, Weil, Gotshal & Manges, LLP....................   350
        Prepared statement...........................................   378

                  Additional Material Supplied for the Record

    Miscellaneous exhibits submitted by Ira M. Millstein, Co-Chairman
      of the Blue Ribbon Committee on Improving the Effectiveness of
      Corporate Audit Committees; Senior Partner, Weil, Gotshal &
      Manges, LLP....................................................   388

                                  ----------

                                   VOLUME II

                                  ----------

                             TUESDAY, MARCH 5, 2002

    Opening statement of Chairman Sarbanes...........................   505

    Opening statements, comments, or prepared statements of:
        Senator Bunning..............................................   506
        Senator Dodd.................................................   507
        Senator Miller...............................................   507
        Senator Crapo................................................   508
        Senator Corzine..............................................   508
            Prepared statement.......................................   550
        Senator Stabenow.............................................   515
            Prepared statement.......................................   550
        Senator Bennett..............................................   515

                                   WITNESSES

    David M. Walker, Comptroller General of the United States, U.S.
      General Accounting Office; accompanied by: Thomas McCool,
      Managing Director, Financial Markets and Community Investment;
      and Robert Gramling, Former Director, Corporate Financial
      Audits.........................................................   508
        Prepared statement...........................................   551
    Robert R. Glauber, Chairman and Chief Executive Officer, National
      Association of Securities Dealers, Inc.........................   527
        Prepared statement...........................................   569
    Joel Seligman, Dean and Ethan A.H. Shepley University Professor,
      Washington University School of Law in St. Louis; Public
      Member, American Institute of Certified Public Accountants
      Professional Ethics Executive Committee........................   530
        Prepared statement...........................................   573
    John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia
      University School of Law.......................................   534
        Prepared statement...........................................   582

                  Additional Material Supplied for the Record

    GAO Report, SEC Operations, Increased Workload Creates
      Challenges, dated March 2002...................................   594
    GAO Report, Highlights of GAO's Corporate Governance,
      Transparency and Accountability Forum, dated March 2002........   638
    Business Week article submitted by Senator Paul S. Sarbanes,
      dated March 11, 2002...........................................   653
    The Wall Street Journal article submitted by Senator Robert F.
      Bennett, dated February 25, 2002...............................   654
    Letter from GAO Comptroller General of the United States David M.
      Walker to Senator Paul S. Sarbanes, dated May 3, 2002..........   657
    Letter from John C. Coffee, Jr., Bevis Longstreth, and Joel
      Seligman to Senator Paul S. Sarbanes, dated July 1, 2002.......   670
    Letter from SEC Chairman Harvey L. Pitt to Senator Phil Gramm,
      dated July 3, 2002.............................................   674
    Letter from SEC Attorney General Eliot Spitzer to Senator Paul
      Sarbanes, dated June 5, 2002...................................   676

                                  ----------

                            WEDNESDAY, MARCH 6, 2002

    Opening statement of Chairman Sarbanes...........................   679

    Statement of Senator Gramm.......................................   680

                                   WITNESSES

    Shaun F. O'Malley, Chairman, 2000 Public Oversight Board Panel on
      Audit Effectiveness (O'Malley Commission); Former Chairman,
      Price Waterhouse; Past President, Financial Accounting
      Foundation.....................................................   681
        Prepared statement...........................................   716
    Lee J. Seidler, Deputy Chairman of the 1978 AICPA Commission on
      Auditors' Responsibilities; Managing Director Emeritus, Bear
      Stearns........................................................   685
        Prepared statement...........................................   725
    Arthur R. Wyatt, CPA, Former Chairman, American Institute of
      Certified Public Accountants' Accounting Standards Executive
      Committee; Former Chairman, International Accounting Standards
      Committee; Former Partner, Arthur Andersen & Co.; Professor of
      Accountancy Emeritus, University of Illinois...................   689
        Prepared statement...........................................   739
    Abraham J. Briloff, Emanuel Saxe Distinguished Professor
      Emeritus, Bernard M. Baruch College, CUNY......................   692
        Prepared statement...........................................   745
    Bevis Longstreth, Member of the O'Malley Commission; Former
      Commissioner of the Securities & Exchange Commission, 1981-
      1984; Retired Partner, Debevoise & Plimpton....................   696
        Prepared statement...........................................   793

                  Additional Material Supplied for the Record

    Letter from Chairman Paul S. Sarbanes to President George W.
      Bush, dated March 6, 2002......................................   802
    Letter from the National Association of State Boards of
      Accountancy to Chairman Paul S. Sarbanes and Members of the
      Banking Committee, dated March 22, 2002........................   804

                                  ----------

                            THURSDAY, MARCH 14, 2002

    Opening statement of Chairman Sarbanes...........................   809

    Opening statements, comments, or prepared statements of:
        Senator Bunning..............................................   811
        Senator Gramm................................................   811
        Senator Corzine..............................................   813
        Senator Enzi.................................................   813
        Senator Dodd.................................................   815
        Senator Bayh.................................................   816
        Senator Stabenow.............................................   817
            Prepared statement.......................................   860
        Senator Miller...............................................   817
        Senator Carper...............................................   842

                                   WITNESSES

    James G. Castellano, CPA, Chairman, Board of Directors, American
      Institute of Certified Public Accountants (AICPA); Managing
      Partner, Rubin, Brown, Gornstein & Company, LLP................   818
        Prepared statement...........................................   860
        Response to written question of Senator Miller...............   888
    James E. Copeland, Jr., CPA, Chief Executive Officer, Deloitte &
      Touche, LLP....................................................   820
        Prepared statement...........................................   862
    William E. Balhoff, CPA, CFE, Chairman, Executive Committee,
      AICPA Public Company Practice Section; Senior Audit Director,
      Postlethwaite & Netterville, A.P.A.C...........................   823
        Prepared statement...........................................   865
    Olivia F. Kirtley, CPA, Former Chairman, Board of Directors,
      AICPA (1998-1999); Retired Vice President and CFO, Vermont
      American Corporation...........................................   825
        Prepared statement...........................................   866
    James S. Gerson, CPA, Chairman, Auditing Standards Board, AICPA;
      Partner, PricewaterhouseCoopers, LLP...........................   827
        Prepared statement...........................................   868
    Robert E. Litan, Vice President and Director, Economic Studies
      Program, The Brookings Institution.............................   848
        Prepared statement...........................................   870
        Response to written question of:
            Senator Gramm............................................   889
            Senator Miller...........................................   890
    Peter J. Wallison, Resident Fellow and Co-Director, Project on
      Financial Market Deregulation, American Enterprise Institute...   853
        Prepared statement...........................................   879

                                  ----------

                            TUESDAY, MARCH 19, 2002

    Opening statement of Chairman Sarbanes...........................   893

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................   894
            Prepared statement.......................................   939
        Senator Corzine..............................................   894
        Senator Dodd.................................................   917
        Senator Carper...............................................   936
        Senator Akaka................................................   939

                                   WITNESSES

    Charles A. Bowsher, Chairman, Public Oversight Board; Former
      Comptroller General of the United States; accompanied by: Alan
      B. Levenson, Counsel to the Public Oversight Board.............   895
        Prepared statement...........................................   939
    Aulana L. Peters, Member, Public Oversight Board; Former
      Commissioner, U.S. Securities and Exchange Commission; Retired
      Partner, Gibson, Dunn & Crutcher...............................   902
        Prepared statement...........................................   963
    John C. Whitehead, Former Co-Chairman, Goldman Sachs & Co.;
      Former Deputy Secretary of State...............................   918
        Prepared statement...........................................   965
    L. William Seidman, Former Chairman, Federal Deposit Insurance
      Corporation; Former Chairman, Resolution Trust Corporation.....   921
        Prepared statement...........................................   967
    Michael Mayo, Managing Director, Prudential Securities, Inc......   925
        Prepared statement...........................................   969

                  Additional Material Supplied for the Record

    The Road to Reform, a White Paper from the Public Oversight
      Board, dated March 19, 2002....................................   973
    Letter from Harvey L. Pitt, Chairman, U.S. Securities and
      Exchange Commission to Charles A. Bowsher, Chairman, Public
      Oversight Board, dated January 22, 2002........................   994
    Fortune news article, The Price of Being Right, dated February 5,
      2001...........................................................   996

                                  ----------

                           WEDNESDAY, MARCH 20, 2002

    Opening statement of Chairman Sarbanes...........................  1003

    Opening statements, comments, or prepared statements of:
        Senator Akaka................................................  1004

                                   WITNESSES

    Senator Howard M. Metzenbaum (Ret.), Chairman, Consumer
      Federation of America..........................................  1004
        Prepared statement...........................................  1032
    Sarah Teslik, Executive Director, Council of Institutional
      Investors......................................................  1009
        Prepared statement...........................................  1040
        Response to written questions of Senator Akaka...............  1056
    Thomas A. Bowman, CFA, President and Chief Executive Officer,
      Association for Investment Management and Research.............  1012
        Prepared statement...........................................  1043
    Damon A. Silvers, Associate General Counsel, American Federation
      of Labor and Congress of Industrial Organizations..............  1016
        Prepared statement...........................................  1053

                                  ----------

                            THURSDAY, MARCH 21, 2002

    Opening statement of Chairman Sarbanes...........................  1059

    Opening statements, comments, or prepared statements of:
        Senator Dodd.................................................  1060
        Senator Bunning..............................................  1060
        Senator Corzine..............................................  1061
        Senator Enzi.................................................  1062
        Senator Gramm................................................  1064
        Senator Bennett..............................................  1084
        Senator Schumer..............................................  1087
        Senator Carper...............................................  1089
        Senator Johnson..............................................  1102

                                    WITNESS

    Harvey L. Pitt, Chairman, U.S. Securities and Exchange Commission  1065
        Prepared statement...........................................  1103

                  Additional Material Supplied for the Record

    The Washington Post article, submitted by Harvey L. Pitt,
      Chairman, U.S. Securities and Exchange Commission, dated
      November 15, 2000..............................................  1167
    Letter from Stephen M. Cutler, Director, Division of Enforcement,
      U.S. Securities and Exchange Commission, to Chairman Paul S.
      Sarbanes and Congressman Michael G. Oxley, dated July 23, 2002.  1168

                                  ----------

                                   VOLUME III

                                  ----------

                              MONDAY, JULY 8, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1171

                                  ----------

                             TUESDAY, JULY 9, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1225
    Continuation of the Senate Floor Debate in Regard to the
      Accounting Reform and Investor Protection Act of 2002 taken
      from the Congressional Record..................................  1247

                                  ----------

                            WEDNESDAY, JULY 10, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1261

                                  ----------

                             THURDAY, JULY 11, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1355
    Continuation of the Senate Floor Debate in Regard to the
      Accounting Reform and Investor Protection Act of 2002 taken
      from the Congressional Record..................................  1387

                                  ----------

                             FRIDAY, JULY 12, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1423
    Continuation of the Senate Floor Debate in Regard to the
      Accounting Reform and Investor Protection Act of 2002 taken
      from the Congressional Record..................................  1429

                                  ----------

                             MONDAY, JULY 15, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1463

                                  ----------

                            THURSDAY, JULY 25, 2002

    Senate Floor Debate in Regard to the Sarbanes-Oxley Act of 2002
      Conference Report taken from the Congressional Record..........  1613
                                  ----------

                                   VOLUME IV

                                  ----------
    Transcript of President Bush's remarks at the Signing Ceremony
      for the Sarbanes-Oxley Act of 2002 on July 30, 2002............  1653
    The Sarbanes-Oxley Act of 2002, Public Law 107-204 signed by
      President Bush on July 30, 2002. Text is identical to
      Conference Report on H.R. 3763 passed by the House of
      Representatives on July 25, 2002, by a vote of 423 Yeas to 3
      Nays and by the Senate by a vote of 99 Yeas to 0 Nays..........  1657

    H.R. 5118, Corporate Fraud Accountability Act of 2002, passed by
      the House of Representatives on July 16, 2002, by a vote of 391
      Yeas to 28 Nays................................................  1723

    S. 2673, Public Company Accounting Reform and Investor Protection
      Act of 2002, passed by the Senate on July 15, 2002, by a vote
      of 97 Yeas to 0 Nays. For procedural purposes, the bill is
      renamed H.R. 3763..............................................  1737

    Senate Committee on Banking, Housing, and Urban Affairs report on
      S. 2673, Public Company Accounting Reform and Investor
      Protection Act of 2002, filed by Chairman Sarbanes on June 26,
      2002...........................................................  1879

    S. 2673, Public Company Accounting Reform and Investor Protection
      Act of 2002, passed by the Senate Committee on Banking,
      Housing, and Urban Affairs on June 18, 2002, by a vote of 17
      Yeas to 4 Nays.................................................  1953

    Senate Committee on the Judiciary Report on S. 2010, Corporate
      and Criminal Fraud Accountability Act of 2002, filed by
      Chairman Leahy on May 6, 2002..................................  2071

    S. 2010, Corporate and Criminal Fraud Accountability Act of 2002,
      passed by the Senate Judiciary Committee on April 25, 2002, by
      a vote of 19 Yeas to 0 Nays....................................  2109

    H.R. 3763, Corporate and Auditing Accountability, Responsibility,
      and Transparency Act of 2002, passed by the House of
      Representatives on April 24, 2002, by a vote of 334 Yeas to 90
      Nays...........................................................  2135

    House Committee on Financial Services Report on H.R. 3763,
      Corporate and Auditing Accountability, Responsibility, and
      Transparency Act of 2002, dated April 22, 2002.................  2193

    H.R. 3763, Corporate and Auditing Accountability, Responsibility,
      and Transparency Act of 2002, passed by the House Committee on
      Financial Services on April 16, 2002, by a vote of 49 Yeas to
      12 Nays........................................................  2257

                             ACCOUNTING REFORM AND
                              INVESTOR PROTECTION

                                  ----------

                                    VOLUME I

                                  ----------

                           TUESDAY, FEBRUARY 12, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:10 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, the Senate Committee on Banking, Housing, and
    Urban Affairs conducts the first in a series of hearings that
    have been scheduled and are being scheduled on accounting and
    investor protection issues raised by the problems of Enron
    Corporation and other public companies. These issues have taken
    on increasing significance in recent years and Enron's
    situation has, of course, placed them in the national
    spotlight. They have a critical impact on the national
    confidence in the financial markets.
        In 2000, Enron Corporation was among the top 10 of the
    Fortune 500 and had a stock market value of over $60 billion.
    Its financial statements had been audited and certified by one
    of the major public accounting firms, Arthur Andersen. Stock
    analysts glowingly recommended its stock.
        On October 16 of last year, Enron took a billion dollar
    write-down of investments. On November 8, Enron reported that
    it had overstated earnings since 1997 by $586 million. On
    December 2, Enron filed for bankruptcy.
        The stunning collapse of Enron has cast a long and dark
    shadow over our capital markets, crowding other important
    stories off the business pages and creating widespread anxiety.
    Headlines like: ``Worries of More Enrons To Come Give Prices A
    Pounding,'' The New York Times, January 30; and ``Nervous and
    Scandal-Shy Investors Hold Prices Down,'' The New York Times,
    February 6, have become routine. The Baltimore Sun just 2 days
    ago has: ``Investors Squeamish Amid Turmoil.'' And you can pick
    up virtually any paper in the country and see comparable
    headlines.
        A troubled and uncertain economy is further aggravated by
    what is widely referred to as the ``Enron Effect.'' The
    enormity of the losses that Enron employees have suffered in
    their retirement
    savings has sent shockwaves through working men and women
    everywhere. As The Washington Post put it, if one company
    ``issued make-believe accounts, why should anyone believe that
    dozens of other companies aren't practicing the same
    deception?''
        The failure of Enron raises numerous important issues that
    have arisen on occasion in connection with other public
    companies as well. These involve: The integrity of certified
    financial audits; appropriate accounting principles and
    auditing standards; the effectiveness of the accounting
    regulatory oversight system; the impact of auditor independence
    on the quality of audits; the completeness of corporate
    disclosure in SEC filings and shareholder communications; the
    adequacy of the SEC's ``selective review'' process for
    disclosures filed by public companies with novel and complex
    finances; conflicts of interest among affiliated securities
    underwriters, stock analysts, and lenders, as well as
    accountants; insider abuses; the clarity of recommendations by
    stock analysts; corporate governance; the quality of agencies'
    debt ratings; and the adequacy of resources available to the
    Securities and Exchange Commission to meet its
    responsibilities.
        The Committee will hear from a broad array of witnesses
    with long and distinguished experience in the relevant fields,
    in both the public and private sectors. We will seek their
    views on the developments that made the collapse of Enron and
    other significant failures possible. Above all, we will seek
    their recommendations as to appropriate steps this Committee
    might take to minimize the prospect of any future event of this
    type.
        The Committee's inquiry in the weeks ahead will focus on
    the protection of investors and the efficient functioning of
    our capital markets. These markets are critical to a healthy
    economy and, indeed, to our national economic strength at a
    time when our Nation faces unprecedented challenges.
        It is commonplace, but nonetheless worth repeating, that
    our markets depend on investors' confidence. As The Washington
    Post, among others, has pointed out in an editorial on January
    24, it is the public trust that allows our Nation's vaunted
    markets to function. As investors make the financial decisions
    that significantly shape their lives and assure their families'
    well-being, they must be able to rely on information available
    to them as being complete, accurate, timely, and
    comprehensible.
        Today, for the first time in our Nation's history, a
    majority of Americans are investors, either directly or
    indirectly--a development in which our markets take great and
    understandable pride.
        As we proceed with our work, we must keep in mind that
    although many of the issues we will be examining in the weeks
    ahead are highly complex, they have implications that are
    critical to the security of the American investing public. They
    reach the fundamental principles of trust, which it is our duty
    to protect and strengthen.
        We are very pleased this morning to have this panel of very
    distinguished witnesses to share their views on the current
    situation and to offer recommendations for minimizing the
    likelihood of similar problems in the future.
        I will introduce each of them as we proceed through the
    panel. But I simply want to say that we have the former
    Chairmen of the Securities and Exchange Commission over the
    last quarter of a century here with us this morning. We very
    much appreciate the effort, time, and thought which has
    obviously gone into the prepared statements that have been
    submitted, and we are very much looking forward to this panel.
        At this point, I will yield to my colleagues for any
    opening statements they may have.
        Senator Shelby.

                 STATEMENT OF SENATOR RICHARD C. SHELBY

        Senator Shelby. Thank you, Mr. Chairman. I commend you for
    holding this hearing. It will be the first of many, I hope, to
    get to the bottom of a real problem.
        I think that everyone recognizes that the Enron story is
    what has focused our attention and led to today's hearings. I
    am hopeful that the present investigations will uncover the
    facts and lead to the appropriate sanctions and perhaps
    prosecutions.
        The Enron story is just one chapter in a larger book. Its
    collapse is just one indication of the existence of much larger
    problems. Enron highlights systemic issues which merit
    consideration.
        Over the last few years, a troubling pattern has developed.
    Time and again we have heard of public corporations having to
    restate the financial information they provided to the
    investing public.
        These recalculations have not been made because the
    corporations were too conservative in their assessments. Indeed
    not. What we have seen are corporations admitting that revenues
    were not as large, that expenses and losses were not as small,
    and that, in the end, things were really not as good as had
    been initially indicated. This seems to be a corporate scheme
    to trick the investors.
        That public companies would try to make things sound as
    positive as they can to the investing public does not surprise
    me. Obviously, they have a strong interest in driving up their
    share prices.
        This self-interest, however, has long been recognized. To
    counter it, our financial markets have traditionally relied on
    the independent, objective analysis of audits performed by
    certified public accountants.
        The outside audit gave investors confidence that corporate
    numbers did not come from the Land of Make Believe. Investors
    could make decisions knowing that, for whatever risks they were
    taking, at least the financial information had been reviewed
    and certified as true by an unbiased party.
        Regrettably, Mr. Chairman, growing doubt is replacing
    investor confidence regarding the accuracy of financial
    information. The trend of restatements and audit failures has
    put the independence and objectivity of outside auditors in
    question. In far too many cases, the numbers have just not
    added up.
        There are serious consequences associated with this
    situation. First, real people have lost real money because they
    relied on information that later proved to be inaccurate, if
    not outright false. Look at the Enron situation. Billions of
    dollars of market value have been wiped out and investors and
    creditors will get back very little of what they put into the
    company.
        Unfortunately, Enron is only the tip of the iceberg. Some
    experts have estimated that investors have lost almost $200
    billion over the last 6 years due to earnings restatements and
    to lost market capitalization following audit failures.
        It must be noted, Mr. Chairman, that some amount of that
    $200 billion represents retirement savings, investments for
    children's educations--the financial hopes and dreams of
    thousands of Americans--all gone after the follow-up stroke of
    an accountant's pen.
        Mr. Chairman, there are additional but perhaps less
    tangible losses associated with the unchecked flow of bad
    financial information in the marketplace. When some companies
    put out inaccurate information about their financial condition,
    investors cannot make informed investment decisions. They make
    choices based on appearances instead of reality. What results
    is that good companies that provide useful goods and services
    fail to attract their fair share of capital because less
    valuable companies look better on paper. Our society suffers
    because the development of new and better products and services
    are delayed or perhaps never occurs.
        When auditing failures result in good investments on paper
    being bad investments in reality, capital does not flow to its
    best use, the market does not properly reward innovation, and
    over time, the firms that lose out themselves see the value of
    cooking the books.
        Mr. Chairman, the unchecked flow of bad financial
    information in the marketplace has a final and perhaps most
    devastating effect: It destroys investor confidence.
        If people believe that the markets are rigged, if they
    believe that some have greater access to crucial information,
    if they cannot trust the information that is available to them,
    they will walk away. They will stop investing. They stop
    participating.
        Our economy has provided the best material standard of
    living in the world because the goal of our laws and
    regulations has been to favor clarity over complexity,
    disclosure over dissembling, and fairness over favoritism.
        Mr. Chairman, it would seem that the important goals we
    once established are no longer being met. Audits no longer
    consistently provide the type of accurate information that the
    markets require.
        At the end of the day, I believe it is our responsibility
    to do something about this serious problem.
        Chairman Sarbanes. Thank you very much, Senator Shelby.
        Senator Miller.

                    COMMENTS OF SENATOR ZELL MILLER

        Senator Miller. Thank you, Mr. Chairman, for conducting
    this hearing and I thank these distinguished panelists.
        I am going to pass on an opening statement, but I look
    forward to asking some questions after we hear from them.
        Chairman Sarbanes. Thank you very much.
        Senator Enzi.

                  STATEMENT OF SENATOR MICHAEL B. ENZI

        Senator Enzi. Mr. Chairman, I appreciate your holding
    today's hearing and especially collecting the brain power of
    every living Chairman of the SEC since 1975. It is very
    impressive and should be extremely helpful to us.
        In the Enron case, of course, we are still in the finger-
    pointing stage. There are enough fingers being pointed in
    enough directions to cover almost everybody. I am anxious for
    us to get through the investigation-reporting stage and get to
    some reasonable solutions.
        And by reasonable solutions, I am hoping they are not
    artificial actions that will give the investor over-confidence,
    and I am also hoping that it won't be an over-reaction that
    will cause problems for companies and force them into a
    situation like we are seeing.
        The rise and the fall of this company is complex and
    confusing. From a visible standpoint, it happened over just a
    couple of months and is pretty astonishing, even though the
    troubles developed much earlier and probably should have been
    caught much earlier.
        As more and more details become apparent, we know that
    complex accounting gimmicks with partnerships overstated
    earnings by hundreds of millions of dollars and hid additional
    debt of over a billion dollars, and this was all at the same
    time that the executives at Enron were deriving tens of
    millions of dollars of compensation from these same corporate
    partnerships.
        This was happening as the investors and employees were
    being misled into investing their money in the company. What is
    even more troubling is that the company's executives had to
    know these problems would be realized at some point. They had
    to know that the masquerade could not go on forever. However,
    instead of being forthright, company officials were often
    uncommunicative and arrogant during conference calls with
    analysts. And if an analyst asked a question the company did
    not feel they should answer, they would simply accuse the
    analyst of being unknowledgeable and did not know what he was
    talking about. This should have raised eyebrows through the
    analyst community.
        Enron is a situation where the system failed at every step.
    The executives misled everyone, the board did not catch it, the
    auditing firm neglected to do their duty adequately, the
    credit-rating agencies did not fully understand the financial
    position of the company when they gave Enron an investment-
    grade rating and, as I already mentioned, the analyst community
    did not lower their rating on the company when they refused to
    answer questions.
        Today, we need some insight from the SEC. In 1995, Enron
    had revenues of $9.2 billion. In 1999, they were $40 billion
    and then made an astounding jump in 2000 of over $100 billion.
    Why, with this incredible increase in revenues didn't Enron
    have audits reviewed more frequently?
        I understand that companies in the economy overall were
    showing incredible growth. But over a 10 year period, Enron had
    returns a thousand percent higher than the S&P 500 as a whole.
    Shouldn't this have sounded alarms to almost everyone?
        Mr. Chairman, details are slowly emerging from this crisis.
    I have every confidence that our enforcement agencies at the
    SEC and the Department of Justice will prosecute any executives
    who violated existing laws. However, I join all of my
    colleagues in committing that we will take the necessary steps
    to protect investors and ensure them that they can once again
    be confident in placing their investments in markets.
        We will take the necessary actions to strengthen laws where
    needed and to make new laws if necessary.
        Again, I thank the Chairman for beginning the process and
    in bringing this distinguished panel to us.
        Chairman Sarbanes. Thank you, Senator Enzi.
        Senator Corzine.

                  STATEMENT OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman. I commend you for
    holding this hearing and the process that we are about to begin
    to work through the problems that we have been faced with that
    are, I think, revealed by the Enron debacle.
        Let me also begin by commending and thanking the witnesses
    that are here. It is an extraordinary panel. Your work to
    prepare for this hearing is exceptional and I want to
    compliment you on the service you have given our Nation in
    serving as Chairmen of the Securities and Exchange Commission.
        It is time to move from the blame game into, in my view,
    coming up with the right kind of responses that do not inhibit
    our financial system and our ability to work well, but also
    restore the kind of investor confidence that I think people
    expect from America's public companies and is a necessary
    element to the effective functioning of our financial markets.
    I certainly believe we need to find the right balance in all of
    the issues. I would just mention a few of them that certainly
    concern me.
        I think that we need to certainly restore the independence
    of the outside auditors. Not only the auditors, but also other
    outside analysts and commentators with regard to corporate
    valuation, corporate reporting.
        We certainly need to improve the oversight of the auditing
    industry and there are different ways to review that and I
    certainly look forward to hearing the comments of the witnesses
    who have the experience along this line.
        We need to upgrade the independence and I believe the
    public's confidence in the corporate governance. We believe in
    corporate democracy. We have to have a corporate governance
    system that is reflective of that and in a sincere and serious
    way.
        We need to provide adequate resources so the SEC can
    actually do its job. It has many authorities, but without the
    resources, I think we have a hard time expecting people to do
    the job the way that they are expected to, troubled by the
    current flat allocation of budget resources to that.
        I certainly look forward to questioning what kinds of
    resources are necessary and where you think we ought to go with
    that. And then there is the whole issue of speed and
    facilitation and clarity with which accounting rules are
    developed and provided.
        I, being a student from time to time, know that these are
    difficult to understand even by those most trained and I
    certainly hope to hear your comments with regard to these
    issues and a number of others.
        We have kind of had a train wreck in this country, maybe a
    number of them. We focus on one company, but there has been a
    series of these and the restatement issues that several of my
    colleagues have mentioned is a troubling aspect. I think we
    ought to take this opportunity to be thoughtful and reflective
    and come up with balanced reforms.
        I certainly look forward to working with the Committee, the
    Chairman, Senator Dodd, with all of you to try to get that
    right balance and sense of direction that we should follow in
    this.
        Mr. Chairman, thank you very much.
        Chairman Sarbanes. Thank you, Senator Corzine.
        Senator Hagel.

                    COMMENTS OF SENATOR CHUCK HAGEL

        Senator Hagel. Mr. Chairman, thank you.
        I also want to welcome our distinguished panel of witnesses
    and thank them for taking their time to be with us this
    morning.
        Mr. Chairman, I look forward to their testimony.
        Chairman Sarbanes. Thank you very much.
        Senator Stabenow.

                  STATEMENT OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Thank you, Mr. Chairman, and to all of
    our guests today for your input. We very much need your
    thoughtful suggestions and input to us.
        I want to thank the Chairman for your thoughtful and
    thorough approach that you are taking to this very difficult
    challenge of reassessing the accounting and consulting
    industry.
        The issues that are going to be raised in the next 6 weeks
    I think are critically important to the Nation. And in
    particular, we must work to insure that the public can receive
    useful and reliable information before they make investment
    decisions, as my colleagues have said.
        Unless we assure that companies provide accurate
    information that is widely available to all potential
    investors, we are allowing companies to jeopardize the American
    people's retirement funds. And of course, we have seen that
    most recently with Enron.
        Whether the unraveling scandal reveals intentional fraud
    and deception of a criminal nature or not, it is clear that the
    information available was not enough for the public to make
    informed investment decisions.
        Now more than ever, with about half of the American public
    invested in the stock market, we need accounting information to
    be accurate, to say the least.
        Investing in the market is becoming a necessity for
    people's long-term economic security. And the Enron scandal was
    not just an event unique to Houston or Texas, but of course we
    know that there has been a ripple effect across the country.
        In fact, in Michigan, the Genessee County Employees Pension
    Fund lost $370,000 on Enron's fall, and I know that there were
    hundreds of thousands of dollars that were lost in other
    pension funds, not to mention the employees who lost their life
    savings.
        How can people have confidence in the market if they are
    not given accurate information? Obviously, they cannot.
        The fate of thousands of people's life savings is too
    important for us not to act, and that is why I very much
    appreciate this hearing.
        Mr. Chairman, I hope that once we move beyond the
    discussions to eventual legislation, that we will be able to
    look at a number of different issues. I hope we will discuss
    whistleblower protections. In the case of Enron, it appears
    that many people in the company knew what was going on was
    wrong, but were stuck in the corporate culture that prevented
    them from coming forward. And I would like to know what
    suggestions you would have for us to address that.
        We must examine the issue of the correct regulatory system
    for the industry, as we all know. It is clear that there are
    serious problems that have been raised by the many stories
    about insufficient oversight and regulatory authority,
    problematic audits of consulting companies by other consulting
    companies, and the degree to which it is appropriate for
    companies to offer auditing and consulting services to the same
    client.
        I look forward to the input today. Mr. Chairman, I look
    forward to the next 6 weeks and I am hopeful that we will be
    able to arrive at some thoughtful and just responses that will
    protect the investment security of the American public.
        Chairman Sarbanes. That is certainly our objective. Thank
    you very much, Senator Stabenow.
        Senator Bayh.

                     COMMENTS OF SENATOR EVAN BAYH

        Senator Bayh. Thank you, Mr. Chairman, for holding these
    hearings. I want to compliment you and Senator Shelby on
    particularly comprehensive opening statements. I think you
    framed the issues before us today very well.
        Because of that and the other comments by our colleagues, I
    find myself in the position of a Member of the House of
    Representatives who recently rose on the floor of that body to
    say--I rise to restate that which has already been restated.
        [Laughter.]
        So, I do not want to follow in that pattern today. I will
    limit my comments to three things.
        First, I would also like to thank the panelists for being
    with us today. Each of them are eminent public servants and we
    are grateful for your time and your insights.
        Second, obviously the integrity of the financial data
    available to the public is the foundation upon which our
    financial system is constructed. And when there are questions
    about that foundation, the costs are great, not only for the
    individuals immediately impacted, but also for the system as a
    whole.
        Finally, it seems to me that the balance, Mr. Chairman, we
    are seeking to strike is between putting into place safeguards
    that try to ensure that the tragedy of Enron can never happen
    again with the losses to individuals in the system entailed by
    that on the one hand, and on the other hand, not unduly raising
    costs to the vast majority of honest business people and
    participants in the marketplace, because those costs would be
    felt by investors as well.
        I am keenly interested in your insights, gentlemen, about
    how to strike that appropriate balance to preserve the
    integrity of the financial data and at the same time not unduly
    increasing costs to the system as well. I look forward to your
    comments.
        Mr. Chairman, I thank you.
        Chairman Sarbanes. Thank you, Senator Bayh.
        Senator Carper.

                  COMMENTS OF SENATOR THOMAS R. CARPER

        Senator Carper. In about 26 minutes, I get to preside over
    the Senate. And rather than me giving a speech and telling you
    what I think we ought to do, I am anxious to hear what you
    think we ought to do.
        We are delighted that you are here and for each of you,
    thank you for your stewardship and service to our country. I do
    not know if there has ever been a time that the five of you
    have been together like this. So this might be historic just in
    and of itself.
        The only other thing I would add is that when I am trying
    to make a tough decision, I try to surround myself with people
    that are smarter than me. My wife says it is not hard to find
    them.
        [Laughter.]
        We have five smart people here, Mr. Chairman. My hope is
    that we will come out of this hearing with a confluence of
    opinion, where we can find those areas where there is
    agreement, and that will enable us to go forward, whether we
    act legislatively or regulatorily, or we simply let the
    industry take the appropriate policing action.
        But my hope is that from your mouths, from your words, will
    come the foundation for a very good consensus of what we know
    is an important and tough issue.
        Thank you.
        Chairman Sarbanes. Thank you, Senator Carper.
        Senator Johnson.

                    STATEMENT OF SENATOR TIM JOHNSON

        Senator Johnson. Thank you, Mr. Chairman, for holding this
    timely hearing and welcome to our distinguished panel.
        I will abbreviate my comments because we do need to
    expedite things to get to the panelists themselves. But let me
    note that aside from accounting issues, and we could go on at
    some length about that this morning, another area of special
    concern to me is the conduct of securities analysts and their
    impact on the market.
        In the case of Enron, we saw analysts turn a blind eye to
    the emerging problems, possibly due to conflicts of interest
    because of affiliations with investment banking operations.
    Clearly, the firewall that should have provided an environment
    of independence for analysts did not function in many
    instances.
        The SEC, I believe, must be aggressive in enforcing our
    securities laws and in keeping our markets the most transparent
    in the world. I am deeply concerned that the SEC has not been
    given the resources to maintain a sufficient and stable human
    resource base to fulfill its mission. Over one thousand SEC
    employees, more than a third of the agency's staff, has quit
    over the past 3 years, largely due to the low pay scale at the
    SEC compared to other financial regulators in the private
    sector. As any business person knows, that kind of turnover has
    a clear impact on the institution's ability to operate
    effectively.
        Just before Christmas, the Senate passed H.R. 1088, the
    Investor and Capital Markets Fee Relief Act, which President
    Bush has now signed into law. In addition to reducing
    securities transactions registration fees, the law authorized
    the SEC to bring the pay of its employees in line with the
    higher pay schedules of other Federal financial regulators.
        Mr. Chairman, I was profoundly disappointed to find that
    the President's budget failed to include additional amounts for
    SEC salaries for fiscal year 2003, as was envisioned by the
    Congress when we enacted that legislation.
        It is no overstatement to say that a strong SEC is an
    integral part of our homeland security. And money needs to be
    made available to ensure that the guardians of our markets are
    not paid less than those minding our banks. It is my hope that
    we can engage in a dialogue with the Executive Branch to
    address the pay parity issue and to create an environment at
    the SEC that enables employees to contribute to the economic
    security of our Nation.
        In closing, I would like to note that Mr. Levitt was ahead
    of his time by attempting to address many of these issues
    during his SEC tenure. At the time I supported Mr. Levitt's
    proposal to create strict guidelines governing the consulting
    role of companies' auditors, and I am pleased that the private
    sector and my colleagues are coming to understand the wisdom of
    that proposal.
        In addition, it is my understanding that a study was
    initiated to determine whether the peer-review process employed
    by auditors was appropriate and effective. Clearly, though,
    much more needs to be done.
        I want to thank the witnesses and thank the Chairman for
    this timely hearing.
        Chairman Sarbanes. Thank you.
        Senator Schumer.

                STATEMENT OF SENATOR CHARLES E. SCHUMER

        Senator Schumer. Thank you, Mr. Chairman.
        I want to add my thanks to you for holding this hearing and
    to all of our witnesses today. The witnesses here have a great
    legacy, which is the creation of capital markets that are the
    envy of the world.
        Since the Great Depression, when we decided that regulation
    was necessary for growth of the markets, our country has really
    reached a balance between regulation and free market
    competition that has not just produced public confidence, but
    also a great deal of trust. And it is not an accident that
    billions and maybe even trillions of dollars from the rest of
    the world flow to our capital markets. It is mainly because
    people think they are on the level, that there is trust.
        One of the great worries I guess that all of us have here
    today is that that trust has been eroded. That is a cancer to
    the markets and we have to do everything we can to restore it,
    because if people do not think that they are on the level and
    do not invest in them, that is probably the greatest problem
    that these markets can face.
        I am not going to get into a whole lot of detail, either,
    Mr. Chairman. I know we have a vote. Just to make a couple of
    points.
        First of all, I think that disclosure, which has been the
    hallmark of the SEC, has to be strengthened. There are a lot of
    ways that we can do that. One of them that we should look at is
    building on the Regulation FD that Chairman Levitt had
    advocated.
        People should know when senior executives are selling stock
    and they should know it right away, and then they can make
    their own judgment. But at least that makes sense.
        Disclosure also of all of these special entities,
    everything about them should be far more public than it is now.
    I think that is an important thing to do as well.
        Then we will have to go beyond disclosure, obviously. But I
    think disclosure is sort of a sine qua non, and that is one of
    the problems. If everyone knew about all of this sooner, all
    the problems might not have happened.
        Then, again, trying to, as we always have to every so often
    in the free market system, sort of readjust the balance. And it
    clearly needs some readjustment now. I hope that the kinds of
    things that we have seen Enron do are not widespread.
        The fact that we saw some of them at PNC, the banking
    industry is one of the most highly regulated, and that gives me
    cause for concern.
        I very much look forward to hearing the testimony of all of
    the witnesses today.
        Chairman Sarbanes. Thank you very much.
        Senator Dodd.

                STATEMENT OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Thank you very much, Mr. Chairman. I
    apologize for getting here a few minutes late. We have hearings
    downstairs on early childhood education, which I know is an
    important subject matter for all of you here as well.
        Mr. Chairman, first of all, thank you for today's hearing.
    I know there are a lot of other hearings going around on
    Capitol Hill this morning, last week, next week, delving into
    what happened. But this hearing and the hearings that you have
    scheduled I think may be the most important in many ways, as
    well as the hearings we had last week on financial literacy
    which Senator Corzine, yourself, and others have spent a lot of
    time talking about, because this is forward-looking.
        Obviously, we have to know what happened in order to make
    suggestions about what we should do. But bringing in people
    such as the panel here today is going to be tremendously
    helpful I think in helping us frame those ideas.
        The collapse of Enron has wiped out the life savings of an
    awful lot of good people. Thousands and thousands of dollars
    have been lost. It has unsettled America's capital markets. It
    has shaken investor confidence.
        We saw the market reaction last week, although yesterday,
    the markets seemed to rebound a little bit. But we won't know
    for some time how shaken the markets have been as a result of
    what has occurred.
        Of particular importance to this Committee, the Enron
    bankruptcy, has called into question the fundamental rules and
    regulations that oversee America's financial system, and
    therefore, the importance of this hearing and listening to our
    panel.
        If there is a silver lining in all of this, however, and we
    always try to find silver linings, I suppose, in the dark cloud
    here created by this huge bankruptcy, it may be that it will
    pave the way for some reforms that will not only reduce the
    chance of future Enrons, but also strengthen the American
    economy.
        A top priority for the Congress and this Committee must be
    swift action on these reforms. I suspect we would not even be
    talking about these issues, unfortunately, were it not for the
    kind of situation that has occurred.
        America's financial markets remain the most vibrant in the
    world. And the reason for this has been very simple. The
    Chairman has talked about this over the years, others have as
    well. And in my view, it is the simple notion of investor
    confidence.
        The world comes to America, not because you have the
    potential best return on your investment, but because they
    believe that the rules are fair and the people are treated
    fairly. That has been the cornerstone of our success over the
    years. The integrity and accuracy of information made available
    to the public has been critical to that conclusion.
        The world comes to America because they know our numbers
    are good and they will receive a fair deal. The independence of
    the audit function has placed I think a very vital role in
    attaining and ensuring this investor confidence. The seal of
    approval provided by accounting firms has constituted a
    franchise held in very high regard by the public, and
    deservedly so. However, that franchise is in real danger of
    losing the investing public's trust.
        Once lost, that trust will be very, very difficult, if not
    impossible in some cases, to recover. It would have grave
    consequences, in my view, not only for the accounting
    profession, but also far more importantly in many ways, for the
    investor confidence that is the cornerstone of our financial
    markets.
        In recent years, there have been a series of high-profile
    accounting failures, of which the Enron case is but the most
    prominent and the most highly publicized.
        A recent study by the Financial Executives International
    Trade Group for Corporate Executives found that public
    companies had revised their financial results 464 times between
    1998 and the year 2000, nearly as many restatements as in the
    past 20 years combined. These restatements have, in most
    instances, dramatically downgraded the financial health of the
    companies in question, costing shareholders billions of
    dollars.
        The ability of the accounting firms to audit a company's
    books while at the same time selling it other services, has
    created a significant risk in conflicts of interest and maybe
    have chiefly contributed to this troubling pattern of major
    restatements.
        For example, Arthur Andersen served not only as Enron's
    auditor, but also its primary financial consultant. Indeed, it
    earned more from Enron in consulting fees than audit fees, $27
    million versus $25 million. Such a dual relationship is akin to
    someone building a house who is both the builder and the
    building inspector. Even worse, the very possibility of
    conflicts of interest creates the perception that aggressive or
    creative accounting is commonplace even when it is not.
        Congress can and should, in my view, Mr. Chairman, enact
    several commonsense reforms to strengthen the independence and
    objectivity of financial audits to shore up the public's
    confidence in the integrity of the American financial
    marketplace.
        Two weeks ago, Senator Corzine, our colleague from New
    Jersey, and I, announced our intention, Mr. Chairman, to try
    and put a package together of some ideas for the consideration
    of this Committee. I have also talked with Senator Enzi, my
    Ranking Member on the Subcommittee dealing with the securities
    industry. These ideas are designed, we hope, to improve
    investor confidence, specifically by addressing the issue of
    auditor independence.
        This legislation will not solve all of the challenges which
    we face in abating the current lack of investor confidence, but
    we think the enactment of some, if not all, of them, would be a
    critical component. In fact, we have sent to all of you, I
    think, ahead of time some of these ideas, at least, not in
    legislative form, but to invite your comments on them.
        We think we ought to do this by restricting accounting
    firms from providing nonaudited services to clients whom they
    audit. It doesn't mean you cannot have consulting services. It
    just means that you cannot do the two simultaneously for the
    same client.
        We must strengthen the independence of the FASB, the
    Financial Accounting Standards Board. The best way we think to
    do that is by providing a more independent source of financing
    for the FASB, in order to minimize as much as possible any
    potential unhealthy public or private pressure on the setting
    of accounting standards.
        The Securities and Exchange Commission must increase the
    number of accounting cops it allows to handle increasingly
    complex oversight responsibilities. The Government must have
    the ability to assure the public that audits continue to meet
    the high standards of independence and objectivity that have
    been the hallmark of the American accounting profession.
        Finally, we need to stop the conflicts of interest brought
    about by the revolving door practice of executives from
    accounting firms going to work for companies they audit. There
    needs to be a significant time buffer separating such job
    transfers.
        Those are some ideas. Again, there are many more that
    people have suggested. But I am hoping, Mr. Chairman, we can
    move legislatively in this session of Congress before too long,
    obviously, being careful, not over-reacting, creating
    unintended consequences. But clearly, some of these steps I
    think are warranted and would pass any kind of test as to their
    necessity.
        I thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you.
        I thank all of my colleagues. We are now prepared to turn
    to the panel. We will start with Arthur Levitt, the most recent
    Chairman, and move across the panel.
        Arthur Levitt was Chairman from 1993 to 2000. He is now a
    Senior Advisor to the Carlyle Group and a Director to Bloomberg
    and Neuberger Berman--an asset management firm. I think all of
    us have worked with him in his public capacity.
        I say to each of the panelists, we will include the full
    statement obviously in the record. And as I noted at the
    outset, a great deal of work has gone into these statements. If
    you could take 5 to 10 minutes to summarize, that would be
    helpful to the Committee.
        Arthur, we very much appreciate your coming today. We would
    be happy to hear from you.

                  STATEMENT OF ARTHUR LEVITT, CHAIRMAN

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1993 TO 2000

        Mr. Levitt. Thank you, Mr. Chairman. Thank you for your
    invitation to share my thoughts on the failure of Enron and its
    implications for our financial markets.
        Today, there is an emerging crisis of systemic confidence
    in our markets. What I believe has failed is nothing less than
    the system for overseeing our capital markets. We have an
    opportunity to repair trust in those on whom investors depend,
    and in the process, trust in the numbers that are the backbone
    of our capital markets. But our response, I believe, must be
    comprehensive. Healthy and resilient financial markets depend
    on the accountability of every one of its key actors--managers,
    auditors, directors, analysts, lawyers, rating agencies,
    standard setters, and regulators.
        Enron's collapse did not occur in a vacuum. Its backdrop is
    an obsessive zeal by too many American companies to project
    greater earnings from year-to-year. At one time I referred to
    this as a ``culture of gamesmanship.''
        What was once unthinkable in business has become ordinary.
    In our highly competitive economy, more and more business
    leaders are employing financial maneuvers that approach and
    sometimes cross ethical boundaries. Accounting rules are dealt
    with in terms of ``what can I get away with'' or ``if it is not
    expressly forbidden, it is okay.'' Financial statements, often,
    are not a very accurate reflection of corporate performance,
    but rather a Potemkin village of deceit.
        At Enron and throughout much of corporate America, optics,
    unfortunately, has replaced ethics. When the motivation to prop
    up stock prices overtakes the obligation to keep honest books,
    capital flows to the wrong companies and the very market system
    from which these executives profit is fundamentally weakened.
        That is why undertaking reforms that both preserve and
    enhance the independence of the gatekeepers who safeguard the
    interests of investors is so absolutely essential. These steps
    are not a panacea, but are the beginning of a much-needed
    reinvigoration of our financial checks and balances.
        First, we must better expose Wall Street analysts'
    conflicts of interest. Two years ago, I asked the New York
    Stock Exchange and NASD to require investment banks and their
    analysts to disclose clearly all financial relationships with
    companies they rate. Last week, we finally saw a response from
    the self-regulators. But it is not enough. Wall Street's major
    firms--not its trade group--need to take immediate steps to
    reform how analysts are compensated. As long as analysts are
    paid based on banking deals they generate or work on, there
    will always be a cloud over what they say.
        Second, company boards often fail to confront management
    with tough questions. Stock exchanges, as a listing condition,
    should require at least a majority of the directors on company
    boards to meet a strict definition of independence. That means
    no consulting fees, use of corporate aircraft without
    reimbursement, support of director-connected philanthropies, or
    other seductions. In Enron's case, at least three so-called
    independent board members would have been disqualified under
    such a test of independence.
        Third, many accounting rules need to be updated to better
    reflect changing business practices to give investors a better
    understanding of the underlying health of companies. Because
    the Financial Accounting Standards Board is funded and overseen
    by accounting firms and their clients, its decisions are
    agonizingly slow. This well-meaning group must defend itself as
    well from Congressional pressure, which is often applied when
    powerful constituents hope to undermine a rule that might hurt
    their earnings. FASB's funding should be secured not just
    through the accounting firms and corporations, but, rather,
    than a number of market participants--from the stock exchanges,
    the banks, the mutual funds. And the Financial Accounting
    Foundation, which chooses FASB's members, should be composed
    entirely of the best qualified members--not merely those
    representing constituent interests. The FASB should then be
    able to focus more on getting the standards right, and avoiding
    delays and compromises that ill serve investors.
        Let me turn briefly to probably the most urgent area of
    reform. Like no other, the accounting profession has been
    handed an invaluable, but fragile, franchise. From this Federal
    mandate to certify financial statements, the profession has
    prospered greatly. But as an edict for the public good, this
    franchise is only as valuable as the public service it
    provides, and as fragile as the public confidence that gives it
    life.
        It is well past time to recognize that the accounting
    profession's independence has been compromised. Two years ago,
    the SEC proposed significant limits on the types of consulting
    work an accounting firm could perform for an audit client. An
    extraordinary amount of political pressure was brought to bear
    on the Commission. We ended up with the best possible
    solution--given the realities of the time.
        I would now urge--at a minimum--that we go back and
    reconsider some of the limits originally proposed. While I
    commend the firms for voluntarily agreeing not to engage in
    certain services such as IT work and internal audit
    outsourcing, I am disappointed that the firms have remained
    silent about consulting on tax shelters or transactions, such
    as the kinds of Special Purpose Entities that Enron engaged in.
    This type of work only serves to help management get around the
    rules.
        I also believe that the audit committees--not company
    management--should preapprove all other consulting contracts
    with audit firms. Such approval should be granted rarely, and
    only when the audit committee decides that a consulting
    contract is in the shareholders' best interests. I also propose
    that serious consideration be given to requiring companies to
    change their audit firm--not just the partners--every 5 to 7
    years to ensure that fresh and skeptical eyes are always
    looking at the numbers.
        More than three decades ago, Leonard Spacek, a visionary
    accounting industry leader, stated that the profession could
    not ``survive as a group, obtaining the confidence of the
    public . . . unless as a profession we have a workable plan of
    self-regulation.'' Yet, all along the profession has resisted
    meaningful oversight. We need a truly independent oversight
    body that has the power not only to set the standards by which
    audits are performed, but also to conduct timely investigations
    that cannot be deferred for any reason and to discipline
    accountants. And all of this needs to be done with public
    accountability--not behind closed doors. To preserve its
    integrity, this organization cannot be funded, in any way, by
    the accounting profession.
        Finally, it has become clear that the reputation of our
    markets is rooted--in part--in the quality of their regulation.
    Earlier this year, the Congress passed legislation to fix the
    disparity between compensation for employees at the SEC and
    employees at other financial regulatory agencies.
    Unfortunately, the Administration's budget does not include
    funding for pay parity. We can ill afford--at a moment like
    this--to allow inaction to implicate the quality of regulation
    and, as a direct result, the quality of our markets. My message
    to the Congress and the White House is very simple: ``Fund pay
    parity.''
        The rise of the baby boom generation, changing retirement
    patterns and markets that sometimes defied the laws of gravity
    brought more and more first-time investors into the markets.
    These are our friends and our neighbors, whose hopes and
    aspirations became inextricably linked to the health and
    resiliency of our markets. We assault those dreams if company
    executives sell out shareholder faith and if those purporting
    to be independent are anything but. Enron, like every other
    financial failure before it, proves that investors bear the
    ultimate cost. It is time to repair what has been lost.
        Thank you.
        Chairman Sarbanes. Thank you very much, Arthur.
        Next, we will hear from Richard Breeden, who was Chairman
    from 1989 to 1993 of the SEC, and who is currently the CEO of
    Equivest Finance, Inc. We are very pleased to have you here.

               STATEMENT OF RICHARD C. BREEDEN, CHAIRMAN

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1989 TO 1993

        Mr. Breeden. Thank you, Mr. Chairman, Senator Shelby, and
    Members of the Committee. Thank you for inviting me to join you
    this morning.
        The events at Enron and Global Crossing, coming on top of
    other painful surprises to investors from failed audits and
    hundreds of earnings restatements can be viewed as isolated
    events, each with its own set of circumstances. In some senses
    they are. However, just in Global Crossing and Enron alone,
    investors have lost over $100 billion, which is quite a bit of
    retirement savings or college tuition down the drain. The
    spectacle of corporate insiders plundering their own companies
    or selling their stock quietly in advance of a looming collapse
    has awakened a sense of revulsion among investors who were left
    with worthless stock.
        Aside from the need to investigate and punish violations of
    the law in these specific cases, there may be a growing feeling
    that these events are not isolated and that somehow, our very
    fine disclosure and accounting system may have gotten off
    balance.
        At the center of these concerns is growing doubt about
    whether audited financial statements are believable. Every time
    a company collapses, and it turns out that the auditors knew
    the company was overstating profits, but signed off on the
    numbers anyway, without any warning to the audit committee or
    to the public, a huge bite is taken out of public confidence.
        After all, who would trust an auditor who saw their role
    model as Mary Poppins, feeding us just a spoonful of sugar to
    help the medicine go down. Most investors would like to think
    that their auditor was Dr. No, or at least Officer Joe Friday,
    determined to learn the facts, just the facts.
        If people do not believe the audited numbers, the value of
    a company's stock can fall dramatically, hurting existing
    investors, and we have seen that in the market in the last
    couple of weeks. Companies in that situation, particularly
    those with high levels of debt or aggressive strategies, may
    pay more for capital than they should and may lose access to
    the capital markets as well.
        If people do not trust the auditing profession to do an
    accurate job and to present results fairly, then all companies
    will eventually pay a price.
        So this is important to us all.
        Condemning the excesses is easy, but finding appropriate
    solutions is not. In the main, we have an excellent system for
    accounting and disclosure and we shouldn't overreact to changes
    that aren't necessary. Sometimes we just need people to do the
    job that they are there to do and to use the integrity that
    their mother taught them.
        However, this situation has exposed gaps and problems we
    should address in accounting and auditing disclosure and
    corporate governance. We can use better accounting principles
    and stronger auditing practices to apply them consistently. We
    need faster and more comprehensive disclosure. We need to make
    sure that vital corporate mechanisms such as audit committees
    are not left in the dark by management and auditors. Of course,
    if these things were easy to do, we would have done them
    already. I would like to mention just a few issues that are
    discussed at greater length in my testimony.
        One is auditor independence. Each of the Big 5 has now
    announced that it is selling or spinning off some of its
    consulting businesses. Now that that horse seems to be out of
    the barn, it might not be too controversial to lock the barn
    door. Congress will not solve every problem by prohibiting
    consulting by auditing firms, but I think it is an important
    step. Legislation here can prevent backsliding and competitive
    pressures once the spotlight is off and the current plans are
    out of the news.
        There is a drawback to worry about here, though. If we
    prohibit consulting practices, we make the audit firms far more
    dependent on audit revenues. This means that the CFO and CEO of
    a large audit client will have an even greater economic
    leverage over the auditors by threatening to be able to pull
    the audit than they did before. Some have suggested mandatory
    rotation of auditors or even Government selection of the
    auditor to avoid this pressure coming from the audit fee
    itself.
        Personally, I believe the costs would be too high from
    either of these steps. It might be useful, however, to move
    away from the perfunctory and largely meaningless annual
    ratification of auditors in the proxy to a 3 or 4 year audit
    engagement during which the auditors cannot be fired, except by
    the audit committee. At the end of that engagement, the audit
    committee should be mandated to conduct a more in-depth review
    of the auditor's work and to conduct a reproposal to get bids
    from competing firms.
        Indeed, I think that audit committees should be the
    exclusive parties to both hire and fire the accountants so that
    a CFO of a company doesn't have the power to threaten to fire
    the firm.
        There has been much discussion here about a new oversight
    board for accountants. This can be done in several ways,
    clearly, what we have now is not satisfactory. Before we start
    creating a new board, however, I would suggest that you start
    by beefing up the SEC, by doing it now, and by doing it in a
    meaningful way.
        Every single day that I served as SEC Chairman, I sought to
    obtain pay parity for the SEC staff. I would like to
    congratulate you for getting it done. It took a while, and now
    it should be funded.
        Attrition among the staff at the SEC is the friend of
    everyone who hopes to commit an undetected fraud. Crooks do not
    hold up a sign inviting prosecution. Unraveling a sophisticated
    fraud is usually a job of finding it first and then taking it
    apart, and you have to know what to look for. Experienced staff
    really are critical in being able to get the SEC's job done.
        The SEC also does not have enough resources in the
    accounting area in particular. For many years we did not have
    enough staff to look at both IPO's and 34 Act filings. That is
    not good enough. The SEC's entire budget could be doubled for
    less than $500 million, which is a tiny fraction of what
    investors lost in Enron and Global Crossing alone. And if we
    did so, that money would be very well spent.
        My vote for a new body to oversee the performance of the
    auditing profession is therefore the SEC, which has the
    integrity, the institutional strength, the experience, and the
    determination to get the job done. If we set up other bodies
    downstream from the SEC, then we have to look very carefully
    and make sure that they have adequate teeth to get the job
    done.
        One recommendation for improving the system would be to
    strengthen the internal governance within the Big 5. I believe
    that it would be helpful to mandate the major auditing firms to
    have a board of directors that would have at least a mix of 50-
    50 between inside accountants and outside directors.
        More than 20 years ago, the New York Stock Exchange
    recognized the importance of balancing the interests, on the
    one hand, of the seatholders and on the other hand, public
    investors. Most of our exchanges today have a 50-50 mix of
    insiders and outsiders on their boards. It is a healthy way of
    preventing organizations from forgetting about their public
    mandate and it would be healthy for the major accounting firms.
        In the disclosure area, our program is clearly in need of
    some improvements. Off balance sheet debt has been taken too
    far and is too far out of sight. Disclosure should be made of
    all the SPE's and their obligations and anything else that is
    off balance sheet but capable of hurting a firm's cash flow or
    business.
        Chairman Pitt has noted that disclosure today in many cases
    is far too slow and could become more real in time. That is a
    very good idea. So too is his view that disclosure is too often
    turgid and dense, made more to obfuscate than to illuminate.
    And that too should be worked on.
        Also, all securities trades by top insiders, even with the
    company itself to repay debt, ought to be disclosed promptly.
    Indeed, in a world of instantaneous wireless communication, we
    should do better, even than monthly reporting.
        Similarly, we should have heightened 8(k) disclosure
    requirements for any conflict of interest involving the CFO or
    his or her department, even if the amounts in question wouldn't
    otherwise be deemed material. The auditors and the audit
    committee depend on the integrity of the CFO. That is the heart
    and soul of the financial department of any company, and that
    position, above all others, has to be immune from conflict of
    interest or investors should be disclosed.
        Accounting principles is an area that Arthur has mentioned.
    It is something that each Chairman who served at the SEC has
    had frustrations with. The process today runs at about the
    speed of a glacier running uphill. Standards are judged by
    their length, apparently, or their pounds. Recent standards
    have run to more than 800 pages, and that gives you an awful
    lot of running room if you want to push your numbers
    aggressively.
        This is an area where there is a delicate balance and we
    have to work carefully to make sure that the SEC has enough
    clout with the FASB and that the FASB has enough independence
    to do its job well. But the standard setting process has to
    involve faster action, more relevant principles, and principles
    designed to protect accuracy.
        This is certainly an area where we do not want to throw the
    baby out with the bathwater. But since millions of investors
    have taken a bath in these cases, some of the water really does
    need to be cleaned.
        Chairman Sarbanes. Thank you very much.
        We have a vote on. It is one of three votes in succession.
    This one is almost over, so we are going to have to move very
    quickly to get there.
        I think what we will do is recess. We will stay through the
    second vote, which is about 10 or 15 minutes, do the third vote
    right at the beginning, and then resume the hearing. So, we
    will have a short break here in order to accommodate these
    votes and we will return and then proceed with you, Mr. Ruder,
    and the panel.
        The hearing stands in recess.
        [Recess.]
        Chairman Sarbanes. The hearing will resume.
        Again, I apologize to our panel, but it is not really a
    matter over which we have control. We had three votes in a row.
    That is why we were away this length of time.
        Having heard from Arthur Levitt and Richard Breeden, we
    will now turn to David Ruder, who was Chairman of the SEC from
    1987 to 1989. In effect, he preceded Richard Breeden. David
    Ruder is now the Dean and William W. Gurley Memorial Professor
    of Law at the Northwestern University School of Law.
        David, we are very pleased to have you here. We would be
    happy to hear from you.

                 STATEMENT OF DAVID S. RUDER, CHAIRMAN

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1987 TO 1989

        Mr. Ruder. Thank you very much, although I regret that I am
    no longer the Dean. Dean Van Zandt is now my boss, so I have a
    chief to report to.
        Chairman Sarbanes. Well, you were the Dean.
        Mr. Ruder. I was the Dean. That is correct.
        Chairman Sarbanes. All right.
        Mr. Ruder. The Enron tragedy calls for investigation,
    identification of wrong-doers, the imposition of penalties, and
    reform. I strongly believe that allocation of blame should not
    be made until the facts are known. Nevertheless, I believe that
    some reforms are needed.
        In the United States, the accounting profession plays a
    crucial role in the disclosure process. The investing public
    has learned to rely upon the accuracy of corporate financial
    statements prepared and certified by accountants.
        The regulation of financial statement preparation by
    management and the audit process by independent accountants in
    this country is the strongest in the world. I believe the
    public should continue to have faith in the system.
        Not only is the current system strong and reliable, but
    also the theory that the faulty financial disclosure in the
    Enron matter demonstrates an accounting system that is broken
    and an accounting profession that cannot be trusted is simply
    wrong.
        If individual accountants have failed their duty, they
    should be punished. But the wayward activities of a few is not
    proof that the accounting profession as a whole is dishonest or
    negligent. If the accounting regulatory system has faults, it
    should be corrected. But fault-finding does not demonstrate
    that the regulatory system is not working. Nevertheless, it is
    very important to examine current regulation of auditor
    independence, auditor standard setting, audit practices, and
    accounting standard setting, and to make needed changes.
        One of the substantial worries regarding the Andersen audit
    of Enron has been that Andersen not only audited Enron, but
    also was paid approximately the same amount for nonaudit
    services, raising the question of auditor independence.
        If an accountant is not recognized by the SEC as
    independent, the accountant cannot certify a corporation's
    financial statement. Without a certification, these statements
    cannot be filed with the Commission and the corporation will
    find it nearly impossible to raise capital.
        The SEC has taken steps to increase auditor independence.
    In November 2000, under Chairman Arthur Levitt's leadership,
    the SEC published revised auditor independence standards
    specifying circumstances under which the Commission will not
    recognize an accountant as independent.
        The new independence rules represent a strong improvement
    in addressing the auditor independence program. I believe the
    new rules should be given a chance to work.
        There are categories of nonaudit work that create
    efficiencies for corporations, such as tax advice and opinions
    rendered in connection with registered offerings. These
    categories should be monitored to see whether they impede
    independence.
        In two areas, however, steps should be taken now to
    strengthen the rules. The area of financial information
    services and design is an area likely to create conflicts.
        The Commission's current rules recognize that there may be
    benefits to the accounting control system if the auditor is
    allowed to plan, design, and implement internal accounting
    controls and risk-management controls. These areas are
    fundamental to good accounting systems.
        Strong arguments can be made that a corporation's auditor
    should be able to design and install such systems. The
    Commission has recognized this and should continue to monitor
    this area.
        But the rules contain significant restrictions on the
    design and implementation of such systems and on systems that
    aggregate source data underlying financial statements. This
    area is not likely to justify exceptions and the Commission
    should consider prohibiting this activity.
        The Commission's rules regarding internal audit services
    recognize that outsourcing the internal audit functions to the
    company's external auditors creates conflicts or appearances of
    conflicts because the external auditor eventually will be
    auditing its own work. Here, too, the Commission should
    consider prohibiting external auditors from engaging in
    internal auditing, with exceptions for small business.
        We need to build on the accounting and audit supervisory
    system already in place. Prodded by the SEC, the accounting
    profession last year reorganized its process for overseeing the
    audit process. The AICPA expanded the power of its Public
    Oversight Board, an independent body, to control the auditing
    process in the United States. The Board is composed entirely of
    five public members with no connection to the accounting
    profession and is currently headed by Charles Bowsher, the
    former Comptroller General of the United States. Although in
    January the Board announced its intention to disband, it should
    remain in existence until other audit supervisory measures are
    in place.
        I believe the oversight of the audit system should become
    truly independent and should build on the POB's system.
        A new, separate audit supervisory board should be modeled
    on the private sector Financial Accounting Standards Board--
    FASB--and perhaps on the self-regulatory system of the NASD.
    The Board should be subject to oversight by the SEC, which in
    turn should cooperate with the Board in the investigative area.
    The Board should be composed entirely of public members, not
    associated with the profession. It should have appointive
    administrative, and budget powers and should oversee three
    separate functions.
        First, an auditing standards and ethics board composed of
    persons independent of the accounting profession should
    promulgate both auditing and ethical performance standards.
        Second, an audit quality control committee composed of
    professional staff members reporting to the supervisory board
    should oversee internal audit firm practices. This unit should
    also supervise a peer review system. The peer review system
    which is already in place has been supported by the SEC in the
    past and should be continued.
        Third, an audit disciplinary committee should be
    established which would give a professional staff the power to
    report to the audit supervisory board regarding possible audit
    failure and should have the power to impose disciplinary
    sanctions. The information it gathers should be privileged from
    outsiders. Information gathering activities, privilege
    questions, and disciplinary questions would have to be
    coordinated with the SEC.
        Independent financing of a new board is crucial. An
    independent body that depends upon sporadic voluntary
    contributions from industry or accountants may risk loss of
    financial support if it takes positions seen as contrary to the
    best interests of those it regulates.
        The promulgation of accounting standards by the Financial
    Accounting Standards Board has come under some scrutiny,
    particularly because of failure to produce rules with
    sufficient clarity or lack of detail and because of failure to
    do so in a timely manner.
        The problem with delays in promulgation of rules and with
    the details in rules comes in part because of pressure from the
    business community.
        The Board can increase the speed of its deliberation and it
    is considering ways to do so, but it must continue to assess
    the effect of its proposed standards on business operations.
        Despite its attempts to seek the views of the business
    community, FASB faces difficulty in obtaining financing from
    business. It is financed partly through its sales of work
    product and partly through contributions by businesses and
    accounting firms.
        When businesses do not like the FASB's standards or its
    process for creating them, they sometimes withdraw financial
    support or fail to provide it in the first place. The
    accounting profession is supportive, but, generally speaking,
    business is not.
        Institutional investors and investment bankers who benefit
    greatly from financial statement disclosures contribute little
    to the FAF, creating a classic free-rider program.
        I believe the solution to the financial pressures on the
    FASB would be to provide a system of financing supported by
    Congress which would not depend on voluntary contributions.
        I have some remarks regarding corporate governance in my
    written remarks. I urge that the Commission through its
    disclosure process and the stock exchanges, through their power
    to effect corporate governance, look into the corporate
    governance as an area of possible reform.
        Although not in my prepared testimony, I want to urge
    Congress to provide additional financial resources for the SEC
    and to make pay parity a reality. I was amazed to learn
    recently that the SEC staff has increased from approximately
    2,800 when I was Chairman in 1987, to only approximately 3,000
    today.
        During this same period, the number of filings made with
    the SEC has expanded dramatically, securities market volume has
    grown enormously, and investment company assets under
    management have increased exponentially. The SEC will be much
    more efficient with a larger budget and better paid staff.
        Thank you.
        Chairman Sarbanes. Thank you very much.
        Our next witness is Harold Williams, Chairman of the SEC
    from 1977 to 1981. That is when I first came to the Senate and
    came on this Committee, and I can remember working very closely
    with Harold.
        Mr. Williams is now Of Counsel with the law firm of
    Skadden, Arps, Slate, Meagher & Flom, and had served for almost
    20 years as President and CEO of the J. Paul Getty Trust, the
    Getty Museum that has risen on the top of a hill in Los
    Angeles, which is a marvelous contribution to the cultural life
    of the Nation, really was under his guidance.
        Just as an aside, I want to express appreciation for that
    contribution to the Nation's welfare.
        We would be happy to hear from you.

               STATEMENT OF HAROLD M. WILLIAMS, CHAIRMAN

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1977 TO 1981

        Mr. Williams. Thank you, Mr. Chairman. That was a great
    reward for being a Chairman of the SEC, the Getty.
        [Laughter.]
        I appreciate the focus of this Committee on systemic
    reform. We have a crisis in confidence and one that really
    cannot be ignored.
        I am a great believer in self-regulation and self-
    regulation coupled with rigorous oversight. But it is evident
    that the existing structure is not adequate to the task and
    needs to be redesigned and strengthened. At the center of the
    crisis--but not alone--is the accounting profession. Events
    have heightened concerns about whether the profession has, in
    fact, the requisite degree of independence to discharge its
    auditing responsibilities.
        The profession's auditing responsibility is really a quasi-
    public one and deeply infused with the public interest. And
    this raises several critical issues. Can an auditor be
    independent when his client is paying the bill? Does the
    provision of consulting services impair independence or the
    perception of independence?
        Now, I am sympathetic with the difficulties involved in the
    audit process. Auditing has become much more difficult as
    corporate structures and financing techniques have become more
    complex.
        For example, the pricing of risk or the laying off of risk
    has become an increasingly sophisticated high-technology
    business. And as a result of this increasing complexity, the
    requirement is for a greater exercise of judgment and it makes
    auditor independence and insulation from pressures that could
    compromise it all the more essential.
        The case for insisting that an auditor not provide other
    services to a client that it audits is a strong one. Accounting
    firms have come increasingly to look beyond their traditional
    audit role to consulting work for their revenues and
    profitability. In part this is in response to corporate
    pressures to hold down audit costs and in part to the growth in
    consulting as a very profitable market. Whether providing
    consulting services actually impairs independence calls for
    access to the auditor's state of mind and is virtually
    impossible to determine. However, the perception that it may is
    of such concern that it cannot be ignored. And indeed,
    perception is now at least as important as reality.
        While I was Chair of the Commission, we introduced a
    requirement that the proxy material calling for shareholder
    approval of the selection of the audit firm include information
    on the nonaudit services performed for the company in the prior
    year. This provision was eliminated by my successor. It was
    reintroduced recently under Chairman Levitt.
        Now even if the auditor does not provide other services to
    the companies it audits, given who pays the bill, the incentive
    to keep a well-paying audit client happy will remain powerful.
        I would urge the Commission to consider a requirement that
    a public company retain its auditor for a fixed term with no
    right to terminate. This could be for 5 years or perhaps the
    Biblical seven. After that fixed term, the corporation would be
    required to change auditors. As a consequence of such a
    requirement, the auditor would be assured of the assignment
    and, therefore, would not be threatened with the loss of the
    client and could exercise truly independent judgment. Under
    such a system the client would lose its ability to threaten to
    change auditors if, in its judgment, the assigned audit team
    was inadequate. It would also reduce the client's ability to
    negotiate on fees, and almost certainly the audit would cost
    more.
        The required rotation of auditors would also involve the
    inefficiency of the learning curve for the new auditor. I view
    all of these potential costs as acceptable if it reinforces the
    auditor's independence and makes the work more comprehensive.
    The client could be given a right to appeal to a reconstituted
    independent oversight organization if it believes that it is
    not well served by its auditor and needs some relief.
        Even this proposal would not avoid the issue of providing
    consulting services to audit clients and the perception that it
    compromises auditor independence. There are solutions. One is
    not to offer any nonaudit work to an audit client. Another is
    to restrict those audit services to those totally consistent
    with the audit itself.
        The Public Oversight Board was being implemented by the
    profession during my Chairmanship as an effort at self-
    regulation. We expressed concern at the time whether the peer
    review process administered by the profession would be
    adequate. But as believers in the principle of self-regulation,
    we concluded that the Board should have the opportunity to
    prove itself. In my opinion, the events over the intervening
    years have demonstrated that it does not meet the needs and is
    not adequate. Under the peer review system adopted in 1977, the
    firms periodically review each other. To my knowledge, there
    has never been a negative review of a major firm. However, the
    peer review process is not permitted to examine any audits that
    are subject to litigation. The reviews focus on the adequacy of
    quality control procedures and do not examine the
    audits of companies to see if the peer would have arrived at a
    different conclusion.
        Peer review has proved itself insufficient. Particularly as
    the Big 8 has become only the Big 5, peer review in its present
    form becomes too incestuous. A system needs to be established
    which is independent of the accounting profession, transparent
    and able to serve both effective quality control and
    disciplinary functions.
        Further, the Board is not adequately funded and is beholden
    for its funding to the very people it is supposed to oversee. I
    suggest a requirement that a surcharge of a percentage of the
    audit fees of public companies be assessed to pay for
    independent oversight, whether it is the Public Oversight Board
    or some successor body, so that its funding is assured.
        The disclosure model itself today lacks the necessary
    clarity and transparency and needs to be critically reviewed
    and enhanced by the Commission. Our financial accounting and
    disclosure requirements have not kept up with the rapid
    evolution of our capital markets and corporate finance. The
    existing model has worked well when auditing traditional assets
    such as plants and equipment and accounts receivable. It works
    less well when dealing with items such as intangibles and
    sophisticated financial instruments.
        Part of the responsibility for inadequate disclosure lies
    with the accounting principles themselves and the functioning
    of the Financial Accounting Standards Board.
        The Generally Accepted Accounting Principles, GAAP, need to
    be reviewed and standard setting improved and accelerated. I
    believe the functioning of the FASB could be significantly
    enhanced if its independence could be protected, to withstand
    the pressures of the business community, the profession, and
    even the Congress.
        A source of funding that is dependable and not beholden to
    the profession or the corporate community would increase the
    ability of the Board to address more difficult and critical
    issues and do so in a timely manner.
        Rule making itself is very difficult, particularly as
    financial activity and economic transactions become
    increasingly complicated and sophisticated. For example, the
    FASB has engaged for a number of years in an effort to create a
    clear standard for disclosing off-the-books transactions and
    special purpose entities. They have not been able to come up
    with a rule acceptable to the business community and the
    profession. Perhaps that acceptability should not ultimately be
    the determining factor.
        Some rulemaking amounts to ``closing the barn door.''
    Obviously, that is not something that the corporate community
    takes lightly because of its potentially negative impact on
    earnings. An example is the pressure exerted by corporations
    through Congress in the mid-1990's, that forced the FASB to
    back down on a proposal to make companies take account of the
    cost of awarding employee stock options.
        I have some other comments in that area, but I will forego
    those.
        A separate issue is the lack of regulatory coherence,
    particularly since the enactment of the Gramm-Leach-Bliley Act
    allowing financial services companies to cross the boundaries
    that had existed between firms that could undertake commercial
    banking, securities underwriting, and insurance.
        This is a situation that inevitably will create problems
    unless the various regulatory agencies share and implement a
    common understanding of the rules of behavior expected of the
    various players who collectively oversee the financial markets.
        But as we go about exploring regulatory or statutory
    solutions, we need to be reminded that the more that problems
    lead regulators or legislators to impose prescriptive rules,
    the more people will settle for fulfilling the letter of those
    rules rather than responding to the broader purposes that they
    are designed to serve.
        Rules inevitably leave loopholes that can be exploited if
    the attitude persists that form is more important than
    substance or that complying with the letter of the law rather
    than the spirit is acceptable. At the other extreme, too
    general a rule lacks guidance and invites overly generous
    interpretations.
        Ultimately, any system can be subverted if the parties
    undertake to do so, or if the various players in the system let
    down their guard and fail to act responsibly.
        When everyone involved--management, board members,
    investment bankers, and securities analysts--are caught up in
    and benefit from a hot stock, no one is inclined to do the
    thorough questioning that could raise troublesome issues and no
    one is inclined to be willing to be the skunk at the picnic.
        In the final analysis, the system works as it should only
    when all the players honor the spirit, as well as the letters
    of the law.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you. I think that your point on
    the letter of the rules and the spirit of the law is very
    important.
        One of the tragedies, it strikes me, in all of this is that
    Arthur Andersen himself, the individual who founded the
    accounting firm, was a man of great rectitude and really worked
    very hard to move the accounting profession to a new standard.
    Of course, he passed away in 1947. But Andersen was a path-
    breaker in terms of trying to do the spirit of the law, as you
    put it.
        Our concluding witness this morning is Rod Hills, who was
    Chairman of the SEC from 1975 to 1977. He is a Founder and
    Partner in the law firm of Hills & Stern. We are very pleased
    to have you with us this morning, sir.

                STATEMENT OF RODERICK M. HILLS, CHAIRMAN

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1975 TO 1977

        Mr. Hills. Thank you, Mr. Chairman.
        I came before this Committee just about 26 years ago to
    explain what the SEC was doing about 400 American companies
    that had bribed foreign officials or given them questionable
    payments for some kind of corporate favors.
        Back then, we gave birth to the mandatory audit committee.
    We substantially increased the auditor's responsibility and we
    imposed internal controls on management for the first time, and
    those were good steps of corporate governance. They are still
    important today. But I think it is quite clear that it is time
    for a change, a time for some upbringing. What is wrong? Three
    basic things.
        First, the regulatory system we have is almost 70 years
    old. It is creaky. From my experience, almost anything 70 years
    old gets creaky.
        [Laughter.]
        It needs a major overhaul.
        Second, it has become increasingly clear that the
    accounting profession is not able consistently to resist
    management pressures to permit misleading or incomplete
    financial statements.
        Third, the audit committees of too many boards are not
    exercising the authority given to them or the responsibility
    expected of them. The audit today has become a commodity. The
    CEO's see no added value in it. The accounting firms compete
    for it on the basis of cost, not on the basis of quality.
        The system has too many rules. It has become so precise in
    what cannot be done, that the system has created the
    implication that if it is not prohibited, it is permitted.
        Paul Brown, head of NYU's Accounting Department said it
    just perfectly. ``It is the old adage of a FASB rule: It takes
    4 years to write it, and it takes 4 minutes for an astute
    investment banker to get around it.''
        [Laughter.]
        Finally, the profession is ignoring the plain language of
    its own opinions which traditionally state--in our opinion, the
    financial statement prepared by management fairly present in
    all material respects the financial position of the company. In
    fact, today, the opinion only means we have found no material
    violation of an applicable regulation.
        In addition to its other troubles, the accounting
    profession is not attracting the same talent that it did 20
    years ago, a terribly serious problem for them. This difficulty
    of finding top-notch personnel, the difficulty of finding a
    precise rule to deal with a sophisticated corporate structure,
    and especially the pressing financial need to keep a client,
    allows too many audit partners to let a questionable accounting
    policy to slip by.
        Audit committees should be protecting their auditors. But
    board members are too often chosen by the CEO, who also decides
    who will sit on the audit committee and who will chair it.
        The members seldom ask the auditor if there is a fair or
    better way to present the financial position of the company.
    They seldom play any significant role in choosing the audit
    firm or in choosing the new partner from the audit firm. And
    they seldom establish themselves, in short, as the party in
    charge of the audit and they do not establish themselves as the
    party in charge of retaining the auditor.
        Professor Roman Weil of Chicago's Graduate School of
    Business has written: ``I want accountants to use fundamental
    concepts in choosing accounting methods and estimates. I want
    accountants not to hide behind the absence of a specific
    rule.''
        If this were the practice, companies could be made to be
    far more candid in attempting to examine and express the real
    value of their companies. Those are changes that are not going
    to come easy and they are not going to come early. But there
    are a number of things that can be done quite efficiently,
    quite early.
        If the SEC would state unequivocally that the failure to
    have a competent, independent audit committee constitutes a
    material failure in the internal controls of the company, then
    auditors would have the responsibility of looking to the
    quality of the audit committee. They would have to ask
    questions in writing of board members: How did you get on the
    board? How did you get on the audit committee? Who selects the
    chairman of the audit committee? What percentage of your income
    comes from this board and from other boards? What experience or
    education do you have that is relevant to the service that you
    are giving on the audit committee?
        It should be apparent to everyone, as it has been to many
    for a long time, you cannot have an independent audit committee
    unless you have an independent nominating committee who brings
    people on the board in the first place.
        The SEC should also widely broadcast the significance of a
    rule it passed a couple of months ago, on December 12. That
    release requires auditors to carefully explain how the
    selection of different policies or estimates could cause the
    reporting of materially different financial results. Had that
    rule been in effect a few years ago, there is a substantial
    chance that the Enron debacle would never have happened.
        The SEC should also make it quite clear that the audit
    committee's most important task is to make the auditor believe
    that the audit committee is solely responsible, its discretion
    and its decision is solely responsible for keeping the auditor
    or losing the auditor.
        If such steps were taken, easy steps to take, the
    accounting firm should not take any engagement unless it is
    certain of the support of the audit committee. And with that
    kind of support, the firm should have the resolve to qualify
    their opinion whenever the financial presentation, though it
    may satisfy all the rules, does not seem the best way to
    present the financial position of the company.
        In short, the profession could be cured with a concerted
    effort by the SEC, the FASB, and the IACPA. However, the pace
    of change has been so slow over these 26 years, that Congress
    may very well need to mandate the change, preferably through
    the formation of an informed and effective committee that can
    come back this year with a plan of reform.
        These aren't complicated things.
        Congress may also wish by legislation to do what the SEC
    and audit committees can do without a legislative prod.
        The consulting service thing is a significant issue. I find
    myself basically agreeing with Chairman Levitt. I would hate to
    see a blanket prohibition, but I would like to see some
    discipline. And I think the discipline can be exercised by the
    audit committee.
        Surely, the consulting fees should not regularly exceed the
    audit fees. And surely, the audit committee should understand
    that they are better served by having other people. I would
    hate to see a blanket prohibition, but I would like to see more
    discipline, and I do believe it can be put on the audit
    committee.
        The point I wish to make to this Committee is that Enron is
    emblematic of the problems of the accounting profession. Enron
    has the headlines--sorry--Andersen has the headlines. But all
    accounting firms have had the same kinds of trouble. I have
    seen all five of them have problems.
        As I think I said in my written testimony, I have six times
    in my life personally had to write off more than $100 million
    of income that should not have been reported in the first
    place. And on one occasion, we had to write off literally
    billions of dollars of wrongful income from a publicly-traded
    company.
        I would like to echo the comment that Arthur Levitt made a
    few days ago. And that is that Andersen overall is a splendid
    institution and it is an institution critical to our economy.
    It is necessary that it survive this ordeal.
        Finally, I would like to say that the accounting profession
    is of enormous importance to our country and to the global
    economy. And as we identify its deficiencies, we should also
    acknowledge the responsibility we all have to help it to reform
    itself.
        Thank you.
        Chairman Sarbanes. Thank you very much.
        Again, I thank all of the panelists for very, very
    thoughtful presentations. We will try to move quickly so
    everyone gets a round of questions here. We will hold it to 5
    minutes.
        I wanted to pick up on this restatement of earnings issue.
    Fortune magazine, I think in its latest issue, has an article
    entitled, ``Dirty Rotten Numbers.'' And in the course of it, it
    says: ``No one can calculate how many companies are playing
    loosey-goosey with their books right now. We can only count
    them when they get caught or when they restate earnings, or
    when a journalist or an analyst--God forbid--raises a red
    flag.''
        What is clear, however, is that there is more bad
    accounting out there than ever before. And, of course, we have
    seen the restatement of financial statements, the number of
    them has escalated at a rather staggering pace over the last
    few years. In fact, we have asked the GAO to investigate the
    pattern of publicly-traded companies issuing so many financial
    restatements. And the GAO has launched that inquiry.
        Now, obviously, frequent restatement of earnings go
    directly to the heart of the financial markets because they
    raise questions about the reliability of published financial
    statements and therefore undermine investor confidence. I am
    interested in why you think we have seen such a proliferation
    of accounting restatements? And how specifically might we
    address this problem? Who would like to take a crack at that?
        Mr. Hills.
        Mr. Hills. I think it has happened gradually over the
    years. Obviously, the more important stock prices become to the
    company, the more important it is to meet analysts' estimates.
        Chairman Sarbanes. Now does that relate to the fact that
    stock options have become such an important aspect of executive
    compensation?
        Mr. Hills. I think so, and to a lot of people, the
    pressure. I mean, what you have is human nature. When stock
    goes up as fast as it has during a period of time, it is human
    nature to want some of it, and you get caught up in the frenzy
    of trying to boost the stock price.
        In October of every year, in comes the field with the
    estimates for next year's earnings. And you are 15 cents short
    per share of what Wall Street expects.
        The chief financial officer becomes an operating line
    manager. He goes out to find the 15 cents. He looks at the
    estimates, the appreciation schedules and he finds a way to get
    the 15 cents. He may find a very difficult accounting policy
    and maybe he will wend his way through the maze of it, and he
    comes up with the 15 cents. He goes to the accounting partner,
    the audit partner. The audit partner looks at it and he says,
    that is not exactly the way I would like to do it. He says,
    well, it is okay. Maybe in that first year, it is not 15 cents.
    Maybe it is only a couple of pennies. In the second year, the
    same concept gets to be four pennies. And then six pennies.
    Then, all of a sudden, something that he let slip by the first
    year becomes really quite serious. The audit partner says, how
    the bloody heck do I get out of this? Too often, he goes to
    management and says, can't you sell something for profits to
    offset what you should have taken as losses before?
        They cannot sell it, and they take the loss.
        But it comes from a careless implementation of an
    accounting policy that doesn't seem so important the first
    year. And of course, when one penny can make a difference in 10
    dollars in the stock price, people say, you cannot find a
    penny?
        People always wonder why, when a company does not make its
    price by, say, a penny, the stock plummets. That is because
    Wall Street knows that the corporate community has smoothed
    earnings. It is one of the intolerable things we have all
    tolerated for far too long. Everybody knows that there is a
    cookie jar with a few pennies in it, that you can reach in and
    pull it out. So if somebody cannot find that penny, Wall Street
    says, boy, that company is in real trouble because that cookie
    jar is empty.
        That is the serious problem in our economy. We have
    developed really bad habits in terms of the analyst community.
    Just simply the notion that the world works that way is crazy.
    It is not the way it works and we have allowed it to happen
    that way far too long.
        Mr. Levitt. The number one source of restatements has been
    revenue recognition. Why? Because companies feel the pressure
    to meet Wall Street expectations.
        Chairman Sarbanes. At the Banking Committee hearing last
    week on the failure of Superior Bank, a large thrift in
    Illinois, actually, the FDIC's Inspector General testified that
    the bank's auditor, who had certified the bank's valuation of
    its residual assets, also provided consulting services for the
    bank about the methodology for valuing those same assets. And
    that overvaluation led to the demise of the thrift. That, of
    course, leads to the question of auditor and consulting
    services. Do you think auditors should be able to do any
    consulting services or should there be a complete severance? If
    you do not think there should be a complete severance, what
    consulting services should the auditor be precluded from?
        The accounting firms now have done sort of a self-
    regulation thing. But they have backed off of only certain
    forms of consulting services. Obviously, the whole system needs
    to be examined now. I am interested in your view on that
    question.
        Mr. Ruder. Can I speak to that?
        Chairman Sarbanes. Sure.
        Mr. Ruder. I had the dubious pleasure in preparation for
    writing an article and preparing before this Committee of
    reading the Commission's release relating to auditor
    independence. And it became clear to me that the SEC had spent
    an enormous time under Chairman Levitt's leadership in dealing
    with this independence problem. Although, I do not think any of
    us were satisfied that the Commission had gone far enough in
    its rules, its release, and its rules clearly indicate that
    there are some areas of consulting services that are not in
    conflict with the auditors' independence and which will benefit
    the companies that they are auditing.
        Those areas are fairly narrow in scope and need to be
    looked at and monitored by the Commission in order to see
    whether they have reached the right conclusion in their last
    rulemaking.
        I think, by and large, that the Commission is right and
    Arthur Levitt was right--you can speak for yourself, Arthur, I
    know--that there should be no management consulting. There
    should be no audit services which would amount to self-
    auditing, no internal audit services, and no information
    services which would put the auditor in the position of having
    created areas that it must then audit. But I think one has to
    be quite careful in trying to say, no nonaudit services
    whatsoever.
        Chairman Sarbanes. Arthur.
        Mr. Levitt. I believe, obviously, in self-regulation. I
    think that is terribly important. But I believe even more in
    the importance of public confidence as the backbone of our
    markets.
        And while I think the accounting profession has come to the
    table with some constructive notions, largely out of concern
    that a legislative reaction might be more Draconian, I do not
    think that is enough. I fear backsliding. I think it is all too
    easy to do that.
        Now, I am not saying that there should be a bright line
    which separates all consulting from all auditing. A limited
    amount of tax work might be appropriate to the audit, a limited
    amount. That is a very dangerous area because you slip over
    into--look, you hire us, we are going to save you millions of
    dollars in taxes by investing in heaven knows what else. I
    think that is dangerous.
        But I think the importance of a legislative action here to
    hammer home the separation is terribly essential to see to it
    that we do not face the same problem 5 or 7 or 10 years down
    the road.
        Chairman Sarbanes. Richard.
        Mr. Breeden. I would certainly agree with Arthur's
    comments. Congress for many years, and actually in my White
    House days, we struggled with it and worked with the Committee
    a great deal under the Bank Holding Company Act. We have long
    had a provision in the law saying that bank holding companies,
    because of the unique role they play, could engage in banking
    or activities closely related thereto, and we gave the job to
    the Federal Reserve to define what is closely related enough to
    be allowed.
        There is some consulting that is very closely related to
    the audit. Sometimes we used to do consulting projects for
    companies when I was at Coopers to evaluate their internal
    controls if they wanted to go beyond the internal control work
    that is part of the audit.
        Well, that is very closely related to the audit service
    itself. Building a $100 million computer system is not at all
    related to the audit itself.
        I think we should have some legislation here. The
    backsliding problem is a real one, and the competitive
    pressures--if one firm starts to backslide, then the others are
    going to have a tremendous pressure that their partners are
    going to say, hey, these guys over here are doing it. Why can't
    we do it?
        And so, to reaffirm public confidence, which is really what
    it is all about. There is nothing evil about consulting. There
    is nothing wrong with it as a business. But maybe we are at a
    situation where it is a little bit like breaking up AT&T, maybe
    saying, look, spin off these consulting arms and keep them
    separate and let them be healthy businesses on their own, is a
    good thing.
        Chairman Sarbanes. Harold.
        Mr. Williams. I would agree. I think we are dealing with a
    perception issue here that is insurmountable. My view would be
    either no consulting services, or at least no services that are
    not totally consistent with the audit responsibility.
        In my written testimony, I suggested an additional
    possibility, which is, to whatever extent consulting services
    are performed by the firm, that the revenues and profitability
    from those services be segregated so the people on the audit
    side cannot profit from it.
        Chairman Sarbanes. Rod.
        Mr. Hills. It seems to me that the SEC does have a bully
    pulpit. Arthur had done a marvelous job, quite apart from the
    regulations, to alerting everyone to this problem.
        Every board in which I sit--still three--every board has a
    limit--no consulting service above say $50,000, without
    specific approval by the audit committee. And the presumption
    is you go outside.
        There may be some legislation here that would require that
    kind of discipline. But the idea that we know exactly the
    distinct difference between the audit and consulting is very
    difficult.
        We have talked about the internal audit, and yet, the SEC
    has never required that there be an internal audit. We do not
    know really the difference between the internal audit and the
    external audit. It is there. You can see it in broad terms. But
    there is a very nebulous line.
        So a bully pulpit, maybe some legislation supporting it.
    The SEC can require that there be very precise disclosure of
    what the reason was for the consulting. We have some new rules
    in effect and, to my sense, it would be wise to see how these
    new disclosure requirements work.
        I think if the SEC said there should be a demonstrable
    reason for using a consulting service, that would be good.
        But my great concern is that talking about consulting
    services diverts attention from what really will work because
    you are not going to reduce the pressure on the audit partner
    by taking away the consulting services.
        If he loses his audit position, he loses his job. The
    pressure of keeping the client is there. The only way you are
    going to get that pressure off is by protecting that auditor
    with an audit committee or by some regulatory body.
        I must say, finally, that the depression in the audit
    accounting industry is dramatic. The quality of people going
    into it has changed over 20 years terrificly.
        What we do to make it less appealing as a job is going to
    harm the profession. Clearly, the auditing firms can do
    consulting work for nonaudit clients. They need to keep their
    skills up to some degree. So, in short, please, no bright line
    and let's see what the SEC can do.
        Chairman Sarbanes. My time has expired.
        Senator Shelby.
        Senator Shelby. Thank you, Mr. Chairman.
        I would like everyone to look at the chart I had prepared.
        I believe that there is a clear trend in the number of
    restatements. You can just start over here in 1997 to 2000.
    When a firm or a few firms get away with some accounting
    gimmickry, other firms, their competition, start going down the
    same path in order to compete. A lot of companies start playing
    Follow The Leader.
        Look. The accounting firms start selling their magical
    methods to everyone else, perhaps. The restatement trend in the
    chart here provides evidence of this, I believe.
        It is not just that there are more restatements, although
    they are bad in themselves. The cause of the restatements, as
    Chairman Levitt referred to it--the cause of the restatements
    is very telling. This second chart demonstrates the large
    number of restatements due to the fact that there were errors
    in the methods of revenue recognition that were used.
        Would anyone here care to comment about the significance of
    revenue recognition issues? And does revenue recognition have
    any heightened or particular effect on things like share price?
        I think this is telling--revenue recognition.
        Chairman Levitt.
        Mr. Levitt. You state it as it is. This is part of the
    numbers game. It is so easy to use revenue recognition to prove
    a point, to meet a standard that analysts working for
    investment bankers have set up. And those restatements are
    costly.
        Senator Shelby. They are also costly to the investment
    public, too, aren't they?
        Mr. Levitt. Enormously costly to the investing public. And
    in terms of the standard setters, in some instances, the
    standards are sufficiently imprecise, that companies are
    obliged to restate their earnings.
        Recently, a standard on business combinations has caused a
    rash of restatements, and that is just beginning.
        Senator Shelby. Chairman Breeden.
        Mr. Breeden. Well, I think you have put your finger,
    Senator, on a very serious problem. What you call revenue
    recognition there, I mean, there are several areas in which
    accounting principles today allow future profits to be rolled
    forward into the present day.
        Senator Shelby. Future profits.
        Mr. Breeden. Yes.
        Senator Shelby. Good term.
        Mr. Breeden. Future profits, and some of those standards
    attempted originally--the classic one is gain-on-sale
    accounting.
        Senator Shelby. How do you in reality have future profits?
    We were always taught profits were realized, that it was not a
    gain. You either had a profit or a loss.
        Mr. Breeden. I guess beauty is in the eye of the beholder.
        [Laughter.]
        Senator Shelby. That is what is dangerous here, is it not?
        Mr. Breeden. And in the eyes of the FASB, future profits
    can sometimes be beautiful.
        So, we have a series of rules that have allowed companies
    to take projections--in Enron's case, they formed a joint
    venture that was going to broadcast certain TV programs over
    the Internet, I think, and entered into a joint venture with
    Blockbuster.
        They signed a 10 year contract and they sat down and said,
    all right, we are going to project that over the next 10 years,
    everybody who has ever heard of a movie will subscribe to our
    service. We are going to have this huge amount of revenues and
    we are calculating that our profits will be a fairly
    substantial amount, hundreds of millions of dollars. And they
    booked it right there and then, before any cash had come in the
    door, before there had been any actual cash flows that would
    support those optimistic projects.
        Senator Shelby. Who came up with that rule? Was that FASB
    who came up with that?
        Mr. Breeden. Ultimately, all the standards are FASB
    standards.
        Senator Shelby. FASB. That defies reality, though. I mean,
    you are counting profits before you ever earn them.
        Mr. Breeden. There are a number of areas where----
        Senator Shelby. And most of the time, they never earn them,
    do they?
        Mr. Breeden. Well, the problem is, I think people would
    accept that if you have something that is quite certain, you
    have done something, it is finished, you have a completed
    contract and it is highly likely to produce a certain result,
    that may be one thing. But there are all too many cases now
    where profits are rolled forward based on models that people
    say, we have this wonderful model and we even have some
    derivatives that support it, and try and lock in pieces of it,
    and therefore, we should be allowed to count it today.
        Senator Shelby. But models are based on assumptions for the
    future.
        Mr. Breeden. Exactly right.
        Senator Shelby. They are not based on the real earnings as
    the average investor would think, would they?
        Mr. Breeden. Well, the old adage of garbage in /garbage out
    is a pretty serious one.
        Senator Shelby. Garbage in /garbage out. And we have had a
    lot of garbage as we see here, haven't we?
        Mr. Breeden. Right. Absolutely.
        Mr. Levitt. Senator Shelby, the Commission issued late in
    my final year the Staff Accounting Bulletin 101 about revenue
    recognition. That created an absolute firestorm of opposition,
    mostly from the high-tech community, that pressured the
    Commission against doing that.
        There was vast Congressional inquiry into Staff Accounting
    Bulletin 101. We had to delay the issuance of that and finally,
    over very strenuous objections, we did issue Staff Accounting
    Bulletin 101. But that went to this question and this is highly
    contentious. This question of revenue recognition is a very,
    very divisive issue.
        Senator Shelby. It might be divisive, but the investor
    public needs to know what the truth is, don't they?
        Mr. Levitt. And they were hurt by the delay of 101.
        Senator Shelby. Absolutely.
        Chairman Ruder.
        Mr. Ruder. The problem that accountants face and some
    businesses face is lack of certainty. And the problem with
    accounting as it becomes more complex and reaches more
    difficult areas such as derivatives, is that the accountant and
    the businesses are required to exercise judgment.
        There are estimates that go forward all through the
    accounting system. And as we argue that the accounting rules
    should be less precise and more general, we are then offering
    the businesses and the accounting profession more problems
    about making judgments.
        I think we have to be very cautious about looking for
    certainty in the accounting area. The problem is to get an
    accounting system which will allow people to make reasonable
    judgments.
        Now the problem, you are exactly right, is when people use
    that judgment system to attempt to defraud others.
        Senator Shelby. Absolutely.
        Mr. Ruder. And it is the revenue recognition system and
    other areas in which people take advantage of this judgment
    area.
        Senator Shelby. Maybe we won't have certainty, but we can
    have honesty.
        Mr. Ruder. Absolutely.
        Senator Shelby. Mr. Williams has a comment?
        Mr. Williams. Well, I think it goes back to the earlier
    question, too. We are an environment that encourages aggressive
    accounting. When you are on a track of ever-increasing earnings
    and you are rewarded for it, that pressure is going to be
    there. But part of it goes back to the question of the
    independence of the auditor. If the auditor is in the position
    not merely to say, that is a conceivable way to do it, but has
    the independence to say, that is really not right, I think we
    would see some changes.
        That is why I go back again to the independence of the
    auditor, because you cannot legislate integrity and we cannot
    pass rules that are going to solve this problem. We have to
    create an environment that enables the players themselves not
    only to be able to address the issue honestly, but also to do
    our best to require them to do so.
        Senator Shelby. Chairman Hills.
        Mr. Hills. I have argued with economists and lawyers about
    revenue recognition so often, I have lost so many times about
    what the rules really are, that I am humbled by even trying to
    address it. Suffice it to say, trying to value assets is like
    trying to value a company. Nobody knows how to do it precisely.
        I do believe the right way here is to force the
    independence of the auditors. I think the December 12 release
    of the SEC is the beginning of that path.
        The auditors have to come in and say, there is another way
    to do this. If they put it squarely to the audit committee,
    well, you have done it this way, but, by the way, there is $600
    million of debt and $600 million of losses in that subsidiary
    firm that you are not disclosing, and we the auditors want you
    to know that that was the other way to do it, and if they have
    enough courage, and they should have, they would say, if it was
    left to us, we would do it that way. And if you write that in
    the MD&A, or the 10(k), you have gone a long way to solve the
    problem.
        Senator Shelby. Mr. Chairman.
        Mr. Breeden. One little footnote on that. In the law, we
    have statutes and then we have the Constitution. We have
    sometimes higher principles that are more general principles
    that override lots of other details.
        I think over the years, FASB has issued more and more
    standards that are literally 700 or 800 pages long. And we are
    in need here of a little more of a concept of the Ten
    Commandments, some constitutional principles from the FASB that
    says, look, no matter what the 800 pages, when you are finished
    with the cookbook, thou shalt not do certain things. Thou shalt
    not overstate income. Thou shalt not conceal or fail to
    disclose certain magnitudes of relevant information.
        There is a value to the cookbooks in working through
    specific problems. But we need a better sense of some
    overarching principles that say, when you are all done, the
    result had better fairly reflect what you see in reality.
        Senator Dodd. The international standards in accounting
    follow more that approach.
        Chairman Sarbanes. Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman. I wish we had
    hours to go over these issues.
        Chairman Sarbanes. This is a wonderful panel.
        Senator Corzine. You have talked about revenue recognition.
    One of the other areas is expense recognition. One of the most
    controversial topics is option accounting and payment.
        First, I would love to hear comments with regard to the
    debate that goes on with whether this also undermines the
    quality of earnings of reported and how you all feel about it
    because I think it is equally important to revenue recognition
    and potentially distorting the presentation of earnings.
        Second, I would love a little discussion with regard to
    what is the proper oversight body with regard to the accounting
    industry?
        I was very pleased from a personal perspective that
    Chairman Breeden talked about creating an SEC division of
    accounting, and went on to talk about the need to do that.
        If we cannot pay people, I do not know that we should move
    down that road. But that really is another issue.
        I wonder whether we believe that we can create a self-
    regulatory organization that has the independence and the
    discipline to generate the public confidence.
        I would love to hear any of your specific commentary with
    regard to Chairman Breeden's particular response of a SEC
    division which I guess is a suggestion as an alternative to the
    POB. So both of those areas, I would love to hear comments on,
    and a lot of others, but those I think are maybe important to
    get out on the table.
        Mr. Breeden. Senator, maybe I can start and just summarize
    briefly where I am.
        Self-regulation is a wonderful thing and I think all of us
    have great regard for it, and when it works, it works
    beautifully. But I can tell you that there are enormous
    differences between self-regulation as it exists in the
    securities field and self-regulation as it has historically
    existed in the accounting field.
        We had cases when I was at the Commission where a major
    problem occurred at some of the major securities houses and
    sometimes the person would be out on the street before we would
    even find out about it.
        The firms had, in general, not universally, but in general,
    a good attitude that if they had bad apples in the barrel, they
    were going to get them out of there. And the SEC would come
    after them if they did not.
        So self-regulation, as William O. Douglas said, the SEC was
    the shotgun behind the door, and that Government presence backs
    up self-regulation.
        The accounting industry, I think historically, has not come
    at it the same way. Their attitude is more like Marines. We do
    not leave anybody behind. We do not leave our wounded. We want
    to protect everybody. And it is a noble instinct, but the fact
    of the matter is that you are going to have in any group people
    who deserve to have their ticket pulled, who need to be given
    another line of work because they are just not competent or
    they do not have the affects that are required.
        I think we have had consistent failure of self-regulation
    in the accounting field to do the disciplinary job.
        If an accountant is caught selling drugs on the street
    corner, I think the AICPA will throw them out. But we have had
    case after case in which the SEC has had to try and throw
    people out, where they have knowingly allowed companies to
    overstate income and not forced changes to occur.
        Sometimes we have too many restatements, but sometimes we
    do not have enough, when accountants know that the accounts are
    being overstated.
        My own view is that at least the starting point ought to be
    that the body with ultimate power of overseeing the
    professional behavior of the accounting profession needs to be
    a Government body. They need to have subpoena power. They need
    to have handcuffs. They need to have teeth.
        This is an area where there has to be clear requirements of
    law that become applicable.
        Now downstream from that body, and I believe that body is
    the SEC. We have 70 years of experience. We do not need to go
    and invent another one. We need to invigorate the SEC and make
    sure it has the tools to do the job. Let's not reinvent the
    wheel. Downstream from the SEC, private sector groups can be
    helpful. And I do not mean to exclude that. But let's do not
    lose sight. The primary enforcer of the law needs to be the
    Commission.
        Mr. Williams. I would support that.
        Mr. Ruder. My testimony really follows what I think the SEC
    is proposing generally. And that is the creation of, not a
    self-regulatory organization, but a regulatory body in which
    all of the members are not connected with the accounting
    profession. That body would have the power to create auditing
    rules and then would have a disciplinary function and would
    have a function which would allow it to review the way in which
    the auditing profession is self-regulating itself.
        That whole apparatus would be financed by a legislatively
    imposed finance system, but would then be supervised by the
    SEC.
        I think that Richard and I agree that we are talking about
    a way
    in which the SEC can leverage its resources by having a public-

    private body which it can use to accomplish its functions.
        Senator Corzine. That is really different, though, than
    what I thought I heard Chairman Breeden say. I think he was
    suggesting expanding, creating an SEC division of accounting.
        Mr. Breeden. I think we agree in part and diverge in part.
        I think that if the problem is we need to leverage the
    SEC's resources, then impose the user fees and give the
    resource to the SEC and let them go out and do the job.
        We shouldn't be creating private-sector groups because we
    think that we do not have the resources to enforce the law. And
    we are talking about law enforcement here, not just a trade
    association.
        Mr. Levitt. I am not sure that there are any absolutes
    here. I tend to be closer to David Ruder's formulation in that
    we are not talking about self-regulation any longer. We are
    talking about oversight. We are talking about reassuring a
    public whose confidence has been severely shaken.
        I tend to believe that the SEC is pretty stretched right
    now in terms of resources. And while they retain the ultimate
    responsibility for overseeing this effort, if you were able to
    assemble a small group of publicly credible individuals that
    would undertake this assignment, perhaps even on a short-term
    basis, overseen and perhaps appointed by the SEC, that would be
    a useful first step.
        As to your question about options, I clearly believe that
    options have value. The fuss and furor would never be as great
    as it has been if options did not have value.
        I believe the greatest mistake that I made in my years at
    the Commission was not encouraging the FASB to move forward
    with an accounting for that value on the income statement.
        So, I think that issue, which the international accounting
    standards board is much further along than the FASB is today, I
    think that this should be very much on the front burner.
    Recognize it as a contentious issue, but move ahead with it. It
    has implications that are enormously important to America's
    investors. And in this environment, for us to stand back and
    allow that chasm to not be closed I think is a dereliction of
    our responsibility.
        Mr. Hills. Senator, I quite agree with that. The notion
    that we do not have an expense item in our balance sheets for
    profit and loss options is perfectly silly.
        On the accounting profession, let's say again, the SEC is
    way, way short-handed in dealing with accounting problems. I
    had a case 3 years ago where we reported a $2\1/2\ billion
    write-off. I know the Commission is working very hard on it. It
    is a very difficult case. They do not have the manpower. They
    will bring it sooner or later, but they do not have the
    manpower to bring justice swiftly.
        Senator Corzine. I would say, though, and this is a
    recurring theme of the comments, that subject of self-help by
    the Congress, making sure that we have both the resources, pay
    parity, to have the SEC do the job that it is being asked to
    do.
        Mr. Hills. Absolutely.
        Senator Corzine. It is one thing to say that we ought to do
    something else because we do not have the resources. We can
    correct that problem if we think it is important enough.
        Mr. Hills. In addition, the idea of having a separate body
    that is supported by guaranteed funds rather than voluntary
    funds is important.
        But Arthur Andersen, in response to its problems, did an
    interesting thing in turning over considerable authority to a
    different board.
        There is nothing wrong with auditing firms having their own
    audit committees.
        Chairman Sarbanes. Senator Enzi.
        Senator Enzi. Thank you, Mr. Chairman.
        I really appreciate this learned panel and I really
    appreciate the fuller statements that you did not have the
    opportunity to share with us. I would encourage all of my
    colleagues to read those. There are a tremendous number of
    ideas in there that are worth looking at. I have to say that I
    started with Mr. Hills' paper, because he was the furthest
    removed from any of this.
        [Laughter.]
        Mr. Hills. I wish it were true.
        [Laughter.]
        Senator Enzi. And I have to say that, after reviewing that,
    I looked at your credentials and found out that you have done
    some teaching as well. I decided that I would really like to
    take a course from you.
        [Laughter.]
        I learned a lot from all of the papers, but I like the
    clarity with which you presented things. There was a focus on
    accounting because there has to be a focus on accounting, but
    it did not dominate quite the way that the testimony did.
        I know that in this one, the accountants are the easy
    target. But I think it is kind of like when there is an
    airliner that crashes, all planes become a little safer the
    next day.
        There is a depression in the accounting market. I tried to
    talk all three of my kids into going into accounting, but none
    of them would. I think there is kind of a shortage of people
    going into that.
        I have a concern for what happens if some of the drastic
    things that we are talking about on a Federal level get adopted
    into small business. If the bankers themselves, when they are
    talking to a small group of investors, want to have some of the
    same separation, thinking that it would make it a far safer
    investment. And it might. But it might not also be available.
        One of the things I had hoped was that there would be a
    little bit more concentration on some things that the SEC could
    do.
        Now, I appreciate the comments about the need for pay
    parity, and this Committee on a number of occasions has tried
    to get that, and we will be working for it in the budget and in
    the appropriation as well, I am sure.
        Chairman Sarbanes. My own view, the package that was put
    together on the fee reduction and the pay parity was linked and
    that, really, the good faith was broken by taking the one and
    not coming through with the other. But that is an issue we will
    have to try to address and resolve.
        Senator Enzi. I do have a couple of questions.
        In 1997, the SEC granted an exemption for the Investment
    Company Act to Enron and the exemption allowed Enron to shift
    debt off of the books of its foreign operations. It also
    allowed executives to invest in partnerships affiliated with
    Enron.
        I wondered if Chairman Levitt could give me some more
    information about this type of an exemption, why it would be
    granted and if that exemption is granted widely to other
    companies.
        Mr. Levitt. I am told that that exemption followed a
    pattern of events that occurred and exemptions that occurred in
    the past and was part of delegated authority given to the
    Division of Investment Management and other divisions in those
    instances where a particular Commission action followed along a
    pattern of action that had occurred in the past.
        In talking to the then-director of that division, I am told
    that the exemption followed a much more limited application of
    a request that was made at that time and was entirely
    consistent with practices that the division had followed for
    some years before that.
        Senator Enzi. Thank you.
        It also appears that Enron's board suspended their
    corporate ethics codes. Specifically in mid-1999, they granted
    a waiver to Mr. Fastow, who set up LJM-1. What are the
    restrictions on companies waiving ethics codes? Do they have to
    report these waivers to the SEC?
        Mr. Levitt. I do not know the answer to that question.
        Mr. Breeden. I do not think, Senator, that there is any
    direct reporting requirement. Of course, the question of
    fiduciary standards is principally an issue of State law under
    a Federal system. The corporation laws of Delaware or other
    States would principally apply.
        One of the things I said in my testimony was, certainly,
    that we should require, and this is something that the
    Commission can do, to go out and require the filing of an 8(k)
    in events like that where an ethics code is being suspended or
    certain types of conflicts are created.
        There is a concept that 8(k)'s, which is the immediate
    report--you do not wait for your quarterly report. That is
    something you file right away. There is a concept in the law,
    rightly, that you only disclose things that will have a
    material impact.
        And for a huge company, the number of what is material is a
    huge number. So that companies can take the view that, well, we
    allowed Mr. Fastow to go out and do an investment and that is a
    small dollar amount and therefore, it doesn't meet the
    materiality threshold.
        In my view, we should define conflict situations involving
    the key corporate officers, and certainly key financial
    officers, as inherently material, because they say something
    about the level of board oversight. They say something about
    the risks the corporation is willing to tolerate, and that they
    will be dependent on other defense mechanisms to protect
    against those conflicts, and therefore, we ought to just define
    that as always material.
        Senator Enzi. I see that my time is expired. I would
    appreciate the opportunity to submit some questions to you. I
    have some very specific ones based on what you wrote that I
    would like some clarification on, and would hope that I could
    do that with each of you.
        Chairman Sarbanes. I am sure they would be happy to respond
    to your questions.
        Senator Enzi. Thank you for your testimony.
        Chairman Sarbanes. Senator Stabenow.
        Senator Stabenow. Thank you, Mr. Chairman.
        Again, thanks to all of you. This has been a very important
    opportunity for us to hear your input. It has been extremely
    helpful and I hope we will be able to call upon you as we move
    forward.
        In the interest of time, I will be brief. But I do have a
    question for Mr. Levitt that relates to the report that was put
    together or in the process of being put together by your Chief
    Accountant when you were at the SEC, Lynn Turner.
        I am sure you are aware of the Wall Street articles that
    have been done regarding this report in the amount of dollars
    and outside consultants that were put together, and the
    description of the report, even though it was not released,
    which is a concern of mine. I have some questions for Mr. Pitt
    as to why the report was not finished and released.
        I am wondering if you might give a sense of your goals in
    requesting that the report be put together, and any
    recommendations that you are aware of that were in that report,
    even though it was not released at this point.
        Mr. Levitt. Our concern during this period was that the
    very real danger to the public interest represented by a fierce
    and contentious fight between three of the Nation's largest
    accounting firms and the Commission that was aired publicly in
    a series of public hearings throughout the country left
    unresolved a number of issues dealing with the independence
    question.
        In that connection, knowing that we were unable to get
    everything that we wanted in terms of rulemaking, I asked the
    division to take the results of that public hearing, together
    with letters that we had received from a variety of sources in
    the months prior to our rulemaking, and turn that into a
    document which would be widely distributed throughout the
    country, to both reassure and warn the public about the dangers
    inherent in an unresolved independence issue.
        I had urged our Chief Accountant to do this, even after I
    had left the Commission. But I believe that she too was seeking
    separation and I think in the change-over, the transition
    period where a new Chairman had not yet been chosen, the
    Commission was short-handed, it fell between the cracks.
        I became so frustrated that I told him to send me all his
    work papers and I would write it myself.
        But what has happened, interestingly enough, is the Enron
    issue has so ventilated and exposed this issue, that the need
    for such a report has been totally obviated.
        I would like to make another point clear. And that is that
    my successor Chairman Pitt, was in no way involved in the
    decision not to move ahead with this report. That just resulted
    from administrative confusion and all of that occurred before
    he set foot in the agency.
        Senator Stabenow. I appreciate that. I would still welcome,
    if you would like to sit down and put that together, I would
    certainly welcome having the opportunity to review that.
        One other quick question.
        Mr. Ruder, in your testimony, you argued that steps should
    be taken to prevent employees with 401(k) plans from over-
    investing in employer's stock.
        I am surprised that my colleague, Senator Corzine, did not
    ask you this question because I know of his leadership and work
    on this issue. But I wonder if you have a percentage in mind
    when you speak about capping such investments in 401(k)'s. What
    would be your recommendation?
        Mr. Ruder. Well, my testimony takes the position that an
    employee determining his retirement benefits, should not be
    engaged in having all of his or her investments in a single
    company, and that the portfolio theory of diversification ought
    to be applied.
        I am not a portfolio theorist, but my number would be
    between 10 and 20 percent of an employee's portfolio, and no
    more to be allowed in a company's stock.
        If that employee has other resources and wants to buy stock
    on the outside separate from his or her employment account,
    that is fine. But to put that employee at risk regarding the
    success or the failure of his or her company based upon his
    retirement amounts, I think is wrong.
        Senator Stabenow. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Dodd.
        Senator Dodd. Thank you, Mr. Chairman.
        Let me echo the comments of others that have been made.
    This has been very, very worthwhile, tremendously helpful. The
    only problem you are probably going to create as a result of
    this is we are going to be calling on you a lot, I think, in
    the next number of weeks to talk about some of this.
        Mr. Breeden, you had a rather lengthy summary and analysis
    of very specific suggestions, and I commend you for it.
        I mentioned earlier that Senator Corzine and I had
    submitted a series of suggestions, not in legislative form.
    Some of them we have all gone over already--the auditor
    independence issue, the SEC's resources, the independency of
    FASB.
        In your testimony, a lot of you included this, and very
    quickly, the revolving-door issue. I think, Mr. Breeden, that
    you called it the cooling-off period. There has been a
    suggestion here that we ought to, in terms of people being
    hired, this not uncommon practice of people who are part of the
    auditing team or the accounting team being then hired by the
    very firm.
        We have seen these rules adopted here at the Federal level
    in terms of periods of time, limitations of a couple of years
    or more. Just very quickly, do you feel as if a rule in that
    area is necessary?
        Mr. Levitt. Yes, I do.
        Senator Dodd. You do.
        Mr. Breeden. Yes.
        Mr. Ruder. I think it would be very positive.
        Mr. Williams. I agree.
        Senator Dodd. Would you do a couple of years, more or less?
        Mr. Hills. I think it is definitely needed. Keep in mind
    that there are a lot of jobs in a corporation. This is a
    terrific example of something that needs some real thought.
        Senator Dodd. Yes. And by the way, we would appreciate it,
    you commented on this pretty much, but we think the FASB issue,
    for instance, there that you might have the exchanges become
    the source of the funding for FASB, done through the exchanges.
    It is one idea that is not unique. I think others have raised
    this.
        I think, Mr. Ruder, you talked about having obviously a
    separate, maybe Federal, agency hired by the SEC, but paid for
    out of Federal taxes, rather than being paid out of any other
    entity. Is there a possibility of the issue being paid by the
    exchanges? Does that have any appeal?
        Mr. Levitt. I think the exchanges are one vehicle. But I
    think maybe a better vehicle would be perhaps a user fee based
    upon public companies that are audited and could pay a small
    percentage of that toward funding these.
        Chairman Sarbanes. All these fees we gave away, we could
    have kept a little bit of it to fund this operation on the
    basis of investor protection, providing a direct assurance to
    the investor that the judgments that were going to be made were
    going to be done by independent people whose paycheck wasn't
    dependent.
        Mr. Levitt. You just cannot imagine the problem of seeing
    the members of the board of the FASB have to go hat in hand to
    corporate America asking for funding each year. It is crazy.
        Senator Dodd. I looked and tried to get a breakdown of how
    they do it. I think 20 percent comes directly from the
    accounting industry and the rest comes from selling of
    publications and reports. Is that correct?
        Mr. Levitt. A lot comes from selling publications and
    reports, but a lot comes from going to corporations.
        Chairman Sarbanes. They sell them by weight. That is why
    they have 800-page rules.
        [Laughter.]
        Mr. Breeden. We could perhaps kill two birds with one stone
    by putting a user fee on that would apply, require the payment
    of a small percent of all assets that are held off balance
    sheet.
        [Laughter.]
        Senator Dodd. I was going to get to that in a minute here.
        [Laughter.]
        Go ahead, Mr. Williams. I am sorry.
        Mr. Williams. My proposal was that we add it as a surcharge
    to the audit fees.
        Senator Dodd. Yes, that is another way of doing it.
        Mr. Ruder. There are many ways that it can be done. I
    happen to be on the board of the Financial Accounting
    Foundation at the present time. It is really a hard matter to
    be a board member there and find that the body just does not
    have enough money to fulfill its obligations, and then to feel
    that you have to go out and raise the money for it.
        I would like to see a fee which was sufficient to fund the
    FASB and this new body that we are talking about and relieve it
    even from attempting to have to make money from its
    publications. These publications should be free, in my view.
        Senator Dodd. Yes.
        Mr. Ruder. We ought to make them widely available to
    everybody and not require people to pay for them.
        Mr. Williams. And intelligible.
        Senator Dodd. Also, and he's not here, but the Chairman
    knows him and we have had him here before. That is Ed Jenkins.
    I think he has done a terrific job at FASB. I have a very high
    regard for Ed Jenkins. He is leaving I think in a couple of
    months.
        But as people start to whack the FASB, and some of the
    shortcomings, and we are all aware of why they occur--I also,
    and I ask you to comment on this, the idea that we are going to
    sort of politically through a legislative process determine
    accounting principles and standards, makes me uneasy.
        I have been a Member of this Committee when, frankly, I
    have seen the Committee try to dictate what an accounting
    standard or practice ought to be, and it scares me, where you
    get votes of 12 to 13 on something because of obvious reasons
    rather than what may be the wisest decision.
        Also, how the board makes decisions. What are there, seven
    members of this board? It takes five votes to get anything
    done. You have had the SPE rule for, what, 15 years.
        By the way, I am glad you included this very specifically
    in your recommendations of what ought to be done. And I agree
    with you totally. But there is obviously a reason. What has
    happened over 15 years?
        Arthur, why has this taken 15 years?
        Mr. Levitt. The pressure on this, as in other issues, has
    been enormous, and in their efforts to respond to that. There
    are an endless series of hearings and resubmissions and delays
    in the interest of meeting the demands of the community and the
    demands of legislative pressure. It is a very cumbersome,
    unresponsive process. And you are quite right that the efforts
    to legislate a change injects a measure of politics into this
    that we were supposed to insulate it from.
        Senator Dodd. Yes.
        Mr. Williams. It is another example of lack of
    independence. It is not just the auditors that lack
    independence. It is the rulemaking agency that does as well.
        Senator Dodd. Exactly. Let me just add something. What
    Enron did on the SPE's, is that legal? That is legal today what
    they did. I mean, they may have, how they handled the money----
        Mr. Levitt. They would argue that it was legal. I am not
    convinced that it is. But they would make the argument that the
    rules are sufficiently vague.
        Senator Dodd. That you could set up 4,000--that is the
    number I read in the press--separate entities to hide losses?
        Mr. Levitt. That was the number.
        Mr. Breeden. Certainly one of the things the investigations
    and others will look at is whether they were using these
    entities in compliance with the law or whether they, in fact,
    violated the standards applicable to them.
        Senator Dodd. Yes.
        Mr. Breeden. Clearly, we do not have enough disclosure with
    these entities. But we do have to be careful that asset-backed
    financing is a hugely important technique for particularly
    smaller companies, letting credit be extended against the
    credit of certain income-generating assets rather than against
    the credit of the company itself, is perfectly responsible.
    There is nothing wrong with it.
        The company in which I was CEO, we had not one, but two
    SPE's. Maybe that is a little bit of a public confession here,
    but we did run every penny of our SPE's through the income
    statement and they were on the balance sheet. They could have
    been off balance sheet. We put them on. But whether on or off
    balance sheet, they at least should be disclosed.
        Mr. Levitt. Senator, in 1990, the SPE issue came before the
    FASB and the firms strenuously argued against reconciling this
    issue at that time.
        Senator Dodd. Which firms?
        Mr. Levitt. The accounting firms.
        Mr. Ruder. Sir, there is one other thing that needs to be
    borne in mind here. And that is, if management of companies are
    not honest in their approach toward their accounting, they can
    use the accounting system to their advantage. That is a
    fundamental question that is very hard to deal with.
        Senator Dodd. Last, I just want to make the point, and Mr.
    Chairman, I wish we had time just to discuss this one issue if
    we could. It is a point that you have all made to one degree or
    another.
        That is what I consider the sort of international approach,
    which is the Ten Commandment approach that, Dick, you talked
    about--thou shalt not--as opposed to writing, because every
    time you write that subparagraph third, there is someone out
    there figuring how to get around that paragraph.
        Mr. Breeden. Exactly.
        Senator Dodd. I will make it as an observation rather than
    a question so we get to the next person. But I think it is a
    very important point that we may want to look at as we try to
    detail this in such a way, so fly speck it that you obviously
    create massive loopholes by someone just trying to then get
    around your wording, as opposed to the more generic commandment
    that then puts people on notice that if you cross the line, the
    rules are going to be a little bit more vague. And I realize
    that there is danger in that. But there also may be a real
    advantage to it.
        When you start looking at corporate boards of directors,
    audit committees, regulators, the accounting standards, the
    security analysts, the stock exchanges, the rating agencies,
    this is a very complex area.
        Your testimony today has been terrific. I appreciate it.
        Chairman Sarbanes. Senator Reed.
        Senator Reed. Thank you very much, Mr. Chairman. Thank you,
    gentlemen, for your testimony today.
        Let me begin with perhaps an overly simplistic question. It
    may be naive. But the sophistication of financial instruments
    today, it seems that directors certainly are very much
    dependent upon the advice of accountants and the management of
    companies. Indeed--I will phrase the question--perhaps with the
    sophistication of some of these instruments, that the
    profession of accounting is not up to giving that kind of
    advice. What is your views on that?
        Mr. Levitt. I think you have put your finger on something,
    in terms of why are we where we are today? I think the
    development of these instruments and the changes in the economy
    and the rise of technological innovation has far outpaced the
    ability of gatekeepers of all kinds to stay on top of this. And
    that is why we are where we are now.
        Senator Reed. If anyone else would like to comment.
        Mr. Williams.
        Mr. Williams. I even wonder whether in many cases the
    accountants themselves are capable of understanding what they
    are looking at.
        Senator Reed. Is that a concern that all of you have? I
    have and it is very intuitive because I am certainly not an
    expert here. But it seems to me we have created this situation
    where directors, intelligent, capable people who want to do
    right, just simply do not understand the complexity of these
    instruments. Then you have accountants who they turn to,
    assuming that they are the experts, et cetera, and they too
    might not have that expertise, which leaves it up to the very
    clever architect of these instruments sometimes within the
    company or without the company, to sell them a bill of goods.
    And that might be why we are here.
        Mr. Ruder. Good corporate practice today involving
    complicated derivative instruments calls upon the valuation of
    those instruments, not only by internal financial people, but
    also by a third party. And there are third parties out there
    that can advise boards of directors. It is my understanding
    that the better governed companies will turn to those third
    parties.
        Senator Reed. But that is not a requirement.
        Mr. Ruder. No.
        Mr. Breeden. Senator, just to insert----
        Senator Reed. Mr. Breeden and then Mr. Hills.
        Mr. Breeden. On your point, it is, I think, important to
    recognize that--and this goes back to what we were talking
    about with Senator Dodd--the SPE standard, the whole concept of
    off balance sheet debt creates an enormous, it is like an
    enormous gravitational force.
        Chairman Sarbanes. Yes.
        Mr. Breeden. Because if you can borrow money and use it in
    your business to increase earnings, and you can not report the
    debt so that people taking a quick look at your company say, ah
    ha--I mean, wouldn't we all like to live in our house but not
    have our mortgage?
        So it is kind of the best of both worlds. You can have the
    proceeds of the debt, but you just do not have to show people
    it.
        And, yes, the rating agencies should look through that and
    should go do the homework and find all 4,000 SPE's and add them
    up. But it is more likely to most corporate executives that you
    might get away with it if it is hidden out of sight.
        Now when you talk about pressure, and we have beaten up the
    accountants a little bit and talked about the independence
    pressure, but Wall Street should not come out unscathed here in
    this panel. We have sold trillions upon trillions of dollars of
    instruments whose primary purpose is to do a financing and keep
    it out of sight.
        Mr. Levitt. Absolutely.
        Mr. Breeden. That is done because the rules allow it. No
    one is trying to break the law. No one is trying to defraud
    anyone. But the rules allow it, and so Wall Street says, fine,
    we will help you do that. Executives want to keep the data out
    of sight. Wall Street wants the accounting rules there and
    figures out a way to do it, with the net result that Enron
    shows tragically, that you can have half of the balance sheet
    hidden away under the camouflage netting somewhere. And that
    whole system, it is not any one person's fault.
        Senator Reed. Right.
        Mr. Breeden. But we have to try and tackle all parts of it
    to get back to where investors can really understand, along
    with directors and rating agencies, what the heck are they
    dealing with.
        Senator Reed. Mr. Hills, you had a point.
        Mr. Hills. Let me say again that the audit process has
    become a commodity. The CEO's are not looking for added value.
    The auditing firms are not getting the people. Twenty-five
    years ago, roughly 23 percent of all the graduates of Wharton,
    30 percent of all the graduates of Chicago Business School went
    into the accounting profession. Nobody goes any more from those
    sources.
        The auditors are going to have to pay more money for people
    and the companies are going to have to pay much more for the
    audit.
        Senator Reed. Let me follow up a point that was raised I
    think indirectly by Mr. Breeden's comment. That is, it seems to
    me that in any transaction there are several things. One is the
    impact on the company, the consequence financially. But also,
    there is a purpose to it of why are they doing that?
        Again, this is a question that I do not know the answer.
    Does the accounting profession have to take into consideration
    in their reporting the purpose of the transaction or simply an
    evaluation of what effect it will have on the bottom line?
        And is it important to understand the purpose of some of
    these transactions and disclose those purposes, as well as
    potential financial impacts.
        Mr. Breeden. Senator, I think the starting point is to
    understand, is there an economic purpose at all?
        Senator Reed. Yes.
        Mr. Breeden. The Powers Committee Report indicated that
    many of the transactions that Enron engaged in did not, in
    fact, shift risk, did not, in fact, have any true economic
    purpose. Therefore, their only purpose was to massage the
    financials.
        Senator Reed. But under present accounting rules, SEC
    rules, an accountant would have no obligation to disclose to
    the audit committee, to the public, to anyone else, that this
    transaction has no economic purpose.
        Mr. Breeden. No, sir. I think if the accountant concluded
    that--and I am a lawyer, not an accountant here, although I
    worked in an accounting firm, so take this with a grain of
    salt.
        Senator Reed. I am just a country lawyer.
        [Laughter.]
        Senator Dodd. You played one on television.
        [Laughter.]
        Mr. Breeden. I think if the accountant concluded that you
    have a transaction that has no economic purpose, and yet is
    being reflected in the financial statements, particularly in
    very large magnitudes, that comes close to the accounting
    definition of a fraud.
        If you are putting things in the financial statements that
    have no economic purpose whatsoever, then the only purpose that
    you by definition have is you are trying to manipulate the
    financial statements to appear different than they should.
        I think then you get into the mandatory reporting that was
    put in place by Congress several years ago in which an
    accountant, when they see something that they believe is an act
    of fraud, they are required to go to the board, give the board
    their opinions on that, and if the board does not act, they are
    required to go to the SEC. That is certainly a statute that
    appears to not have been invoked here.
        Mr. Levitt. It is a statute that does not apply to the
    legal profession. The legal profession, a lawyer, according to
    the ABA, if he encounters fraud on the part of one of his
    clients, financial fraud, is not allowed to report it to any
    regulatory body. That is wrong.
        Senator Reed. Thank you very much. Does anyone else have
    any other comments?
        Mr. Hills.
        Mr. Hills. I was just going to say, do not underestimate
    the fear that the auditor has in telling somebody.
        In the case I mentioned a while ago where we wrote off more
    than $3 billion, for 4 years, the auditors were telling
    management that there was 12 serious things they had to do.
    They never mentioned it to the audit committee.
        Senator Reed. Thank you very much.
        Chairman Sarbanes. Senator Schumer.
        Senator Schumer. Thank you, Mr. Chairman.
        I thank the witnesses for their testimony. I have been here
    for some of it, watched some of it on our little closed-circuit
    television. And I guess the general thing that concerns me, and
    I think Chairman Hills touched on this a little bit, is the
    free-rider problem.
        Overall, we have goodwill for our accounting profession.
    So, everyone says, okay, that goodwill, which is essential to
    every firm's functioning, stays. Even if I cut the corner a
    little bit, it won't hurt. And that adds up and adds up and
    adds up and sooner or later, something happens.
        So one of my questions is, what can we do to stop that from
    happening? I have a number of ideas here. Some of them are
    pretty calm, some of them are pretty radical. But I would like
    to know your opinions of all of them as we try to figure out
    what to do.
        Maybe I will mention all four and then have you comment
    because I know we have to get going. So that may speed things
    up a little bit. Here are the four.
        Obviously, with special purpose entities, this is one of
    the most opaque accounting techniques that have been brought to
    the public's attention. One of the most disturbing elements of
    these offshore partnerships, I was shocked to learn that only 3
    percent of the capital must come from outside investors for a
    partnership to be considered off balance sheet. Has there been
    consideration to raising that number to, say, 15 or 20 percent?
    I have never understood the rationale of the 3 percent.
        Should we consider the use of SPE's material de facto? I
    think somebody brought that up and I would be interested in the
    other four people's opinion. What is the result if we do
    nothing on SPE's? We do a lot of other things, but we do
    nothing on SPE's. That is the first area.
        The second, also people have talked about this, is
    disclosure of stock sales. I think the thing that bothered
    Americans the most was that the top people at Enron sold stock
    and other people did not know. Some were prohibited from
    selling and others were not. But nobody knew. I mentioned this
    in my opening statement. Chairman Levitt has done some work in
    regard to this. I wonder if an instantaneous disclosure
    requirement of stock sales by senior executives, the Internet
    makes it all very easy to do, might help solve this problem.
        Obviously, there might be too much information. But at
    least it would be out there and it is better than no
    information--too much meaning some of these sales--a guy wanted
    to build a new house in Aspen and he sold a lot of stock and it
    had nothing to do with the performance of the company, but so
    be it.
        These two others are a little stronger.
        One which I think Chairman Levitt has mentioned is
    mandatory rotation. I do not know if that has come up here, the
    idea of--it has been raised. Okay. Well, if everyone's talked
    about that, I will go look at the record and see what people
    have said. If anyone wants to say anything more about it, it
    has its pros and cons.
        Someone against it who I trust told me that they thought
    the worst thing--this could be bad because the biggest--the
    time when the companies would most get away with stuff if they
    wanted to, like in Enron, would be the first 2 years of the new
    auditor before the auditors learned about the company.
        Finally, what about an uber-auditor, so to speak? When you
    hear of an IRS audit, everyone says, uh oh, IRS audit. Well,
    what about the SEC occasionally going in on its own, giving it
    the authority and resources, which of course we tried to do in
    the 31(e) bill and we hope--Senator Johnson has talked about
    this--but what about occasionally the SEC just doing its own
    audit, like the IRS does, probably not on that frequent a basis
    as the IRS does, not for one out of every 50 or 100 companies.
        Particularly if they had the power to go in and they began
    to smell a little something, they could go in and do it. And
    the fact that they could do it would be prophylactic and that
    they would do it on occasion might help reveal some of these
    problems before they grew and grew and grew.
        I am particularly interested in your answers to the last
    two, that one, but all the others as well. We can go down the
    line, Chairman Levitt first.
        Mr. Levitt. As far as the mandatory disclosure, I think
    that would be a useful exercise. I think the notion of the SEC
    doing spot audits occasionally, if they had the resources, that
    might be a useful exercise. As far as the SPE's are concerned,
    I really would have to think more about that issue. I know that
    the Big 5 and all the investment banks like the imprecision of
    the SPE's, which gives them an opportunity to be creative and
    charge fairly hefty fees. But this is a complex issue and I
    would rather not give you a knee-jerk answer to it.
        Senator Schumer. Thank you.
        Chairman Breeden.
        Mr. Breeden. Well, I too think your idea of an uber-
    auditor, I guess that is part of what I was trying to say in an
    earlier exchange about my doubts about all these private-sector
    bodies that we are going to form and it will take 2 or 3 years
    to get up and running. Meanwhile, what are investors supposed
    to think about our markets.
        I think the SEC has always had this role built into its
    function, not to do a whole audit. I do not know that this is
    as important. But to go in and test accounting interpretations
    that are really being used in the field and if they find that
    they are not allowable, then to prosecute people for it,
    because that can be fraud.
        It may not be with fraudulent intent and it may just be
    something that people have to be forced to go back and restate
    and make disclosures. But the SEC has long had that role. It
    has been underfunded. They have not had enough people. But we
    should give them more people and use the SEC, not reinvent the
    wheel.
        I absolutely believe that, ultimately, at the top, it has
    an important role.
        Remember, we have five auditing firms. There are five CEO's
    who, in a way, control the audits of every major company on the
    planet. That is a concentration of power that has never existed
    before and it creates huge responsibilities on the firms and
    somebody has to be overseeing how they carry out their
    responsibilities.
        The stock sales, I think instantaneous disclosure is the
    way to go, for at least things that are above trigger levels.
        The SPE's, the 3 percent rule, I believe comes from an SEC
    interpretation that says, well, you may not be entitled to SPE
    if you are above that, but you certainly are not entitled to it
    below it.
        But people then take that as saying, okay, if you get 3
    percent, you are home free. And that should not be the end of
    the analysis and we should certainly make people disclose them.
        Senator Schumer. Chairman Ruder.
        Mr. Ruder. The Financial Accounting Standards Board has the
    SPE matter on its agenda. I hope it will be faster than usual
    in dealing with it. It is also going to be dealing with a
    special problem called lease financing, which creates similar
    problems.
        The disclosure of stock sales through the Internet or
    whatever, immediately or a day after is absolutely a wonderful
    idea and I hope the SEC will go forward with it.
        I think the SEC does currently perform an auditing function
    in its investigative role. Under Chairman Levitt's regime, the
    lawyers in this field began to talk about the year of the
    accountant, and the SEC was very active in investigating
    companies.
        One of the reasons you saw so many restatements in the last
    3 years was because the SEC was putting great pressure on
    companies through their accountants and their lawyers. I think
    that, with more resources, which I agree with, the Commission
    can expand that role.
        I understand you are going to have a discussion of foreign
    matters here. One of the things you should be quite aware of is
    that the auditing function in the United States is one thing.
    But the auditing function abroad is still another.
        We have conglomerate companies with auditing going on by
    foreign auditors who do not even come close to the standards
    that we insist upon in the United States.
        So there is a whole area out there of concern both for the
    United States and for foreign countries which needs to be
    investigated.
        Senator Schumer. Chairman Williams.
        Mr. Williams. I do not understand the standard either,
    where it originates from and certainly I think it needs a
    relook.
        A lot of these issues could be dealt with by disclosure.
    And if we forced greater disclosure of the rules of recognition
    or even the SPE's, the ventilation itself, the public
    disclosure, would give the security analysts and others a
    chance to revalidate the decisions that were made.
        On stock sales, I agree. I think simultaneous reporting
    would be valuable.
        On mandatory rotation, I have been one of the supporters of
    it. I would add another dimension to it, and that is I think
    the audit firms ought to have a firm commitment for 7 years. So
    there is not only the matter of rotating after the 7 years, but
    they ought to be assured of that account so they are
    independent and they are not threatened with losing the
    account.
        Finally, on uber-auditor, I do not like the concept. If the
    SEC had more resources and a sophisticated enough staff to
    really do the job that they are now trying to do, which means
    greater review of filings when they are made, greater review of
    annual reports and 10(k)'s than they are able to do now, and
    the kind of sophistication to smell a lot of this stuff, which
    is not that easy, then with that stronger oversight function
    and oversight of the profession and a different kind of self-
    regulatory body reporting to the SEC who would in turn have the
    responsibility to conduct these audits, with disciplinary
    authority to go along with it, I think we would have a very
    viable structure.
        Senator Schumer. Thank you.
        Chairman Hills.
        Mr. Hills. The short-term answer to SPE's is lots of
    disclosure and understanding and the auditors should be
    responsible for that.
        Stock sales, absolutely. The companies, however, should
    have a policy with respect to key employees selling stock, and
    that policy should be disclosed.
        As to mandatory rotation, I would like to submit a more
    thoughtful piece on that. I think it is a serious issue.
        Chairman Levitt and I conspired to bring somebody of real
    caliber into the enforcement division as an accountant. The
    trouble he had finding somebody of that caliber gives you an
    example of how hard it is going to be.
        Absolutely, they should have that talent. We do not have
    that talent in sufficient numbers.
        Mr. Levitt. Senator Schumer, I would like to make a point
    that, in some of the cases that we have seen most recently, the
    really outrageous cases of Waste Management, Enron, and
    Sunbeam, these were failures that occurred with accountants
    having been there for long periods of time.
        I do not accept the notion that the failure is likely to
    occur during the first years of introduction of a new auditor.
    And there are so few firms today, that I just reject that as a
    problem.
        Senator Schumer. Just to review, so the majority here do
    support rotation.
        Mr. Hills. Well, let me say this. Accountants are not
    perfect and I would not like the idea of being saddled with the
    same accounting firm and no discretion if I am on an audit
    committee to deal with them. So it is not an easy answer.
        Mr. Breeden. Senator, I think I was maybe the odd man out
    there on rotation.
        The resources to audit a multinational company that is
    doing business all over the world are stupendous. There is a
    lot of lead time and a lot of planning. The idea of rotation is
    appealing to deal with independence. But in practical
    application, it will create very substantial risks, not just
    your 2 year risk, but also finding the right groups. Firms over
    time bring in specialists who can help handle particular
    companies, who have certain kinds of accounting risks, and you
    break all that up when you force a change.
        It may be something that the overriding importance of
    independence will take us to. But I do think that there are
    some intermediate steps.
        The one thing I had suggested, not a 7 year engagement
    because I think that is too long, but a 3 or 4 year fixed
    engagement with a requirement that at the end of that, the
    audit committee itself make a determination that the auditor
    should be retained.
        If so, tell the market, put it in the proxy, explain why
    they believe that it is in the interest of shareholders not to
    rotate and to keep that auditor. And if they do, there may be
    good reasons for it, let them.
        Mr. Ruder. On rotation, sir, I have advocated that there be
    a public body to oversee the auditing function and that is the
    kind of issue that a knowledgeable public body could determine.
        As to my own view, I think the suggestion that has been
    made is that you should rotate the engagement partner as a
    means of dealing with this conflict problem, is a much more
    meaningful way of answering the problems that Richard has given
    us rather than trying to rotate the entire accounting firm.
        Mr. Breeden. But we do rotate engagement partners today.
    They cannot stay more than 7 years and it has not solved the
    problem. We clearly have to go beyond just rotating the senior
    partner.
        Senator Schumer. Thank you, Mr. Chairman.
        Thank you, everybody.
        Chairman Sarbanes. I think we need to draw this hearing to
    a close, and the witnesses have been enormously generous with
    their time, both here today and in the preparation of their
    statements.
        I very much regret that we lost that chunk of time earlier
    in the morning because of the votes. We would have had quite an
    extended period there to get the benefit of your wisdom. But
    you have been enormously helpful.
        First of all, we have not talked about derivatives. Do we
    need to look at that and the unregulated nature of the
    derivatives? Is there general agreement that that needs to be
    examined.
        Mr. Hills. Can we break for dinner?
        [Laughter.]
        Chairman Sarbanes. I do not want to get into the substance.
        Mr. Ruder. I believe there is both systemic risk in the
    derivative area and individual risk in the derivative area, so
    that there needs to be a new look at the way derivatives are
    regulated.
        Mr. Williams. I agree with that.
        Chairman Sarbanes. Now, I would like to ask this of the
    panel. I hate to impose on you further.
        We are very interested in the systemic and structural
    changes that might be made that would change the balances of
    these decisions that are made. So, you get a higher standard of
    care and scrutiny working. Obviously, we need to think
    carefully about what that would be.
        And so, I think, if you could take the written testimony of
    the other members of the panel and look through it as well,
    because those statements are quite good, and if you could then
    give us the benefit of your thinking in that regard. In
    particular, any legislative language, since you are all former
    Chairmen, that would deal with some of the proposals you
    suggested that you could forward to us, that would be very
    helpful.
        I would hope we could come back to consult with you as we
    proceed ahead.
        The Committee work program, just partly to outline it, on
    Thursday, we are hearing about international accounting
    standards.
        We are going to have Sir David Tweedie, who is the Chairman
    of the International Accounting Standards Board and former
    Chairman of the U.K.'s Accounting Standards Board. And Paul
    Volcker, who is Chairman of the Trustees of the International
    Accounting Standards Committee.
        Right after the recess, we will hear from the former Chief
    Accountants of the SEC, former Chairmen of FASB, and then we
    are also going to do a corporate governance panel. Then we will
    move on to March with a series of hearings, probably two a
    week.
        But we really want to examine very carefully and lay the
    groundwork here for reaching some judgments about what should
    be done, much of which, of course, each of you has outlined
    here today in your testimony before the Committee.
        So, we very much hope you will be willing to continue to be
    of assistance to us. I hope we have a chance here to get
    systemic and structural changes that will really move us to a
    different plateau.
        I have watched much of this over the years and FASB has
    been criticized for being slow. But every time they try to do
    something of significance, they run into a storm of counter-
    opinion.
        We talk about the Congress not setting accounting
    standards, and I agree with that. But then the Congress does
    not want the FASB to set accounting standards, if the
    accounting standards are, ``moving in the wrong direction, as
    they perceive it.'' Of course, they perceive it because of the
    people who come in on them and say, ``well, this is moving in
    the wrong direction.''
        We have to somehow be able to break out of that mold and
    put in place a structure and a system that gives us greater
    assurances we are not going to be confronting what we are
    looking at now.
        We very much appreciate your coming today. Unless my
    colleagues have something they want to add, I am going to draw
    this to a close.
        Senator Dodd. I think it has been very worthwhile, Mr.
    Chairman, tremendously helpful. And I hope that you will stay
    engaged with us on these issues. They are tremendously
    important and tremendously complex.
        I think the Chairman has a great schedule here for us to
    look at all of these carefully because when you start pulling
    all of this together, and the unintended consequences.
        Everybody has 20/20 hindsight. When you are in the middle
    of this trying to craft rules of the road here that are not
    just going to respond to an Enron, which is the obvious matter
    that has brought us all to this level of temperature and
    interest.
        We want to make sure in solving that problem, that we are
    not creating some other ones and lose sight of the fact that
    the world still comes here because of the confidence in the
    markets and also the fairness and the openness of them.
        And I want to make sure as we go through this that we are
    not creating problems that we wouldn't want to look back on in
    some future Congress and have to undo again.
        So, we look forward to working with you.
        Chairman Sarbanes. We have an intense period ahead of us.
    There is no question about it. We need to address this
    situation with some expedition. At the same time, we need to be
    very thorough and careful so we reach the right judgments. I do
    not regard those two as being inconsistent with one another.
    You just have to redouble your efforts in order to move ahead.
        Obviously, we have to have some sense of urgency about it.
    Otherwise--I quoted those headlines in the paper and if we do
    not put something into place, I do not know how you are going
    to restore investor confidence.
        Plus, I do not intend to let it languish and then we lose
    the momentum to do something of consequence here.
        Did someone have something that they wanted to add?
        [No response.]
        Thank you all very much. We appreciate it tremendously.
        Mr. Williams. Thank you.
        Mr. Ruder. Thank you.
        Mr. Hills. Thank you.
        Chairman Sarbanes. The hearing is adjourned.
        [Whereupon, at 1:56 p.m., the hearing was adjourned.]
        [Prepared statements, response to written questions, and
    additional material supplied for the record follow:]
                   PREPARED STATEMENT OF SENATOR TIM JOHNSON
        Chairman Sarbanes, thank you for holding today's hearing concerning
    the accounting and investor protection issues raised by Enron and other
    public companies. I would also like to thank the distinguished panel of
    former SEC Chairmen for agreeing to discuss this matter with us today.
        The Enron bankruptcy is a national scandal, one with terrible human
    and financial cost. We in Congress are faced with the task of figuring
    out what went wrong, whether current laws are adequate, and the role
    that greater enforcement of existing laws might play. The collapse of
    such a large, publicly-traded corporation raises a host of issues
    related to auditing, financial reporting, pension fund management,
    corporate governance, and Federal regulation. We must explore every
    avenue to ensure that all Americans, big and small investors alike,
    have the information and the confidence they need to invest in our
    economy.
        The panel before us today is particularly well qualified to speak
    about what role the SEC could or should play to ensure that more
    situations like Enron do not occur. In an ideal world, I would hope
    that Enron was an isolated incident. However, a number of other similar
    situations appear to be cropping up daily. And I have a real concern
    that these problems may indicate system-wide problems related to the
    accounting industry.
        Just last week, this Committee heard testimony from Federal banking
    investigators on the failure of Superior Bank of Hinsdale, Illinois, a
    failure that may cost the FDIC in the neighborhood of $500 million. At
    the heart of the institution's failure was inaccurate valuation of
    residual interests in securitizations. Superior's auditor, a nationally
    recognized accounting firm, failed to unearth obvious problems that
    ultimately led to the failure of the institution.
        Another recent high profile bankruptcy involved the
    telecommunications firm Global Crossing. Last Friday, it was reported
    that the FBI would investigate the firm's accounting practices.
        Clearly, accounting irregularities can have far reaching effects.
    Consider last week's massive sell-off in the stock market. The sole
    reason cited by analysts for this sell-off was investor concern over
    accounting practices. And no wonder--our markets function only when
    investors have the information they need to evaluate the health of a
    business. If the disclosures are incomplete or incorrect, investors,
    even the most sophisticated, cannot make good decisions.
        Aside from accounting issues, another area of special concern to me
    is the conduct of securities analysts and their impact on the market.
    In the case of Enron, we saw analysts turn a blind eye to emerging
    problems, possibly due to conflicts of interest because of affiliations
    with investment banking operations. Clearly, the Chinese wall that
    should have provided an environment of independence for analysts did
    not function in many instances. Incredibly, some analysts continue to
    rate Enron a ``strong buy.''
        [The issues we are talking about can often have far reaching and
    sometimes unanticipated consequences. Take, for example, Enron's effect
    on the surety bond market, which pushed Kmart into bankruptcy. Enron
    utilized surety bonds to insure the proper execution of energy and
    other types of forward contracts. When Enron failed, many of the
    companies involved in issuing these types of bonds got out of the
    market, causing remaining issuers to raise their fees significantly.
    This, in turn, put pressure on companies like Kmart, which use surety
    bonds to insure large inventory orders. The unraveling of the surety
    bond market was the last straw for Kmart, forcing them into
    bankruptcy.]
        The SEC must be aggressive in enforcing our securities laws and in
    keeping our markets the most transparent in the world. I am deeply
    concerned that the SEC has not been given the resources to maintain a
    sufficient and stable human resource base to fulfill its mission. Over
    1,000 SEC employees more than one-third of the agency's staff--has quit
    over the past 3 years, largely due to the low pay scale at the SEC
    compared to other financial regulators and the private sector. As any
    businessperson knows, that kind of turnover has a clear impact on any
    institution's ability to operate effectively.
        Just before Christmas, the Senate passed H.R. 1088, the Investor
    and Capital Markets Fee Relief Act, which President Bush signed into
    law on January 16. In addition to reducing securities transaction and
    registration fees, which essentially amounted to an unfair tax on
    American investors and businesses, the law authorized the SEC to bring
    the pay of its employees in line with the higher pay schedules of other
    Federal financial regulators.
        I was profoundly disappointed to find out that the President's
    budget failed to include additional amounts for SEC salaries for fiscal
    2003. It is no overstatement to say that a strong SEC is an integral
    part of our Homeland Security. And money should be made available to
    ensure that the guardians of our markets are not paid less than those
    minding our banks. It is my hope that we can engage in a dialogue with
    the Executive Branch to address the pay parity issue and create an
    environment at the SEC that enables employees to contribute to the
    economic security of our Nation.
        In closing, I would like to note that Mr. Levitt was ahead of his
    time by attempting to address many of these issues during his SEC
    tenure. At the time, I supported Mr. Levitt's proposal to create strict
    guidelines governing the consulting role of a company's auditors, and I
    am pleased that the private sector and my colleagues are coming to
    understand the wisdom of that proposal. I also understand that a study
    was initiated to determine whether the peer review process employed by
    auditors was appropriate and effective. Clearly, though, more needs to
    be done.
        I thank the witnesses for their extensive and thoughtful written
    testimony, and I once again thank you, Mr. Chairman, for scheduling
    this hearing.
                                   ----------
                 PREPARED STATEMENT OF SENATOR DANIEL K. AKAKA
        Thank you, Mr. Chairman.
        Last week, we examined the issue of financial literacy. The
    testimony of the witnesses confirmed my belief that all citizens need
    to be better prepared to make informed decisions regarding fundamental
    undertakings such as saving and investing for a comfortable retirement.
    However, as Enron, Sunbeam, and Waste Management have shown, even
    individuals with the greatest financial knowledge can be misled because
    of inaccurate and potentially fraudulent information provided by
    companies and approved by auditors.
        Institutional investors owned 70 percent of Enron's shares
    according to the Chicago Tribune. Mutual fund managers, public employee
    pension plan administrators, and bankers were deceived by the
    accounting techniques used by Enron and approved by Andersen.
        Those who suffered most from the collapse of Enron were 401(k) plan
    participants and individual investors. We all are all too aware of the
    Enron employees and the retirees who staked their retirements on the
    future success of their company.
        Institutional and individual investors were taken by surprise last
    fall when Enron announced a third quarter loss of $638 million,
    reduction in stockholder's equity, overstated earnings, and significant
    debt to various partnerships.
        Expanded participation in the financial markets has provided
    increased opportunities for individuals to build wealth. In my home
    State of Hawaii, over half of all households own stock. Investing
    decisions are already extremely complex. When information provided by
    companies is false, investors are not given the opportunity to make
    informed decisions. False information can lead to losses which destroy
    the wealth of investors.
        I look forward to this Committee's thorough examination of
    accounting practices and investor protections. We must ensure that
    investors are provided reliable information to use in making their
    investment decisions.
        I thank the witnesses for joining us and look forward to their
    recommendations on what can be done to restore the confidence in our
    financial markets after the implosion of Enron.
        Again, Mr. Chairman, thank you for convening this hearing.

                                   ----------
                      PREPARED STATEMENT OF ARTHUR LEVITT

               Chairman, U.S. Securities and Exchange Commission
                                  1993 to 2000
                               February 12, 2002

        Thank you for the invitation to share my thoughts on the failure of
    Enron and its implications for our financial markets.
        Today, there is an emerging crisis of systemic confidence in our
    markets. What has failed is nothing less than the system for overseeing
    our capital markets. We have an opportunity to repair trust in those on
    whom investors depend, and in the process, trust in the numbers that
    are the backbone of our capital markets. But our response must be
    comprehensive. Healthy and resilient financial markets depend on the
    accountability of every one of its key actors--managers, auditors,
    directors, analysts, lawyers, rating agencies, standard setters, and
    regulators.
        Enron's collapse did not occur in a vacuum. Its backdrop is an
    obsessive zeal by too many American companies to project greater
    earnings from year-to-year. When I was at the SEC, I referred to this
    as a ``culture of gamesmanship'':

        . . . A gamesmanship that says it is okay to bend the rules, tweak
    the numbers, and let obvious and important discrepancies slide . . .

        . . . A gamesmanship where companies bend to the desires and
    pressures of Wall Street analysts rather than to the reality of numbers
    . . .

        . . . Where analysts more often overlook dubious accounting
    practices and too often are selling potential investment banking deals
    . . .

        . . . Where auditors are more occupied with selling other services
    and making clients happy than detecting potential problems . . .

        . . . And where directors are more concerned about not offending
    management than with protecting shareholders.

        What was once unthinkable in business has become ordinary. In our
    highly competitive economy, more and more business leaders are
    employing financial maneuvers that approach and sometimes cross ethical
    boundaries. Accounting rules are dealt with in terms of ``what can I
    get away with'' or ``if it is not expressly forbidden, it is okay.''
    Financial statements, often, are not an accurate reflection of
    corporate performance, but rather a Potemkin village of deceit.
        At Enron and throughout much of corporate America, optics has
    replaced ethics. Too often, those who manage public companies, audit
    them, and serve on their boards of directors have forgotten that the
    opportunity to realize wealth in our capitalist system comes with a
    responsibility to the public from whose capital they are able to
    prosper. When the motivation to prop up stock prices overtakes the
    obligation to keep honest books, capital flows to the wrong companies
    and the very market system from which these executives profit is
    fundamentally weakened.
        That is why undertaking reforms that preserve and enhance the
    independence of the gatekeepers who safeguard the interests of
    investors is so important. These steps are certainly not a panacea, but
    are the beginning of a much-needed reinvigoration of our financial
    checks and balances.
        First, we must better expose Wall Street analysts' conflicts of
    interest. For years, we have known that analysts' compensation is tied
    to their ability to bring in or support investment banking deals. In
    early December, with Enron trading at 75 cents a share, 12 of the 17
    analysts who covered Enron, rated the stock either a hold or buy.
        Two years ago, I asked the New York Stock Exchange and the National
    Association of Securities Dealers to require investment banks and their
    analysts to disclose clearly all financial relationships with the
    companies that they rate. Last week, we finally saw a response from the
    self-regulators. But it is not enough. Wall Street's major firms--not
    its trade group--need to take immediate steps to reform how analysts
    are compensated. As long as analysts are paid based on banking deals
    they generate or work on, there will always be a cloud over what they
    say.
        Second, company boards often fail to confront management with tough
    questions. Stock exchanges, as a listing condition, should require at
    least a majority of the directors on company boards to meet a strict
    definition of independence. That means no consulting fees, use of
    corporate aircraft without reimbursement, support of director-connected
    philanthropies, or other seductions. In Enron's case, at least three
    so-called independent board members would have been disqualified under
    this test of independence.
        Third, many accounting rules need to be updated to better reflect
    changing business practices to give investors a better understanding of
    the underlying health of companies. Because the Financial Accounting
    Standards Board is funded and overseen by accounting firms and their
    clients, its decisions are agonizingly slow. This well-meaning group
    must defend itself as well from Congressional pressure, which is often
    applied when powerful constituents hope to undermine a rule that might
    hurt their earnings. FASB's funding should be secured not just through
    the accounting firms and corporations, but also a number of market
    participants--from the stock exchanges to banks to mutual funds. And
    the Financial Accounting Foundation, which chooses the FASB's members,
    should be composed entirely of the best qualified members--not merely
    those representing constituent interests. The FASB should then be able
    to focus more on getting the standards right, and avoiding delays and
    compromises that ill serve investors.
        Let me turn briefly to probably the most urgent area of reform.
    Like no other, the accounting profession has been handed an invaluable,
    but fragile, franchise. From this Federal mandate to certify financial
    statements, the profession has prospered greatly. But as an edict for
    the public good, this franchise is only as valuable as the public
    service it provides, and as fragile as the public confidence that gives
    it life.
        It is well past time to recognize that the accounting profession's
    independence has been compromised. Two years ago, the SEC proposed
    significant limits on the types of consulting work an accounting firm
    could perform for an audit client. An extraordinary amount of political
    pressure was brought to bear on the Commission. We ended up with the
    best possible solution--given the realities of the time.
        I would now urge--at a minimum--that we go back and reconsider some
    of the limits originally proposed. While I commend the firms for
    voluntarily agreeing not to engage in certain services such as IT work
    and internal audit outsourcing, I am disappointed the firms have
    remained silent about consulting on tax shelters or transactions, such
    as the kinds of Special Purpose Entities that Enron engaged in. This
    type of work only serves to help management get around the rules.
        I also believe that the audit committee --not company management--
    should preapprove all other consulting contracts with the audit firm.
    Such approval should be granted rarely, and only when the audit
    committee decides that a consulting contract is in the shareholders'
    best interests. I also propose that serious consideration be given to
    requiring companies to change their audit firm--not just the partners--
    every 5 to 7 years to ensure that fresh and skeptical eyes are always
    looking at the numbers.
        More than three decades ago, Leonard Spacek, a visionary accounting
    industry leader, stated that the profession could not ``survive as a
    group, obtaining the confidence of the public . . . unless as a
    profession we have a workable plan of self-regulation.'' Yet, all along
    the profession has resisted meaningful oversight. We need a truly
    independent oversight body that has the power not only to set the
    standards by which audits are performed, but also to conduct timely
    investigations that cannot be deferred for any reason and to discipline
    accountants. And all of this needs to be done with public
    accountability--not behind closed doors. To preserve its integrity,
    this organization cannot be funded, in any way, by the accounting
    profession.
        Finally, it has become clear that the reputation of our markets is
    rooted--in part--in the quality of their regulation. Earlier this year,
    Congress passed legislation to fix the disparity between compensation
    for employees at the SEC and employees at other financial regulatory
    agencies. Unfortunately, the Administration's budget doesn't include
    funding for pay parity. We can ill afford--at a moment like this--to
    allow inaction to implicate the quality of regulation and, as a direct
    result, the quality of our markets. My message to the Congress and the
    White House is simple: ``Fund pay parity.''
        The rise of the baby boom generation, changing retirement patterns
    and markets that sometimes defied the laws of gravity brought more and
    more first-time investors into the markets. These are our friends and
    neighbors, whose hopes and aspirations became inextricably linked to
    the health and resiliency of our markets. We assault those dreams if
    company executives sell out shareholder faith and if those purporting
    to be independent are anything but. Enron, like every other financial
    failure before it, proves that investors bear the ultimate cost. It is
    time to repair what has been lost.
        Thank you very much.

                                   ----------

                    PREPARED STATEMENT OF RICHARD C. BREEDEN

               Chairman, U.S. Securities and Exchange Commission
                                  1989 to 1993
                               February 12, 2002

        Chairman Sarbanes, Senator Gramm, and Members of the Committee. It
    is a great pleasure to appear once again before this Committee. I was
    privileged to serve as Chairman of the Securities and Exchange
    Commission from 1989 -1993. In total I served for nearly 10 years in
    Government posts spanning the Administrations of Presidents Ronald
    Reagan, George H.W. Bush, and William J. Clinton.
        I began my career in New York City as a corporate finance lawyer.
    For the past few years I have served as the bankruptcy trustee
    unraveling what is thought to have been the largest ponzi style fraud
    in U.S. history,\1\ with petition date liabilities to creditors of just
    over $1 billion. When the case is closed later this year I expect total
    recoveries will exceed $700 million. As part of that case I built up a
    public company controlled by our bankruptcy estate and served as its
    CEO for several years. That company was sold yesterday for just over
    $100 million for our creditors and other shareholders.\2\
    ---------------------------------------------------------------------------
        \1\ The Chief Financial Officer of Bennett Funding was sentenced to
    30 years imprisonment after conviction on more than 60 felony counts.
        \2\ This company owned two ``special purpose entities,'' or
    (SPE's), although our SPE's were fully disclosed and included in our
    financial statements.
    ---------------------------------------------------------------------------
        After leaving the Commission in 1993, I spent 3 years as a Senior
    Partner at Coopers & Lybrand, LLC, where I coordinated the financial
    services industry program. I currently serve as an outside director on
    two boards and audit committees of publicly-traded companies, and my
    firm works as an intensive care specialist for companies experiencing
    financial distress or crisis. Thus, during my career I have had the
    occasion to consider the issues of accounting, disclosure, and
    corporate governance as a lawyer, business executive, outside and
    inside director, accounting firm principal, and, of course, as a
    regulator.
        In 1989, while serving as Assistant to the President for President
    George H.W. Bush, it was my great privilege to work with the Members
    and staff of this Committee to craft the landmark legislation that
    ended the savings and loan crisis in America. That was an example of
    the utmost level of bipartisan cooperation to solve a financial threat
    to the American economy, and to the savings of tens of millions of our
    citizens. As a result of our work, the United States was able to
    eliminate the threat to the financial system and to put the savings and
    loan industry back on the path to solvency.\3\ Though I do not think
    anyone involved in that effort received much credit, from President
    Bush who provided strong leadership to the Members of Congress who
    worked closely with us and made forthright decisions for America's
    future. However, we successfully repaired a system that had been
    devastated by financial corruption, extremely poor business and lending
    practices, and in some cases outright criminality. Today, America has
    the strongest banking system in the world, and our savings institutions
    are strong and healthy due in no small part to the legislation that we
    created together.
    ---------------------------------------------------------------------------
        \3\ The savings and loan reform legislation contained a mix of
    changes to criminal and to civil liability statutes, additional
    resources for the FBI and Justice Department to search out and
    prosecute fraud on insured institutions, and changes to enhance the
    authority of the regulatory system to require strong capitalization and
    prudent practices. We took the best of the existing system, and then
    made bold reforms where necessary to fix problems that had occurred. We
    also made sure to vindicate the public trust by bringing to justice
    those who had enriched themselves through fraud and other unlawful
    acts, and doing our best to make sure that the problems could not
    reoccur in the future.
    ---------------------------------------------------------------------------
        With this example in mind, I am optimistic that this Committee has
    the capacity to play a vital leadership role in devising responses to
    the events that took place at Enron Corporation and Arthur Andersen
    (Andersen). The collapse of Enron and the parallel shredding of
    documents and audit failures at Andersen have highlighted weaknesses in
    our corporate governance, accounting principles, auditing practices,
    disclosure standards, pension systems and bankruptcy laws, to say
    nothing of the ethics of some of the major actors.
        While it is easy to condemn the abuses that occurred at Enron /
    Andersen, the difficult task is to design successful reforms. Improving
    transparency of information in the market, producing better accuracy in
    audited financial statements and encouraging better governance of both
    accounting firms and corporations are worthwhile goals, but the trick
    is how to actually accomplish these objectives. Also, we need to make
    any improvements without damaging the systems we already have in place,
    or creating unnecessary costs or overbroad regulation. A group of
    specific possible improvements are included in this testimony for your
    consideration. These are phrased as things that the Committee should
    consider, since there are pros and cons associated with every step,
    though in my experience they would improve our current system. However,
    before describing the specific steps, I would like to outline the
    overall philosophy that I bring to this analysis to give context to the
    problems these recommendations are meant to address.

    Overview
        Overall, the United States has the finest system of accounting and
    disclosure for publicly-traded companies of any country. Our equity
    markets have historically provided a wonderful opportunity for
    democratic capitalism that has allowed tens of millions of investors to
    participate in a broad-based ownership of our economy. For decades
    public policy in the United States has mandated a rule of law for the
    market to prevent price manipulation, financial fraud, insider abuses,
    and other forms of market corruption. In doing that, the Federal
    Government has sought not to limit free markets, but to protect their
    integrity by precluding attempts to rig markets or dilute market forces
    through fraud. We have more comprehensive disclosure of business
    practices, risks and results than any other marketplace, and that
    policy of ``transparency'' has served our Nation well.
        Since the SEC was created in 1934, both Republicans and Democrats
    have been willing to put teeth into the commitment that our markets
    will function within the rule of law, and to achieve the values that
    are embedded in those laws. We believe our markets should be fair and
    open to all participants, from the smallest individual investor to the
    largest institutions. We also believe that it is morally wrong to lie,
    and to seek to profit based on misleading others concerning the truth
    of your financial statements. We have made such conduct unlawful both
    because such market corruption is inconsistent with our values as a
    Nation, and also because this conduct harms our economy by driving
    investors and their liquidity away from the market where it can finance
    jobs and growth.
        Trading on insider information, for example, was unlawful in the
    United States while it was an Olympic sport in other countries. We have
    not only formally required transparency, but also we have devoted real
    resources to policing the accuracy and relevance of financial
    statements and the adequacy of disclosure. All of us who have served at
    the SEC have had the job of putting aside any consideration other than
    protecting honesty and integrity in our markets, and vindicating the
    trust of Americans of all walks of life in the fundamental fairness of
    our markets.
        In the Enron /Andersen case, the trust of investors and employees
    alike was subverted principally by senior executives seeking to enrich
    themselves by painting a picture of an Enron that evidently did not
    exist. While the real Enron had lost hundreds of millions of dollars
    speculating in stocks of other companies and through bad investments of
    one kind or another, the Enron shown to investors had nothing but
    successes to its credit. They were supermen not because of good
    performance, but because they were good at hiding ``income statement
    volatility,'' also known as losses, behind a wall of accounting tricks.
    Indeed, with the savings and loans we used to criticize ``smoke and
    mirror'' accounting. In those terms Enron burned down the forest, and
    employed the entire Hall of Mirrors.
        The interests of employees, retirees, and investors across the
    country were thrown under the Enron bus, and from the facts we have
    seen this appears to have been done deliberately. Of course, someone
    always has to light the fire before the books can be cooked. The
    spectacle of insiders aware of the deadly risks of the ``Raptors''
    selling securities while encouraging their employees to invest has
    aroused the indignation of millions, as has the flagrant breach of
    trust that some of the Enron executives displayed in plundering their
    own company.
        More threatening to the economy than the personal dishonesty of
    individual executives is the rising question in the markets of whether
    the accuracy of financial statements can be trusted. If the market
    loses the ability to trust the accuracy of the financial presentations
    that auditors certify, the result could be very significant risk
    premiums or lack of liquidity for other companies. This is serious
    collateral damage for investment markets, and we have seen this effect
    in the market over the past few weeks.
        Given the stakes, it is very troubling that Andersen is reported to
    have had very serious doubts about the potential for massive inaccuracy
    in the statements. Yet they apparently sat on their hands when they
    could have shared their doubts with the audit committee or refused to
    acquiesce in the company's proposed financial presentations. The fact
    that Andersen had accepted millions of dollars in fees to help design
    the accounting for the partnerships creates a considerable question of
    conflict for Andersen in making its audit decisions.
        Enron may have won its favorable accounting treatment in part by
    failing to disclose all the facts to Andersen, or Andersen may have
    adopted a ``hear no evil, see no evil'' approach to its audit to avoid
    the risk that management might have dumped it from an extremely
    lucrative audit assignment. The timing of the destruction of documents
    by the Andersen audit team suggests that these individuals may have
    thought they had something to hide. At a minimum Andersen was unable to
    put aside its economic interests to stand up to Enron.

    The Critical Role of Auditors
        Accountants play a unique role as the scorekeepers of the market
    economy. While companies in the United States do not have to employ a
    law firm, an underwriter, or other types of professionals, Federal law
    requires a publicly-traded company to hire an independent accounting
    firm to perform an annual audit. In addition to this shared Federal
    monopoly, more than a hundred million investors in the United States
    depend on audited financial statements to make investment decisions.
    This imbues accounting firms with a high level of public trust, and
    also explains why there is a strong Federal interest in how well the
    accounting system functions.
        Auditors are there to get the numbers right, not to help CEO's or
    CFO's hide debt, artificially inflate income, and conceal risk. The
    ultimate objective of the system is for investors, creditors, and other
    participants in the market to have a full and fair picture of the
    financial condition of the company and its results. Market participants
    need to be able to understand a company's risk posture and trends in
    its results. To do that, they have to be able to see the entire picture
    of a company's financials, not carefully selected pieces. Auditing a
    financial statement is supposed to be an exercise in sober reality, not
    abstract art.
        Our tools in getting the numbers right include accounting
    principles that accurately reflect economic substance (GAAP or
    Generally Accepted Accounting Principles), auditing standards that
    detect false numbers (GAAS or Generally Accepted Auditing Standards),
    and trained and capable accountants proficient in the application of
    GAAP and GAAS, backed by firms with sophisticated software, and
    multiple layers of internal review. The system also relies on the
    auditor's independence and integrity to apply GAAP and GAAS
    competently, and irrespective of pressure from the issuer. Enron has
    exposed weaknesses in every one of these areas.
        Part of the problem in Enron was the abysmally poor quality of FASB
    pronouncements concerning off balance sheet liabilities, and the
    latitude that exists to ``accrue'' profits out of mathematical models
    without adequate safeguards to test the validity of the results. The
    poor quality of these standards gives wide scope for mischief in their
    interpretation. Another part of the problem, however, was that those
    with responsibility for insisting on full and fair disclosure by the
    company appear to have ignored their duties to the investing public.
        Even as accounting firms have steadily consolidated into some of
    the largest businesses in the world, earnings restatements and blown
    audits appear to be happening with more frequency, and getting bigger.
    Each of the Big 5 has had huge cases where reported earnings either
    were nonexistent or were substantially overstated. This suggests that
    there is something in the internal dynamics of the firms themselves
    that has gotten in the way of audit accuracy and integrity. Clearly, we
    can do a better job and everyone should work together toward that
    objective.

    Summary of Reforms
        As described above, I recommend that this Committee should consider
    a number of steps to make our financial reporting and disclosure system
    better and more resilient. These would include:

    I. Improving Government Oversight of Accounting and Disclosure
        1. Strengthen the SEC's resources through expanded budget authority
    (offset by increased user fees), immediate and continuing funding of
    pay parity provisions, and addition of 200 new accounting positions. A
    new division within the SEC, not another private sector body, should be
    formed to oversee performance of auditors and their firms.
        2. Add surveillance and prosecutorial resources at the Justice
    Department to oversee accounting fraud cases.
        3. Simplify criminal and civil standards so that there will be
    realistic deterrence against accounting abuses through speedy and
    effective disciplinary cases.
        4. Give the SEC authority to suspend accounting firms from
    accepting new audit clients for limited periods (e.g., 6 months
    suspension) where repeated and flagrant audit failures from the same
    audit firm suggest failure of internal supervision and training. SEC
    should also have the authority to bar an accounting firm from accepting
    the renewal of a specific audit engagement where large restatements or
    other problems have occurred.
        5. Give the SEC authority to mandate the retention of ``books and
    records'' of accounting firms relating to the audit of publicly-traded
    companies. Make destruction of documents relating to audits of public
    companies a criminal offense, and failure to supervise compliance with
    SEC requirements as well.
        6. Mandatory review of all audits when any company files for
    bankruptcy within defined period of receiving a ``clean'' audit
    opinion, or when major restatements occur.
        7. Give the SEC enhanced authority over the setting of accounting
    standards themselves, without politicizing standard setting. SEC should
    have authority to mandate deadlines, or to establish standards (or
    utilize standards from international accounting standards board or
    other authorities) where it finds FASB pronouncements not to be in the
    interest of investors.

    II. Enhancing Performance and Accountability for Accounting Firms
        8. Accounting firms that audit publicly-traded companies should be
    required to have a board of directors with a majority of outside,
    nonindustry directors in a manner similar to current governance of
    stock exchanges.
        9. Consulting activities by accounting firms should be prohibited,
    save for activities determined by the SEC to be closely related to
    auditing and that can be performed in a manner determined by the SEC.
        10. Cooling off periods should be established for senior auditor
    personnel prior to employment at audit clients.
        11. Risk management and audit quality control programs should be
    improved within audit firms.
        12. Enact statutory affirmative duty to supervise audit personnel
    for management of audit firms.

    III. Improved Accounting and Disclosure Standards
        13. Enhance disclosure of ``off balance sheet'' transactions and
    debt.
        14. Enhance disclosure of accrual profits.
        15. Enhance disclosure of specific impact of alternative accounting
    principles.
        16. Enhance disclosure of use of ``special purpose entity''
    (SPE's). All SPE's doing business with an issuer, or whose results will
    affect the financial statements of the issuer, should be disclosed.
    Issuers should be required to disclose regularly the identity of any
    employees who perform services for an SPE, or who receive compensation
    from, or hold direct or indirect investments in, any SPE. Where any
    issuer has an SPE that is not accounted for as part of the issuer's
    financial statements, the issuer should publish its balance sheet,
    profit and loss statement, and cash flow statement as they would appear
    if the SPE was treated as an ``on balance sheet'' entity.
        17. Enhance disclosure requirements for acts raising conflict of
    interest concerns involving senior financial personnel or corporate
    leadership, irrespective of standard ``materiality.''
        18. Speed up disclosure of all stock transactions by senior
    corporate executives.
        19. Consider increased use of cash flow in accounting principles
    and disclosure.

    IV. Corporate Reforms
        20. Prohibit or require disclosure of conflicts of interest by the
    CFO or by other financial officials.
        21. Enhance audit committee independence and role.
        22. Disgorgement of profits from insider stock sales within certain
    periods of time of corporate bankruptcy filing.
        23. Prohibit use of stock or stock options to repay loans to
    executives or require immediate 8-K disclosure. Require compensation
    committee explanation in proxy statement of all loans to executives,
    specify amounts drawn down or repaid, and require shareholder
    ratification of any loans above a certain level.

    V. Bankruptcy Reforms
        24. Consider mandatory trusteeship for large bankrupt companies.
        25. Strengthen the power of the bankruptcy trustees to bring
    actions against professionals, including accountants and lawyers,
    through express grant of standing irrespective of procedural hurdles at
    common law.

    VI. Other Steps
        26. Enhance rating agency integrity.
        27. Improve independence of stock analysts.

    Specific Reforms
    Improving Government Oversight
        Substantially increase SEC resources, particularly focused on the
    accounting area. Add 200 new positions dedicated to detection and
    prosecution of accounting abuses and discipline of professionals, and
    provide full funding of pay parity.

        For decades the SEC has provided taxpayers with a great value per
    dollar expended. However, there has been chronic underfunding of the
    number of trained accounting examiners to review 34 Act filings, as
    well as to provide other vital oversight over the performance of
    auditing firms and their personnel. While 100 million Americans invest
    their savings in the market, and investors in Enron alone lost nearly
    $80 billion in market value, we spend less than $500 million per year
    on protecting the market with SEC oversight. The overall budget should
    ideally be doubled, with new resources directed to accounting
    specialists and examiners. Among other steps, implementing pay parity
    is vital, and this should be funded immediately to lower the ruinous
    rate of attrition among the most experienced accountants and analysts
    who are most capable of detecting a sophisticated problem.
        Our markets are bigger and faster than at any time in history, and
    our oversight resources have not kept pace with growth in the size of
    the market and the number of investors. This is particularly true with
    respect to the resources to analyze financial statements and to
    challenge accounting presentations that are not justified. Like other
    big public companies, Enron's regular filings were sampled every 3 or 4
    years, while as events showed financial condition can change
    substantially in a much shorter period. The SEC should have enough
    staff in the accounting area to review new offerings and periodic
    filings, as well as to support enforcement cases in the accounting
    area.
        Chairman Pitt has recently recommended a new private sector body to
    oversee the performance of auditors and accounting firms. A new body to
    supplement the SEC's activities may be useful. However, I believe that
    oversight of the performance of auditors must ultimately come from the
    SEC itself. The history in this area is quite clear that private sector
    oversight has failed to make a meaningful impact on audit quality. The
    big firms will not challenge each other, and neither will the AICPA.
    Any new private sector group would be inherently too weak to take on an
    Arthur Andersen and /or a giant issuer. The pressure in any large case
    involving the major firms is enormous, and this is such serious
    business that the institutional strength of the SEC is absolutely
    necessary. An experimental new board, however qualified its members,
    will have virtually no chance to win the large cases of accounting
    failure that even the SEC has achieved only rarely over fierce
    opposition from the industry. Of course increasing the budget at the
    SEC is not the only answer to the Enron problem, but it happens to be a
    necessary and vital step in putting better protections in place for
    investors in these vital markets.

        Add surveillance and prosecutorial resources at the Justice
    Department to oversee cases involving accounting fraud.

        One temptation to cook the books in a large public company is a
    possible gain measured in tens or hundreds of millions of dollars. It
    is essential that exposure to jail time be a realistic deterrent
    backing up the SEC's efforts. Accounting cases are long and complex for
    the Justice Department, and require extensive pretrial preparation.
    These cases also benefit trustees in bankruptcy, and the creditors of
    failed firms who may recover more funds due to cooperation from
    criminal defendants. With multiple cases such as Enron and Global
    Crossing occurring after a long bull market, additional prosecutorial
    resources would be extremely helpful.

        Simplify legal standards and clarify authority to discipline
    accounting firms and their personnel, and increase potential penalties.

        During my time at the Commission, the SEC sought to suspend two
    partners of Coopers & Lybrand who had been found to have misapplied
    GAAP by allowing a company to capitalize expenses that should have been
    expensed, thereby overstating earnings. The audits in question occurred
    beginning in 1981 when John Shad was Chairman. The disciplinary case
    brought by the SEC extended from his tenure through 1998, when it was
    finally dismissed after at least three hearings at the Commission and
    two appeals to the D.C. Circuit Court of Appeals. Endless litigation
    took place over the standards the Commission was required to use to
    discipline accounting professionals. This type of challenge has also
    been raised in cases seeking to use cease and desist authority to
    discipline accountants who have failed to properly apply GAAP or GAAS.
    If disciplinary cases can be tied up in court for 17 years, the law
    should be clarified so that the Commission can provide realistic and
    timely discipline in its oversight process.

        Give the SEC authority to bar accounting firms from accepting new
    audit engagements for temporary periods, or to order the replacement of
    an audit firm or to bar it from the next annual renewal of an auditing
    engagement where there have been large restatements or other serious
    problems, or the SEC determines that there has not been adequate
    adherence to GAAP or GAAS.

        Where an audit firm experiences repeated audit failures, and has
    failed to install adequate safeguards for internal controls to prevent
    blown audits and restatements, the Commission should have the power to
    suspend the firm's ability to accept new audit engagements until the
    SEC is satisfied that the internal quality controls of the firm are
    adequate. This is comparable to the FAA's authority to revoke an
    airline's license to provide service, or to ground a type of airliner
    due to repeated problems. Where a major bankruptcy or restatement has
    occurred, the SEC should have the ability to require a mandatory
    rotation of accountants, or to bar the incumbent firm from accepting
    renewal of the audit mandate.

        Give the SEC specific authority to set minimum standards for
    ``books and records'' retention by auditors of publicly-traded
    companies.

        Given the shredding of documents that transpired at Andersen, the
    auditing firms should not be allowed to determine what documents they
    will preserve. These documents may prove vital to both SEC
    investigations, and also to investor or creditor actions against a
    company or its auditors in cases of fraud. The SEC should have the
    authority to specify minimum retention periods for various types of
    documents by auditors of publicly-traded companies, in the same manner
    as the SEC can prescribe such record retention for broker-dealers. The
    destruction of documents other than in compliance with SEC rules should
    be a criminal offense, as should be failure to supervise such
    compliance. Shredding of vital potential evidence should never be
    allowed.

        Mandate reviews of audit performance in any case of bankruptcy or
    major earnings restatements.

        When there is an airplane crash, the NTSB investigates the cause of
    the crash. Similarly, when a publicly-traded company files for
    bankruptcy or makes a major restatement of earnings, within a specified
    period of receiving a clean audit opinion, either the SEC or some
    alternative body should be mandated to conduct a review of the
    compliance of the audit with GAAP and GAAS and to make its finding
    public.

        Enhance SEC authority over the establishment of accounting
    standards.

        Without politicizing standard setting, the SEC should have greater
    say in the establishment of accounting standards by the FASB. Among
    other things the SEC should have the ability to designate priority
    actions and to set binding deadlines for FASB action. In addition, the
    SEC should be able to adopt international accounting standards or
    standards drafted by other authorities, as well as its own staff, where
    it finds that FASB standards are not in the interest of investors. The
    FASB is too slow, standards are too complex, and it is not sufficiently
    accountable for action.

    Enhancing Performance and Accountability of Accounting Firms

        Require audit firms to have boards of directors with a majority of
    outside directors.

        Getting to the heart of these problems involves shifting the
    balance of priorities inside the auditing firms in the direction of
    greater concern for getting the numbers right, and for creating healthy
    governance structures that will open up the highly insular big firms.
        One way of shifting internal dynamics in favor of the public trust
    would be to require that, as a condition of satisfying the
    ``independence'' requirements, an auditing firm for a public company
    must have a board of directors with full power to remove management, to
    determine compensation, and to set overall policy. At least a majority
    of the members of such a board should be from outside the firm. As with
    stock exchanges, there should be a minimum number of ``nonindustry''
    directors on each board representing the interests of shareholders and
    users of the markets. Officers of audit clients should not be eligible
    to sit on such boards.
        For historic, licensing and other reasons, the Big 5 operate as
    limited liability partnerships rather than as corporations. They are by
    far the largest private business organizations that do not have a real
    board of directors. Internal governance comes from various committees
    drawn from within the firm, whose members are elected or chosen by the
    partners or the CEO. They are generally subordinate to the CEO, not
    independent of him or her. While it is an axiom of good corporate
    governance to have a majority (and typically much more than a majority)
    of independent directors who can among other things hold the CEO
    accountable for performance of the firm, the large accounting firms may
    not have ANY independent directors to provide a wider public
    perspective or to have the power to remove the CEO.\4\
    ---------------------------------------------------------------------------
        \4\ PricewaterhouseCoopers has recently announced it would add
    three outside directors to its board, a definite step in the right
    direction.
    ---------------------------------------------------------------------------
        A board composed of independent directors (with similar standards
    for independence as a corporate director is required to have) would go
    a long way to bringing a more balanced approach to how these firms
    manage conflicts between their legitimate profit interests and their
    public responsibilities. Ultimately the CEO of any Big 5 firm should be
    subject to getting replaced if the board does not have confidence in
    the firm's ability to deliver on its professionalism. There should be
    accountability for performance in audit quality, not just profit per
    partner, and that accountability at the top would be better exercised
    by a board of directors rather than the Government. When Andersen was
    agonizing over its doubts regarding Enron's potential accounting fraud
    in February of 2001, discussing the issues with a board including
    outside independent directors could certainly have given management a
    better perspective on the decision they had to make and its potential
    impact on investors, retirees, and others.
        A good precedent for requiring the Big 5 and other auditors of
    publicly-traded firms to create boards of directors can be found in the
    operation of stock markets themselves. Though stock exchanges have
    generally been mutually-owned institutions with many similarities to
    partnerships, these organizations have a board of directors, with a 50/
    50 balance of inside and outside directors. Independent boards is one
    way we institutionalize a body within each Exchange that is directly
    concerned with carrying out the exchange's responsibilities to the
    public.\5\
    ---------------------------------------------------------------------------
        \5\ I served as a public governor of an exchange where the board
    replaced the exchange's CEO because, among other things, he failed to
    satisfy the board that he had taken strong enough steps to create an
    effective legal compliance system. The successor CEO certainly viewed
    building a robust system to stop compliance failures as a direct
    mandate from the board, and understood that failure to make this a top
    priority could cost him his job. Boards within the accounting firms
    could help provide similar perspective and accountability for audit
    failures, while still understanding the economic interests of a firm
    and its business strategies.

        Prohibit consulting activities by the audit firms except where
    ---------------------------------------------------------------------------
    closely related to the performance of audits.

        As Chairman Levitt noted repeatedly during his tenure, the pressure
    to win large consulting fees appears to have eroded auditor
    independence and professionalism, and it certainly has diverted focus
    and attention from the difficult job of auditing within the firms.
        While each of the Big 5 has now announced that it will terminate
    most consulting activities, the firms may differ in exactly what they
    will do, and who they will do it for. Competitive pressures may cause
    firms to minimize the services subject to voluntary restraints.
    Congress can formalize the separation the firms have already announced
    by limiting auditing firms to auditing services and other audit-related
    services as defined by the SEC. At a minimum, the auditing firms should
    be prohibited from providing financial structuring, investment banking,
    internal audit, data processing systems, and legal services for audit
    clients, and perhaps for any client. Audit committees should have the
    ability to authorize hiring the auditor for consulting services that
    are audit-related, such as using the auditors for tax or employee
    benefits planning so long as the fees for such services do not exceed
    10 to 15 percent of the audit fee itself.
    Consider Mandatory Rotation of Audit Engagements
        Though restricting the unhealthy pressure of auditor consulting
    makes sense, this step alone is not a magic bullet that will fix the
    deeper problems of the system. We have not yet seen evidence that
    Andersen's acquiescence to Enron's accounting decisions or its frenzy
    to destroy documents were driven by the consulting business Andersen
    performed for Enron, though this was most likely an element of the
    picture. However, the economic pressures relating to the audit fee
    itself are just as serious a threat to independence of the auditor,
    particularly if the firm is stripped of consulting businesses and
    becomes substantially more dependent on audit revenues than it is
    today.
        There aren't many audit engagements in the world that pay $25
    million each year in perpetuity, so Andersen management probably would
    have stretched as far as it thought was possible to maintain that
    lucrative annuity. Enron's audit fees to Andersen were probably large
    enough to make the Enron engagement partner at Andersen one of the
    firm's highest paid auditors. Thus, even if Andersen had been
    prohibited from everything other than auditing Enron, Andersen's
    decisions on the Enron audit could well have been influenced by many of
    the same pressures.
        One means of insulating the audit firms from the pressure of
    keeping the audit engagement would be to provide for mandatory limits
    on audit engagements to a specified period of time, such as 5 to 7
    years. This would cause considerable costs and dislocation, and could
    also have an adverse effect in some cases lay displacing knowledgeable
    audit teams. A less drastic alternative would be to mandate that the
    audit committee conduct a formal reproposal process at least every 4 to
    5 years, but leaving the decision up to the management and board.
    Cooling Off Periods
        Both Lincoln Savings and Enron hired senior personnel from the
    audit team in senior financial position. The reward of a senior job
    could easily weaken audit independence. While we should not create
    excessive employment barriers, a cooling off period for a senior
    auditor hired by the issuer for its finance department in a senior
    capacity would be a defense against subtle pressures resulting from
    recent service together at the audit firm.

    Investing in Audit Quality and Internal Controls
        Another issue is the basic organization and control systems of the
    major firms. Ironically, while most of the firms provide consulting
    services to evaluate corporate ``internal controls,'' risk management
    as a discipline is far less developed within the audit firms than would
    typically be true at a bank or broker-dealer. There are large numbers
    of analytic measures that could be developed to focus a firm's auditors
    on areas of special risk. For example, if profit growth is
    significantly higher than that of a peer group, auditors should at
    least seek to determine why, and whether extraordinary profits are
    located in any one area, as was the case with the Kidder Peabody
    problems a few years ago. If so, the accounting for outsized profits
    should be double-checked. Where total liabilities off balance sheet
    exceed a particular amount, such as 5 percent of assets or debt, then
    the firms should target special reviews of the qualification for off
    balance sheet treatment. Other financial ratios, or swings beyond a
    certain size depending on the outcome of any particular accounting
    issue, should also be considered for use in trying to identify audit
    engagements where supplemental resources, including potentially an
    entire new audit team, should be considered. Congress should encourage
    the audit firms to do much more in this area, such as by subjecting
    firms that do not satisfy an SEC review of their quality control
    program to additional remedial requirements.

    Duties to Supervise
        Another step would be to adopt statutory duties for accounting
    firms to supervise the conduct of their audit professionals in a manner
    parallel to the express duty to supervise that broker-dealers have for
    their personnel. This duty to supervise is a very effective tool in
    overseeing brokerage firms, and it creates accountability for providing
    oversight that works. Where a firm repeatedly fails to supervise the
    conduct of audits properly, the SEC should have authority to require a
    broad range of remedial steps, including suspending the senior
    supervisory personnel.

    Accounting Principles and Disclosure Requirements
        Enron shows a weakness both in our accounting principles for off
    balance sheet transactions, and also in our disclosure policies. The
    FASB has long had a tortuously slow process for writing accounting
    standards, somewhat comparable to the pace of a glacier trying to run
    uphill. In recent years those standards have become enormously
    complicated too. This leaves a great deal of room for engineered
    solutions by those seeking to paint a particular picture.
        Creative investment bankers and users of derivatives have spent the
    last 10 years developing ways to move financial obligations off the
    books of corporations in conformity with highly complex standards.
    Teams of investment bankers and accountants may work years on
    developing structured transactions to accomplish a form of financing
    with attractive costs but that is not required to be shown on the
    balance sheet. Companies may hope that such off balance sheet debt will
    not be counted by rating agencies or noticed by investors. This does
    not mean that such activity violates GAAP or is wrong. Asset backed
    financing provides critical liquidity for many companies, and is very
    positive for the economy. However, such financings should be shown
    either on balance sheet or through supplemental disclosure.
        From the perspective of disclosure policy, this may be the easiest
    problem to fix. Just because GAAP doesn't require something to show up
    in the financial statements doesn't mean it cannot, or shouldn't, be
    disclosed. Where a company will have cash flow from a financing, it
    belongs on its balance sheet, and should certainly be disclosed. Where
    a debt has to be paid directly or indirectly from a company's cash flow
    (or is diverted from cash flow the company would otherwise receive),
    that debt should be on the balance sheet and disclosed. More realism
    and less artificiality in financial statements was something I
    consistently pursued with the FASB during my tenure at the SEC, though
    I am not sure we made too much progress. Following the cash is a good
    way to get to the bottom of many mysteries, and highlighting cash flow
    earnings could provide more reality for investors. Where a company has
    contingent liabilities, such as Enron's obligations to deliver stock to
    some of its partnerships to maintain certain values, the nature of
    those obligations should be disclosed comprehensively, and the impact
    of such contingencies under various scenarios should also be disclosed.
        Some of Enron's financing vehicles appear to have been structured
    to let the company report income that had never occurred, and that
    might never occur, while essentially arming a neutron bomb in its
    financial structure. That this was not clearly disclosed, and that
    nearly 50 percent of Enron's assets could have been held off balance
    sheet, demonstrates that both GAAP and SEC disclosure standards need an
    expedited review and some fast corrective action to increase
    transparency. The SEC and FASB should work together to structure an
    appropriate combination of policies, with more on balance sheet
    treatment and vastly more disclosure.
        Obviously at some point an asset may be sold, with no right to get
    it back, and without any potential future impact on the Company's
    future earnings or operations. However, where transactions are
    financings in one guise or another, with cash ultimately being realized
    by a company that in one form or another will be repaid (or that might
    have to be repaid) out of future operations, then the overall
    transaction and the risks it entails should be shown either on the
    balance sheet, or in clear schedules included with the financial
    statements.

    Real Profits, Not Accrual
        Sometimes accounting standards are constructed in ways that may be
    theoretically elegant but work to the disadvantage of investors and
    give too many opportunities for mischief in the real world. One example
    of this is ``accrual'' of profits that have not yet arrived in fact,
    such as ``gain on sale'' and ``mark to model'' accounting. Under gain
    on sale, profits from the spread between interest earned and interest
    paid over a loan with a term lasting many years are rolled forward to
    the present when the loan is ``sold.'' The accounting rule takes profit
    that might never occur and reports it today as if it already happened.
        A similar problem exists with many derivative instruments,
    particularly the long duration contracts that are one of a kind,
    without a trading market to provide a valuation. Enron created many
    such instruments, and it booked enormous profits on some contracts
    based on theoretical models that purported to value the cash flows that
    might occur pursuant to the contracts as much as 10 or more years in
    the future. Of course if the assumptions that the model uses are bad,
    the answers will be too --``garbage in, garbage out.'' An auditor has a
    difficult job to test the realism of the assumptions used in such
    valuations. An investor cannot evaluate those assumptions, or know how
    one company's models may differ from another's. The result is that
    management can use unrealistic assumptions to pump up earnings,
    possibly enormously. Here earnings will not be comparable from one
    company to another, due to the differences in modeling that are
    impossible for investors to spot. Perhaps here all such ``profits''
    should only be taken into income as the assumptions actually occur and
    the Company realizes the cash flows.
        To the extent possible, the FASB needs to promote the reporting of
    profits that have already occurred, and to preclude reporting of
    profits that haven't happened in fact. Cash flow is a wonderfully
    ``'real'' barometer of when profit or loss should be recognized, not
    the ethereal and unreliable ``profits'' that we allow to be rolled
    forward and reported today even though they may ultimately never occur.

    Corporate Reforms
        Prohibit specific conflicts of interest by the CFO or similar
    finance officials without full disclosure.

        The CFO of a publicly-traded company occupies a uniquely sensitive
    position. Both the outside auditors and the audit committee will rely
    on the CFO to provide financial information, and to highlight areas of
    concern. If the CFO has a personal financial interest contrary to the
    Company, or even potentially so, this can defeat our entire system of
    controls. While State corporation law typically defines the fiduciary
    duties of officers, Congress should consider prohibiting certain types
    of financial interests by CFO's and their subordinates, or at least
    require immediate disclosure of all such interests through an 8-K
    filing whether or not the amount would otherwise be considered
    material. The interests created in Enron should never be allowed to
    occur in a public company.

    Enhance Audit Committee Independence and Role
        Audit committees won't solve every problem, but they play a very
    important role. Their role in selecting auditors and overseeing
    financial conflicts is very important, and overall their roles should
    be strengthened wherever possible.

        Disgorgement of profits from insider stock sales within certain
    time frames of a corporate bankruptcy.

        We have long required officers and directors to disgorge ``short
    swing'' profits for purchases and sales within a 6 month period. We
    should consider similar disgorgement to the company of any net proceeds
    of stock sales or option exercises within 6 months or a year prior to a
    bankruptcy filing.

        Prohibit use of stock to repay insider loans or require immediate
    disclosure.

        The sale of stock back to a failing company to satisfy loans to a
    CEO or other senior officer robs the company of cash, while shielding
    such sales from public view and potential insider trading liability. It
    is not clear why companies allow substantial loans to senior officers,
    but where these exist repayment should be in cash, not stock. Where
    stock is used, there should be contemporaneous filing requirements. The
    SEC should require compensation committees to describe all loan
    programs and their objectives, as well as collateral and repayment
    terms, in the annual proxy statement.

    Bankruptcy Reforms
        Consider mandatory trusteeships for bankruptcies of major size.

        Where a bankruptcy above a certain size occurs, the Congress should
    consider whether investors and creditors would not be well served with
    a mandatory requirement for appointment of a trustee or other fiduciary
    to oversee reorganization. Alternatively this could be a requirement
    only if an interim CEO is not appointed by the board. However, where
    there has been wrongdoing, leaving the incumbent management in place
    may create new risks, particularly to employees and other unsecured
    creditors.

        Strengthen the power of bankruptcy trustees to bring actions
    against accountants, attorneys, and former officers notwithstanding
    common law procedural barriers.

        In some Circuits, the current law restricts the ability of trustees
    representing defrauded creditors from suing the accountants or lawyers
    for a company that collapses due to fraud or other wrongdoing, even if
    the conduct of such professionals violated professional standards, was
    negligent, or otherwise damaged investors. Actions by trustees or other
    fiduciaries should provide a major deterrent against professionals who
    assist someone in defrauding investors and employees, and should not be
    blocked on common law procedural grounds such as ``in pari delicto'' or
    similar defenses relating to the imputation of the company's wrongful
    actions to the trustee suing on behalf of victims.\6\
    ---------------------------------------------------------------------------
        \6\ The Committee should be aware that I am appealing dismissal of
    several such actions as a trustee, and hence could be said to have an
    interest in this recommendation. However, this is an area in which
    professionals may be insulated from accountability to the victims of a
    fraud, weakening deterrence of such conduct in a major way.
    ---------------------------------------------------------------------------
    Other Steps
        Enhance rating agency integrity.

        Consider whether standards should be created to protect or enhance
    the integrity of rating agency decisions.

        Improve independence of stock analyst recommendations.

        Analyst recommendations should be driven by analysis and
    fundamentals, not the pursuit of investment banking business for their
    firms. This is a similar problem to auditors and consulting. New rules
    have been proposed to address this situation, which the SEC and the
    industry should continue to pursue until investors have clear
    disclosure of potential pressures and insofar as possible the integrity
    of analyst opinions is safeguarded.

    Conclusion
        To be sure, most of the men and the women who work in public
    accounting are talented, hardworking, and honest. Nonetheless, there
    will be bad apples in any barrel, and there is certainly a need to make
    sure that we have an adequate practical ability to detect abuses and to
    provide accountability for performance of audits in accordance with
    professional standards. We cannot afford to take the risk that anyone
    auditing major publicly-traded companies believes they are beyond
    accountability for their auditing performance, to say nothing of
    ethical lapses or even criminal conduct.
        Even better would be to follow President Bush's call for a broad
    national effort to enhance the quality of our accounting and disclosure
    system. This effort is too important to leave to the accounting
    profession alone, though all concerned should contribute every idea to
    the debate so Congress can determine the best mix of policies for the
    future.

                     PREPARED STATEMENT OF DAVID S. RUDER*
    ---------------------------------------------------------------------------
        *Chairman of the Securities and Exchange Commission 1987-1989;
    Professor of Law, Northwestern University School of Law 1961-present
    (Dean 1977-1985); Member Board of Trustees, Financial Accounting
    Foundation; Member Board of Trustees, International Accounting
    Standards Committee Foundation; Member Board of Governors, National
    Association of Securities Dealers Inc. (1990 -1993); Chairman,
    Securities and Exchange Commission Historical Society.
    ---------------------------------------------------------------------------
               Chairman, U.S. Securities and Exchange Commission
                                  1987 to 1989
                               February 12, 2002

        It is a pleasure to appear again before the Committee on Banking,
    Housing, and Urban Affairs.

    General Comments
        The Enron tragedy calls for investigation, identification of wrong
    doers, the imposition of penalties, and reform. I strongly believe that
    allocation of blame should not be made until the facts are known.
    Nevertheless, based on newspaper accounts of the Enron matter, I
    believe some reforms are needed.

    Summary of Conclusions
    Accounting Regulation
    Auditor Independence
        The Commission's new Auditor Independence Standards promulgated in
    November of 2000, should be monitored and improved, particularly in the
    nonaudit services areas of information systems and internal audit.

    Supervision of Accounting Audit Practices
        The current accounting audit supervisory system now in place under
    the direction of the Public Oversight Board should be expanded and
    improved in a setting independent from the accounting profession.
    Funding should come from the preparers and users of financial
    statements. Congressional action to secure funding will probably be
    needed.

    Accounting Standards
        Promulgation of accounting standards by the Financial Accounting
    Standards Board under the supervision of the Financial Accounting
    Foundation works well, but an independent source of financing is
    desirable.

    Disclosure
        The SEC's disclosure requirements are a great strength of our
    capital markets. The Commission is moving promptly to create
    improvements in areas related to the Enron matter.

    Corporate Governance
        The managers of the U.S. corporations need to embrace a corporate
    culture emphasizing compliance with accounting regulations and full
    disclosure of financial conditions. The SEC and the stock exchanges
    should take steps to encourage such practices. Congress should not
    legislate in the corporate governance area.

    The Enforcement Process
        The investigations of wrongdoing by the Securities and Exchange
    Commission and the Justice Department will be thorough and will
    eventually yield the true facts and appropriate punishment.

    Pensions
        Congress or the Department of Labor should take steps to prevent
    401(k) plan over-investment in employers stock by employees.
    Derivative Instruments
        Congress should consider regulating the over-the-counter markets in
    derivative instruments.

    Regulation of Accounting
        In the United States, the accounting profession plays a crucial
    role in the disclosure process. The investing public has learned to
    rely upon the accuracy of corporate financial statements prepared and
    certified by accountants. The regulation of the financial statement
    preparation and the audit process in this country is the strongest in
    the world, and I believe the public should continue to have faith in
    the system. Not only is the current system strong and reliable, but
    also the theory that the faulty financial disclosures in the Enron
    matter demonstrate an accounting system that is broken and an
    accounting profession that cannot be trusted is simply wrong. If
    individual accountants have failed their duty they should be punished,
    but wayward activities of a few is not proof that the accounting
    profession is dishonest or negligent. If the accounting regulatory
    system has faults it should be corrected, but fault finding does not
    demonstrate that the regulatory system is not working. Nevertheless, it
    is important to examine current regulation of auditor independence,
    auditing standard setting, audit practices, and accounting standard
    setting and make needed changes.

    Auditor Independence
        One of the substantial worries regarding the Andersen audit of
    Enron has been that Andersen not only audited Enron, but also was paid
    approximately the same amount for nonaudit services. It has been
    reported that in the year 2000 Andersen was paid audit fees of
    approximately $25 million and nonaudit fees of approximately $27
    million. Comparisons of the amounts of audit fees to nonaudit fees for
    a range of companies and auditors have revealed ratios of nonaudit to
    audit fees ranging as high as nine to one. The expressed general
    concern is that an audit cannot be objective if the auditor is
    receiving substantial nonaudit fees.
        The accounting profession seems to have recognized that management
    consulting services, which involve accounting firms in helping
    management make business decisions, should not be performed for an
    audit client. Three of the Big 5 accounting firms (Andersen, Ernst &
    Young, and KPMG) have now separated their management consulting units
    from their audit units by contractual splits and spin-offs, and a
    fourth (PricewaterhouseCoopers) has announced its intention to split
    off its management consulting unit in a public offering. (Wall Street
    Journal, p. 3, January 31, 2002) The fifth firm should also do so, or
    at least refrain from offering management consulting services to audit
    clients.
        If an accountant is not recognized by the SEC as independent, the
    accountant cannot certify a corporation's financial statements. Without
    a certification those statements cannot be filed with the Commission
    and the corporation will find it nearly impossible to raise capital.
    The SEC has taken steps to increase auditor independence. In November
    of 2000, the SEC published revised Auditor Independence Standards
    specifying circumstances under which the Commission will not recognize
    an accountant as independent. (SEC Rel. Nos. 33-7919 and 34-40602,
    November 21, 2000) The Commission also adopted requirements forcing
    registrants to disclose for each fiscal year the amount of audit fees
    and the amount of fees paid to the auditor for nonaudit services in two
    categories: Financial information system design and implementation, and
    all other fees. It also required registrants to disclose whether the
    audit committee had considered the question whether the provision of
    nonaudit services affected auditor independence.
        The Commission specified broad categories of circumstances that
    will cause an accountant to be treated as not independent. The
    categories include financial relationships, employment relationships,
    business relationships, contingent fees, and nonaudit services. In the
    latter category the Commission identified the specific categories of
    prohibited activities (with certain exceptions): Bookkeeping services,
    financial systems design and implementation, appraisal or valuation
    services, actuarial services, internal audit services, management
    functions, human relations
    (executive search), broker-dealer services, and legal services (but tax
    advice is not
    included in this category).
        The new independence and disclosure rules represent a strong
    improvement in addressing the auditor independence problem. I believe
    that the new rules should be given a chance to work. There are
    categories of nonaudit work that create efficiencies for corporations,
    such as tax advice and opinions rendered in connection with registered
    offerings. These categories should be monitored to see whether they
    impede independence, and in two areas steps should be taken now to
    strengthen
    the rules.
        The area of financial information services and design is the area
    most likely to generate the largest nonaudit fees. Recently four of the
    major accounting firms announced their intention to abandon or severely
    limit information technology services for audit clients.
        The Commission's current rules recognize that there may be benefits
    to the accounting control system if the auditor is allowed to plan,
    design, and implement internal accounting controls and risk management
    controls. These areas are fundamental to good accounting systems, and
    strong arguments can be made that a corporation's auditor should be
    able to design and to install such systems. The Commission should
    continue to monitor this area.
        The Commission's current rules permit design and implementation of
    a system that aggregates source data underlying the financial
    statements, but the rules contain significant restrictions on the
    design and implementation of such systems. This area is not likely to
    justify exceptions, and the Commission should consider prohibiting this
    activity.
        The Commission's rule regarding internal audit services seems to
    recognize that outsourcing the internal audit functions to the
    company's external auditors creates conflicts or appearances of
    conflicts because the external auditor eventually will be auditing its
    own work. The Commission should monitor this portion of the rule
    carefully and consider prohibiting external auditors from engaging in
    internal auditing, with exceptions for small businesses.
        The Commission is to be commended on its new independence rules.
    Changes in the rules should remain the responsibility of the SEC.
    Legislation in this area is not needed.

    Supervision of the Accounting Audit System
        We need to build on the accounting audit supervisory system already
    in place and expand it to achieve greater independence, with better
    financing.
        Prodded by the SEC, the accounting profession last year reorganized
    its process for overseeing the audit process. The American Institute of
    Certified Public Accountants (AICPA), expanded the power of its Public
    Oversight Board, an independent body, to control the auditing process
    in the United States. The Board is composed entirely of five public
    members with no connections to the accounting profession, and is
    currently headed by Charles Bowsher, the former Comptroller General of
    the United States, who was head of the General Accounting Office for 15
    years. It is financed through the AICPA budget. Although in January the
    Board announced its intention to disband, it should remain in
    existences until other audit supervisory measures are in place.
        The POB has power to oversee the promulgation of Generally Accepted
    Accounting Standards (GAAS) by the AICPA's Auditing Standards Board. It
    has power to oversee the AICPA's system of monitoring accounting firms
    compliance with auditing requirements. It has the power to oversee the
    AICPA's peer review system which requires a triennial review of each
    firm by a firm of comparable stature. It also has power to oversee the
    AICPA's Quality Control Inquiry Committee which investigates charges of
    audit failure and disciplines violators.
        The POB has functioned well in the past, and there is much to learn
    from its organization and its operations. However, although the POB's
    powers have been strengthened, it does not have sufficient budget to
    allow it to function effectively. It does not have the power to force
    accounting firms to provide the documents necessary to complete
    investigations, nor does it have the power to promise that documents
    received will be protected against discovery in private litigation. It
    is forced to rely upon the accounting profession itself to engage in
    enforcement activities. Most important, its connection to the AICPA
    creates an appearance of control by that body.
        I believe that the POB oversight system should become truly
    independent. The audit standard creation process and audit review and
    disciplinary process should be transferred to a new body which will be
    separate from the AICPA and whose board will be composed entirely of
    public members who have no connection to the accounting profession.
    Until that transfer is completed, the POB should remain in existence
    and the AICPA, including its funding from the AICPA, should provide it
    with greater financial support.
        A new separate Audit Supervisory Board should be modeled on the
    private sector Financial Accounting Standards Board (FASB) and its
    supervisory body, the Financial Accounting Foundation. The Board should
    be subject to oversight by the SEC, which in turn should cooperate with
    the Board in the investigative area.
        The Board should be composed entirely of public members not
    associated with the profession. It should have appointive,
    administrative and budget powers, and should oversee three separate
    functions.
        First, an Auditing Standards and Ethics Board composed of persons
    independent of the accounting profession should promulgate both
    auditing and ethical performance standards.
        Second, an Auditing Quality Control Committee, composed of
    professional staff members reporting to the Audit Supervisory Board,
    should oversee internal audit firm practices designed to improve the
    audit process such as the rotation of audit engagements and an internal
    system for making controversial audit decisions. This unit should also
    supervise a peer review system conducted by the accounting profession.
    A peer review system requiring audit firms to inspect the internal
    audit practices of firms of comparable quality should not be discarded,
    but that system should be independently inspected and supervised. The
    accounting profession peer review system has long been supported by the
    SEC and should continue to be a strong part of the audit regulatory
    process.
        Third, an Audit Disciplinary Committee, also composed of
    professional staff members reporting to the Audit Supervisory Board,
    should have the power to inspect firm compliance with audit standards
    and procedures, investigate allegations of audit failures, impose
    disciplinary sanctions, and refer matters to the SEC for investigation
    and discipline. The information it gathers should be privileged from
    outsiders. Information gathering and privilege questions might be
    addressed through cooperation with the SEC.
        Independent and adequate funding is crucial. An independent body
    that depends upon sporadic voluntary contributions from industry or the
    financial community may risk loss of financial support if it takes
    positions seen as contrary to the best interest of those it regulates.
        The financing problem should be addressed by requiring payments by
    preparers of financial statements (the corporations) and by users of
    financial statements (institutions such as mutual funds who buy and
    sell securities, and brokers who advise others regarding securities
    transactions). The Audit Supervisory Board should have the power to set
    its own budget subject to oversight by the SEC. Congressional action to
    secure funding will probably be needed.
        I believe in a system of private regulation rather than SEC
    regulation in the audit area. I am proposing a voluntary private
    independent organization independent from the accounting profession. If
    a voluntary private system cannot be established, then Congress should
    create such a system. In any event I believe the new audit regulatory
    system should be designed with input from the profession, with strong
    input and guidance from the SEC. The system should be subject to SEC
    oversight.

    Promulgation of Accounting Standards
        Generally Accepted Accounting Principles are promulgated in the
    United States by the Financial Accounting Standards Board, an
    independent standard setting organization to which the SEC has
    delegated power to create accounting standards. High quality,
    transparent, and comparable accounting standards promulgated by the
    FASB have played a major role in making the U.S. financial markets the
    very best in the world. The FASB private independent standard setting
    model has been adopted internationally by the private International
    Accounting Standards Committee, which has appointed an independent
    International Accounting Standards Board. I have observed the
    operations of the FASB closely during the last 5 years as an at large
    member of its supervisory body, the Financial Accounting Foundation and
    I am a member of the International Accounting Standards Committee
    Foundation, which supervises the IASB.
        The Chairman of the SEC and others have recently complained that
    the FASB's process for creating standards is too slow, citing that the
    Board's failure to deal extensively with lease financing, special
    purpose entities, and other off balance sheet financing vehicles.
    Delays in promulgation are in part due to the care taken by the Board
    to hear the views of affected parties, especially the business
    community. The Board can increase the speed of its deliberations, and
    it is considering ways to do so. It must continue to assess the effects
    of its proposed standards on business operations.
        Despite its attempts to seek the views of the business community,
    the FASB faces difficulty in obtaining financing from business, which
    often objects to FASB standards that affect business interests. The
    FASB is financed through sales of its work product and through
    contributions by accounting firms and businesses. When businesses do
    not like the FASB's standards or its process for creating then, they
    sometimes withdraw financial support, or fail to provide it in the
    first place. The FASB continually faces difficulties in financing its
    operations. The accounting profession is supportive, but generally
    speaking business is not. Institutional investors and investment
    bankers, who benefit greatly from financial statement disclosures,
    contribute little to the FAF, creating a classic free rider problem.
        I believe that the solution to the financial pressures on the FASB
    would be to provide a system of financing similar to that which I have
    suggested for a new POB. FASB should be financed by payments by
    preparers and users of financial statements. If a voluntary system
    cannot be established, the Congress should enact legislation creating
    financing for the FASB. If a solution to funding for a new POB can be
    found that will protect the POB's independence, a similar solution
    should be found for the FASB.

    Disclosure Regulation
        As a result of the Enron matter some have questioned whether the
    SEC's disclosure rules and procedures are adequate. As you know, the
    Commission's disclosure regulations are very detailed and are widely
    acknowledged as one of the great strengths of our capital markets.
    These regulations are not static, and are constantly being improved by
    the Commission. Chairman Pitt has recently called for changes including
    a current disclosure system, plain English financial statements,
    transparent disclosure of key accounting principles and policies, and
    better description of the relationship of pro forma earnings to
    earnings reported under GAAP. The Commission recently released a
    statement about management's discussion and analysis of financial
    conditions and operations (MD&A), calling for better disclosure,
    especially in the area of off balance sheet contracts, trading
    activities involving nonexchange traded contracts, and contracts with
    related parties. (Rel. 33-8056, January 22, 2002). I believe the
    Commission is moving promptly to create improvements in areas related
    to the Enron matter. No legislation is needed in this area.

    Corporate Governance
        The primary fault in the Enron failure seems to be poor management.
    From all accounts it appears that Enron became overly aggressive in its
    efforts to dominate the energy trading markets, engaged in highly
    leveraged off balance sheet financing, engaged in extremely aggressive
    accounting, overstated its earnings, failed to disclose the true nature
    of its corporate and financial structure, and eventually lost the
    confidence of its creditors and trading counter parties. Enron
    management appears to be primarily to blame.
        In one sense, the Enron failure is due to a flawed business model.
    The company followed a path in its energy trading business that was too
    risky and too dependent upon relationships with other traders and
    creditors. We may be dealing with a late evidence of the excesses of
    the technology boom.
        However, in another sense the Enron problems represent a failure in
    corporate governance. One striking aspect of this failure is Enron's
    apparent lack of respect for the accounting system that underlies
    financial reporting. Enron seems to have purposely attempted to avoid
    disclosure of its true finances. Instead it should have utilized the
    accounting system as a means of assisting it to make sound management
    decisions and as a source of information helping it to provide the
    securities markets with a truthful statement of financial condition.
        In recent years, the SEC has urged corporate Audit Committees to be
    more responsible, has criticized corporate attitudes toward financial
    reporting, and has brought enforcement actions regarding management of
    earnings, over emphasis on pro forma earnings, and failure to follow
    accounting standards. The SEC's urgings, criticism, and enforcement
    actions are important, but the SEC faces difficulties in overcoming
    management disregard of accounting and financial disclosure
    obligations. Most of our corporate managers know that the purpose of
    accounting rules is to create transparency, not obfuscation. Hopefully
    they know, as Enron teaches, that failure to disclose negative
    information eventually will cause a severe market reaction. The
    managers of all of our corporations need to reject a philosophy that
    seeks to skirt the edges of accounting rules and instead need to
    embrace a corporate culture of full financial disclosure.
        As the investigation of Enron continues, the role of Enron's Board
    of Directors will be closely examined. What did the Board know and
    when? What did the Audit Committee know and when? These after the fact
    questions will seek to assess blame, but they also raise more
    fundamental questions regarding the proper supervisory roles of the
    Board and the Audit Committee. I believe that the role of the Audit
    Committee is particularly important. The Audit Committee should
    understand the corporation's business, ask management hard questions
    about its strategies, accounting policies, and disclosures, and seek to
    ensure that disclosures to investors are accurate and complete.
        As you know, the Federal Securities Laws do not give the SEC the
    power to intervene directly in the internal affairs of corporations. In
    recent years the SEC has urged good corporate governance practices and
    in some areas, such as executive compensation, has sought improvement
    by forcing disclosure. I believe that the Commission should continue to
    examine possibilities for improving conduct by imposing disclosure
    obligations. The stock exchanges have power to force good governance
    practices through their listing agreements, and they too should be
    examining possibilities for increasing good corporate governance.
        Unfortunately, in the area of corporate governance we are dealing
    with attitudes. I do not believe it is possible for the Government to
    legislate good morals, and I believe that efforts to do so may stifle
    innovation. Congress should not legislate in this area.

    The Enforcement Process
        The newspapers and media have been swift to assess blame on those
    whom they believe are responsible for the Enron problems. Most of the
    assertions seem to be based upon facts that have yet to be proven.
        The Securities and Exchange Commission (SEC), the Justice
    Department, and the Congress have all launched investigations which
    eventually will yield the true facts. My experience at the SEC teaches
    me that the Commission will conduct a thorough investigation, using
    whatever resources are necessary to complete that task, and that it
    will cooperate with the Justice Department's criminal investigation.
    When its investigation is complete, the Securities and Exchange
    Commission will bring administrative and judicial actions against the
    wrongdoers. The Justice Department may seek criminal penalties.
        Much concern has been expressed about alleged insider trading by
    officers of Enron. In the Enron case insider trading allegations will
    involve buying or selling securities based upon nonpublic, material
    corporate information in violation of a fiduciary duty. It may be that
    the insiders in this case will seek to invoke newly adopted Rule 10b5-1
    which provides an affirmative defense if the person entered into a
    binding contract, plan, or instruction with an independent third person
    to buy or sell securities. This defense may or may not be available. A
    condition to using that defense is that the person charged with insider
    trading was not aware of the material nonpublic information at the time
    of entering into the contract, plan, or instruction. With regard to
    sales by the Enron officers the question will be whether they were
    aware of material nonpublic corporate information either at the time of
    sale or at the time of entering into a Rule 10b5-1 arrangement.
        I believe the Commission has sufficient resources to conduct its
    Enron investigation and that the Federal Securities Laws provide
    sufficient basis for successful imposition of sanctions. Allegations
    regarding misleading statements to the securities markets by Enron, its
    management, and its accountants are actionable under the SEC's Rule
    10b-5. Insider trading allegations are also actionable under that rule.
    Allegations regarding poor accounting can be treated by the Commission
    under Rule 102(e) of its rules of practice and other rules. No
    legislation is needed in this area.

    Employee 401(k) Plans
        According to newspaper accounts the 401(k) retirement accounts of
    many Enron employees contained extremely large amounts of Enron common
    stock. When the Enron stock declined, many employees lost most of their
    retirement savings. During one period of approximately 30 days the
    employees were not able to sell their Enron stock because of a change
    in plan administrator.
        The Enron employee pension plan losses resulted from the swift and
    dramatic fall in Enron's market values. The risks that Enron employees
    faced because of their retirement investments in Enron stock were
    typical of employees in many U.S. corporations. Many of our
    corporations encourage their employees to choose company stock as their
    primary retirement investment. Some companies match purchases of
    company stock in 401(k) retirement accounts and require that the
    company contributed stock remain in the retirement accounts for
    specified periods. Some companies restrict sales of company stock in
    401(k) accounts until the employee reaches a specified age.
        Although the various restrictions may have prevented a sale of
    Enron stock during certain periods, the primary problem reflected in
    the Enron matter is that employees have invested a disproportionate
    amount of their retirement funds in Enron stock. In doing so they
    ignored diversification--a fundamental principle of investing.
    Financially sophisticated investors understand that it is exceedingly
    risky to invest a large percentage of an investment portfolio in one
    company because of the risk that the company's stock may suffer large
    declines. The Enron employees either did not know this theory, chose to
    ignore it in the belief that Enron stock would continue to climb, or
    experienced express or implied pressures from the company to own Enron
    stock.
        Retirement funds should not be invested in a risky manner that
    avoids standard portfolio diversification theory. Employees should be
    protected from their ignorance, their gambling instincts, and company
    pressure. Legislation should be passed or rules should be adopted
    prohibiting employees from owning more than a specified percentage of
    their company's stock in their retirement accounts, and companies
    should be prevented from imposing long-term restrictions on the sale of
    stock held in retirement accounts.
        The Enron retirement account problem also calls into question
    proposals to allow workers to manage the investment of a portion of
    their Social Security accounts. Should such a proposal be adopted,
    workers would be subject to problems of ignorance or bad judgment, and
    would find themselves subject to pressures regarding investment choice
    from eager brokers or investment advisers who may not be facilitating
    the best interests of persons attempting to invest Social Security
    retirement monies. The Congress should not adopt a Social Security plan
    under which worker retirement benefits would be subject to the risks of
    the securities market.
    Regulation of Derivative Instruments
        Although the subject is beyond the scope of this testimony, I
    believe off exchange (over the counter) derivative instrument trading
    presents both systemic and individual risk. Congress should consider
    whether legislation is needed in this area.

                                   ----------
                    PREPARED STATEMENT OF HAROLD M. WILLIAMS

               Chairman, U.S. Securities and Exchange Commission
                                  1977 to 1981
                               February 12, 2002

        Mr. Chairman and Members of the Committee:
        Thank you for the invitation to bring my perspective as a former
    Chairman of the Securities and Exchange Commission to the current
    concerns about accounting and investor protection issues and their
    impact on the functioning of our financial markets. I served as Chair
    of the SEC from 1977 to 1981, having been appointed by President Jimmy
    Carter. Prior to my service as Chair of the Commission I served as a
    member of the SEC Advisory Committee on Corporate Disclosure. From the
    time I left the Commission until 1998 I served as President and Chief
    Executive Officer of the J. Paul Getty Trust headquartered in Los
    Angeles. Since then I have been dividing my time between various public
    service and public policy activities, primarily in education, the arts,
    and health care, and being Of Counsel to the law firm of Skadden, Arps,
    Slate, Meagher & Flom. The views I express are personal and do not
    necessarily reflect the views of the firm, or its individual members.
    Further, as a consequence of the firm's involvement with corporate
    clients in a number of related matters it would not be appropriate for
    me to comment, directly or indirectly, on any specific situation.
        My comments today will focus on a crisis of confidence unlike any I
    have experienced in my 50 plus years of involvement in the corporate
    and the financial world. Questions are being raised about the adequacy
    and the integrity of financial reporting by public companies and about
    whether our financial reporting system can be trusted. Trust is
    critical to the functioning of the financial markets and the efficient
    allocation of capital and, ultimately, to the willingness of the public
    to invest. This is a crisis that cannot be ignored.
        Let me begin by disclosing that I am a strong believer in self-
    regulation coupled with rigorous oversight. The principle is well
    established in the structure of the self-regulation and SEC oversight
    of the stock exchanges. Self-regulation, aggressively overseen, can be
    much more effective in enforcing the spirit of the rules than can a
    policing agency of Government. However, it is evident that the existing
    structure is not adequate to the task and needs to be redesigned and
    strengthened. It needs to address auditor independence, accounting
    standards and rulemaking, the composition and duties of corporate
    boards and audit committees and the objectivity of security analysts
    and all others whose behavior impact the integrity of our financial
    markets.

    Auditor Independence and Consulting Services
        At the center of the crisis--but not alone--is the accounting
    profession. Events have heightened concerns about whether the
    profession has, in fact, the requisite degree of independence to
    discharge its auditing responsibility.
        The American Institute of Certified Public Accountants begins its
    code of conduct with the statement ``The distinguishing mark of a
    profession is acceptance of its responsibility to the public.'' Indeed,
    the profession's auditing responsibility is a quasi-public one, deeply
    infused with the public interest. This raises critical issues. Can an
    auditor be independent when his client is paying the bill? Can the
    auditor withstand pressure from the client? What if doing so would mean
    losing the client for the firm? What would that mean for the firm and
    for the auditor? Does the provision of consulting services further
    impair independence or the perception of independence?
        I am sympathetic to the difficulties involved in the audit process.
    Auditing has become much more difficult as corporate structures and
    financing techniques have become more complex. For example, the pricing
    of risk or the laying off of risk has become an increasingly
    sophisticated high-technology business and it is increasingly difficult
    for auditors and regulators to assess the risks being assumed by any
    single institution. I even wonder whether some members of the
    profession are up to understanding and dealing with the increased
    complexity. Certainly, the increased complexity requires greater
    exercise of judgment and makes auditor independence and insulation from
    pressures that could compromise it all the more essential.
        The case for insisting that an auditor not provide other services
    to the client it audits is a strong one. Accounting firms have come
    increasingly to look beyond their traditional audit role to consulting
    work for their revenues and profitability. In part this is in response
    to corporate pressures to hold down audit costs and in part to the
    growth in consulting as a very profitable market. Whether providing
    consulting services actually impairs independence calls for access to
    the auditor's state of mind and is virtually impossible to determine.
    However, the perception that it may is of such concern that it cannot
    be ignored. Perception is now as important perhaps more important--than
    reality.
        While I was Chair of the Commission, we introduced a requirement
    that the proxy material calling for shareholder approval of the
    selection of the audit firm include information on the nonaudit
    services performed for the company in the prior year. It reflected the
    Commission's and my concern about the issue at the time. The
    requirement was eliminated by my successor. It was reintroduced
    recently under Chairman Levitt.
        Even if the auditor does not provide other services to the
    companies it audits, given who pays the bill, the incentive to keep a
    well-paying audit client happy would remain powerful.
        I would urge the Commission to consider a requirement that a public
    company retain its auditor for a fixed term with no right to terminate.
    This could be for 5 years or perhaps the Biblical seven. After that
    fixed term, the corporation would be required to change auditors. As a
    consequence of such a requirement, the auditor would be assured of the
    assignment and, therefore, would not be threatened with the loss of the
    client and could exercise truly independent judgment. Under such a
    system the client would lose its ability to threaten to change auditors
    if in its judgment the assigned audit team was inadequate. It would
    also reduce the client's ability to negotiate on fees, and almost
    certainly the audit would cost more. The required rotation of auditors
    would also involve the inefficiency of the learning curve for the new
    auditor. I view all of these potential costs acceptable if it
    reinforces the auditor's independence and makes the work more
    comprehensive. The client could be given a right to appeal to a
    reconstituted independent oversight organization if it believes that it
    is not well served by its auditor and needs some relief.
        Even this proposal would not avoid the issue of providing
    consulting services to audit clients and the perception that it
    compromises auditor independence. One solution would be that consulting
    work not be offered to an audit client. Another would be that the
    revenues and profits from the audit function and from consulting be
    segregated so that those engaged in the audit function could not
    benefit, directly or indirectly, from the profitability of the
    consulting practice. Still another would be to restrict the consulting
    services to those few fully consistent with the audit function and
    independence.

    The Public Oversight Board
        The Public Oversight Board was created by the profession during my
    Chairmanship as an effort at self-regulation. We expressed concern at
    the time whether the peer review process administered by the profession
    would be adequate. But as believers in the principle of self-
    regulation, we concluded that the Board should have the opportunity to
    prove itself. In my opinion, the events over the intervening years have
    demonstrated that it does not meet the needs and is not adequate. Under
    the peer review system adopted in 1977, the firms periodically review
    each other. To my knowledge, there has never been a negative review of
    a major firm. However, the peer review is not permitted to examine any
    audits that are subject to litigation. The reviews focus on the
    adequacy of quality control procedures and do not examine the audits of
    companies to see if the peer would have arrived at a different
    conclusion. The peer review has proved itself insufficient.
    Particularly as the Big 8 has become only the Big 5, peer review in its
    present form becomes too incestuous. A system needs to be established
    which is independent of the accounting profession, transparent and able
    to serve both effective quality control and disciplinary functions.
        Further, the Board is not adequately funded and is beholden for its
    funding to the very people it is supposed to oversee. I suggest that
    the SEC consider a requirement that a percentage of the audit fees of
    public companies be assessed to pay for independent oversight, whether
    it is the Public Oversight Board or a successor body, so that its
    funding is assured.
        I consider Chairman Pitt's public statement encouraging in its
    recognition that more rigorous and disinterested oversight of the
    profession is essential. However, the statement needs more definition
    before we can judge its adequacy or its likely effectiveness.

    Disclosure and Accounting Principles
        The disclosure model itself lacks the necessary clarity and
    transparency and needs to be critically reviewed and enhanced by the
    Commission. Our financial accounting and disclosure requirements have
    not kept up with the rapid evolution of our capital markets and
    corporate finance. The existing requirements worked well when auditing
    traditional assets such as plants and equipment, accounts receivable
    and inventories. They work much less well when dealing, for example,
    with intangibles and sophisticated financial instruments.
        It is not only a matter of numbers. The disclosure of what lies
    behind the numbers should make transparent and comprehensible the
    businesses, the risks involved, the economic substance and the
    accounting methods employed. The company and its auditors should
    disclose and discuss all significant accounting decisions, choice of
    accounting methods and judgments affecting the reported results.
        Part of the responsibility for inadequate disclosure lies with the
    accounting principles themselves and the functioning of the Financial
    Accounting Standards Board (FASB) --the body responsible for
    establishing accounting principles. GAAP--Generally Accepted Accounting
    Principles--needs to be reviewed and standard setting improved and
    accelerated. I believe the functioning of the FASB could be
    significantly enhanced if its independence could be protected, to
    withstand the pressures of the business community, the profession, and
    even the Congress. A source of financing that is dependable and not
    beholden to the profession or to the corporate community would increase
    the ability of the Board to address more difficult and critical issues
    in a timely manner.
        Rule making itself is very difficult particularly as financial
    activity and economic transactions become increasingly complicated and
    sophisticated. For example, the FASB has engaged for a number of years
    in an effort to create a clear standard for disclosing off-the-books
    transactions and special purpose entities. They have not been able to
    come up with a rule acceptable to the business community and the
    profession. That acceptability should not ultimately be the determining
    factor.
        Some rulemaking amounts to ``closing the barn door.'' Obviously,
    this is not something that the corporate community takes lightly
    because of its potentially negative impact on earnings. An example is
    the pressure exerted by corporations thru Congress in the mid-1990's,
    that forced the FASB to back down on a proposal to make companies take
    account of the cost of awarding employee stock options.
        I believe the Board should consider and redefine the very amorphous
    concept of ``materiality.'' Otherwise significant matters can become
    ``immaterial'' if the company is large enough.
        The crisis in financial reporting is perhaps best captured by the
    need to reduce the complexity of corporate earnings every quarter to
    the magic--but uninformative --number called ``earnings per share.''
    While at the Commission I thought often of how wonderful, but
    impossible, it would have been to get rid of it. Perhaps the time has
    come to consider doing so. Indeed, the very concept of ``earnings'' has
    become diluted by the proliferation of use and abuse of ``pro forma
    earnings,'' ``operating income,'' and ``restructuring charges.'' Cash
    flow becomes, in many respects, a more sensitive measure of corporate
    performance.

    Regulating Coherence
        A separate issue is the lack of regulatory coherence, particularly
    since the enactment of the Gramm-Leach-Bliley Act allowed financial
    services companies to cross the barriers that had existed between firms
    that could undertake commercial banking, securities underwriting, and
    insurance. A new kind of financial services entity has been authorized,
    but the regulatory system has not adapted to it. As you know, there are
    a number of Federal regulators. The Federal Reserve licenses a new kind
    of institution--the financial holding company, but other regulators
    continue to supervise the individual business units that make it up.
    The securities markets have the SEC, the commodities and futures
    markets have the Commodity Futures Trading Corporation, and insurance
    companies are monitored at the state level. Finally, derivatives are
    unregulated. Innovations in finance have blurred the historic
    distinctions between the various institutions. As a result, the
    supervisory process has not kept up with the changes that have occurred
    in the financial system. This is a situation that inevitably will
    create problems unless the various Federal regulatory agencies share
    and implement a common understanding of the rules and behavior expected
    of the various players who collectively make up the financial markets
    and determine its integrity and efficiency.

    A Caution
        As we go about exploring regulatory or statutory solutions, we need
    to be reminded that the more that problems lead regulators or the
    legislators to impose prescriptive rules, the more people will settle
    for fulfilling the letter of those rules rather than responding to the
    broader purpose that they are designed to serve. Rules inevitably leave
    loopholes that can be exploited if the attitude is allowed to persist
    that form is more important than substance or that complying with the
    letter of the law rather than the spirit is acceptable. At the other
    extreme, too general a rule lacks guidance and invites overly generous
    interpretations.
        Ultimately, any system can be subverted if the parties undertake to
    do so, or if the various players in the system let down their guard and
    fail to act responsibly. In the final analysis, the system works as it
    should only when all the players honor the spirit, as well as the
    letter of the law.
        When everyone involved--management, board members, investment
    bankers, and security analysts--are caught up in and benefit from a hot
    stock, no one is inclined to the thorough questioning that could raise
    troublesome issues or to be willing to be the skunk at the picnic. The
    corporate community needs to accept its responsibility to be
    informative and more forthcoming in its disclosure. Corporate boards of
    directors and audit committees, the accounting profession, security
    analysts, stock exchanges and rating agencies, as well as the
    regulators, each have an essential role to play--a duty--to be alert,
    to ask the difficult questions, to hold each other to account and be
    held to account and thus assure the adequacy and integrity of the
    financial information upon which our financial markets depend.
        I will be pleased to respond to questions from the Committee.

                                   ----------

                    PREPARED STATEMENT OF RODERICK M. HILLS
               Chairman, U.S. Securities and Exchange Commission
                                  1975 to 1977
                               February 12, 2002

    Introduction
        Twenty-six years ago I sat before this Committee to explain what
    the SEC was doing about a corporate scandal that caused a public uproar
    at least as loud as that now directed at the Enron matter. The focus
    then was on some 400 U.S. companies that were compelled to disclose
    that they had made bribes or questionable payments to foreign officials
    to secure corporate favors. Twenty million dollars said to have been
    given to the Japanese Prime Minister forced his resignation.
        In response, the SEC caused the birth of the mandatory audit
    committee, substantially increased the auditor's responsibility and
    mandated new internal controls. There should be no doubt but that those
    steps greatly advanced the cause of good corporate governance. However,
    the continuing spate of accounting problems makes it clear that much
    more is needed.
        I have no view to express with regard to the question of whether
    Enron or its auditors violated any existing regulation or law in the
    presentation of Enron's financial position. The view I do have is that
    there are substantial weaknesses in our regulatory system. My testimony
    will:

           Identify those weaknesses.
           Suggest steps that can be taken to reduce or eliminate
        them.
           Ask that other steps not be taken.

        I speak with 32 years of experience with corporate governance: As a
    former regulator who dealt with those U.S. companies that made
    questionable payments to foreign officials and with the auditors who
    failed to cause the disclosure of those payments; service on 14 boards
    of directors, as a member of 14 audit committees and as Chairman of 7
    such committees; and participation in the termination of 8 Chief
    Executive Officers. Six times we had to report that over $100 million
    of income had been improperly reported. On one occasion the sum
    exceeded $3 billion (Appendix A). These corporate mishaps will continue
    until we identify and address the very serious weaknesses that our
    regulatory system has produced and tolerated for far too long.
        First, the system itself needs a major overhaul. The head of NYU's
    Accounting Department, Paul Brown, put it well: ``It is the old adage
    of a FASB rule. It takes 4 years to write it, and it takes 4 minutes
    for an astute investment banker to get around it.''
        Second, it is increasingly clear that the accounting profession is
    not able consistently to resist management pressures to permit
    incomplete or misleading financial statements, and the profession has
    serious problems in recruiting and keeping the highly qualified
    professionals that are needed.
        Third, the audit committees of too many boards are not exercising
    the authority given to them or the responsibility expected of them.

    The Weaknesses
    The Financial System
        The financial papers produced dutifully each year by publicly-
    traded companies have become a commodity. Companies produce them
    largely because they are required to do so. Few CEO's regard this work
    product as having any intrinsic value. Accounting firms compete for
    business more on price than on the quality of their personnel or
    procedures.
        If a company does take an interest in the structure of its balance
    sheet and profit and loss statement, it is far more likely to be caused
    by a desire to be innovative in how they report their profits than in
    the quality of the auditor's work. They hire the bankers and
    consultants to design corporate structures that will give them a
    stronger looking balance sheet and, perhaps, keep the profits and
    losses of related companies off of their financial papers.
        For example, news reports are that Enron spent millions of dollars
    on Wall Street bankers and management consultants to create a corporate
    structure that apparently had the effect of keeping both debt and
    losses out of its own financial picture. The audit partner tasked with
    understanding such a structure is way over matched. Unless he can find
    a precise rule or interpretation that frustrates that sophisticated
    corporate architecture, those Wall Street wizards will prevail.
        NYU's accounting department is correct: The existing system,
    developed over some 70 years by the FASB, the AICPA, and the SEC
    produces rules at horse and buggy speed while the global economy moves
    at light speed, developing new and exotic financial instruments and
    corporate structures.
        The ultimate weakness is that the system suffers from too many
    rules. Roman Weil, Professor of Accounting at the Graduate School of
    Business of the University of Chicago Business School has pointed out
    that today auditors, confronted with a somewhat different transaction,
    ask either the FASB or the Emerging Issues Task Force (created by the
    FASB and the SEC) for a new rule. Instead of making their own judgment
    drawn from a conceptual framework, they seek the comfort of specificity
    (Appendix B). The system has been so precise so many times in saying
    what cannot be done that it has created an implication that whatever is
    not prohibited is permitted. In law school this phenomena has long been
    known as: ``Expressio unius exclusio alterius.''
        This maze of rules has become a challenge to innovative minds to
    create corporate structures that wend their way through the maze,
    satisfying all the rules but frustrating the objective of our
    securities laws.
        The sad truth is the profession has lost sight of the significance
    of the signature line of the opinions they give to all their clients.
    That line reads: ``In our opinion, the financial statements [prepared
    by management] fairly present, in all material respects, the financial
    position of the company.'' Today, that broad statement means only: ``We
    have looked but have found no material violation of applicable rules
    and regulations.''
        Auditors should be more willing to qualify their opinion by saying:
    ``The company has satisfied all the rules but its financial statements
    do not fairly present its financial position.'' Today, any auditor
    tempted to qualify his opinion in such a fashion faces the reality that
    a competing accounting firm may be quite willing to sign an unqualified
    opinion.
        Corporate financial papers also suffer from their reliance on two
    flawed assumptions: (1) That the present value of assets can be derived
    reliably from historical costs; and (2) That corporate earnings can
    smoothly move from quarter to quarter without large ups and downs.
        The fiction of the first point should be self-evident. That is
    particularly so today when so large a part of all corporate assets is
    intangible.
        The ``smoothing'' of earnings has been encouraged by analysts and
    tolerated by regulators for many years. To avoid disruptions that are
    inevitably created by unforeseen circumstances, companies create
    reserves in flush periods that can fill the gap in a down quarter. When
    major changes appear on the horizon, companies establish large
    restructuring reserves to cover the shortfalls in future years.
        Investors are often puzzled when the stock of a given company
    plummets simply because it missed Wall Street forecasts by only a penny
    or two. The reason, of course, is that analysts know that healthy
    companies always have a few extra pennies of earnings in their
    corporate ``cookie jar.'' If the company cannot find a penny in that
    jar, the analysts assume the company is in far worse shape than known.
        Finally, it must be said on this point that unless one has been
    subjected to a serious corporate meltdown, you cannot possibly
    appreciate the enormous discretion that management has under GAAP to
    present its financial position. By changing depreciation schedules, by
    using different estimates or by adopting different strategies or
    assumptions, a company can make enormous changes in its annual income.
    Management too often makes these ``top-level'' adjustments without
    adequate disclosure to the public about how much their current earnings
    depend on such adjustments. A corporate meltdown in which I was
    involved 3 years ago was caused by some top-level adjustments that
    accounted for 40 percent of the company's total income and that led to
    a corporate admission that billions of dollars of income had been
    improperly reported.

    The Accounting Profession
        Any effort to reform the system must understand that the accounting
    profession is in trouble. It has been caught in a changing world
    economy in a system that inhibits change. The profession is not at all
    blameless, but the blame is not all theirs. The fact that the work
    product of the profession has become a commodity means it is almost
    impossible for firms to get the same margins on their auditing work as
    they get on their consulting work. The problem is exacerbated by the
    fact that too many audit committees see their job as reducing the
    auditor's fee rather than increasing the quality of the work. Too many
    auditing jobs have been bid at a loss with the belief that the loss
    could be made up by the consulting jobs likely to be given to the firm
    that has the audit.
        One result is that accounting firms cannot attract today the same
    level of talent that entered the profession 20 or 30 years ago.
    Significant numbers of graduates from our more prestigious business
    schools regularly became accountants. No more! Neither the salaries
    paid nor the career offered is competitive with the future available in
    management consulting firms, law firms, investment banking, or
    corporate financial offices.
        The combination of financial pressure to keep a client and the
    difficulty of finding a precise rule to deal with an ingenious
    corporate structure has too often caused an audit partner to allow a
    questionable accounting policy to be adopted. Once such a policy is
    implemented, it can become increasingly difficult for the audit partner
    to throw it out.
        It is so often the case that the questionable policy is of no
    particular significance when it first passes the auditor's scrutiny.
    Whatever transactions are based on such a policy in those years are so
    small that the audit partner can take comfort in the fact that,
    overall, the true financial position of the company has not been
    distorted. After a few years, however, the transactions can multiply
    and present the audit partner with the realization that a significant
    corporate risk has been hidden from the public. If he blows the
    whistle, he will be blamed for allowing the policy in the first place
    and he will surely lose the client. So, he implores the company to
    unwind the policy by selling assets at a profit that can offset the
    concealed losses and hopes for the best.
        I do not know if the scene I just painted occurred at Enron. I only
    know that it could have happened; and I do know that it is an accurate
    view of events at four companies in which I was involved and that with
    respect to those companies, we were required, with a restatement, to
    write off over $100 million of assets that had been improperly recorded
    as income in prior years. On one of those occasions the write-off
    exceeded $2 billion.
        By no means am I suggesting that the auditors should be excused for
    such misbehavior because of the pressures on them. What I do argue is
    that auditors should not allow themselves to be in such a situation. An
    accounting firm should not accept an engagement unless its partners are
    certain that the audit committee will protect them from undue
    management pressure. Seldom will an accounting firm tell the audit
    committee about a problem first. They try to work out a compromise with
    management. Often the audit committee does not even know that there was
    a problem. In short, the accounting firms have demonstrated far too
    often that they have more fear that management will replace them than
    confidence that the audit committee will protect them.

    The Directors of the Audit Committee
        Since 1977, the investment world has looked to the audit committees
    of publicly-traded companies to protect the integrity of financial
    disclosure. As I said earlier, the mandatory audit committee was born
    out of the foreign payment scandals of the early 1970's. Since that
    time, the audit committee has evolved into an important element of
    corporate governance. However, the shortcomings are evident:

     Audit committees may consist of people who satisfy the
        objective criteria of independence, but their election to the board
        is too often the whim of the CEO, who decides each year who will
        sit on the audit committee and who will chair it.
     Audit committees too often seek only to reduce the cost of the
        audit rather than to seek ways to improve its quality. They do not
        play a sufficient role in determining what the fair fee should be.
     Audit committees seldom ask the auditor if there is a better,
        fairer, way to present the company's financial position.
     Audit committees seldom play a role in selecting a new audit
        firm or in approving a change in the partner in charge of the
        audit. They may well endorse an engagement or the appointment of a
        new team, but they are not seen as material to the selection
        process.
     Audit committees seldom establish themselves as the party in
        charge of the audit.

        In short, most audit committees do not understand that the auditors
    will not be truly independent unless they confer that independence on
    them by the manner in which they oversee the audit process.
    What Should Be Done?

    About the System
        A careful but substantial overhaul of the existing regulatory
    system is of paramount importance. Failure to act effectively and soon
    will continue to erode the reputation of our capital markets and
    further weaken the accounting profession. The SEC, with the support and
    direction of Congress, must lead a wholesale revamping of the system
    that regulates the profession. As Professor Weil has written: ``I want
    accountants to use fundamental concepts in choosing accounting methods
    and estimates. I want accountants not to hide behind the absence of a
    specific rule. Whatever the detailed rules accountants write, smart
    managers can construct transactions the rules do not cover'' (Appendix
    B).
        His call is for a major change in the basic nature of the audit. It
    would require companies to be far more candid in explaining the real
    value of their companies; it would place far less emphasis on
    historical values and far more focus on intrinsic values. The
    ``smoothing'' of earnings would end.
        A far different oversight structure would be needed, and the
    training of analysts and particularly accountants, would change.
        Ideally, a system would be created that made the audit of real
    value to management, which would pay far more attention to the quality
    of the people performing the audit and less attention to its cost.
        Such change will not come easy and not early.
        There are, however, substantial steps that can be taken
    immediately, changes that will dramatically reduce the number of Enron
    type debacles in the future.

    Action by the SEC
        The SEC needs to make it absolutely clear that the failure to have
    a competent independent audit committee by itself constitutes a
    material weakness in the internal controls of a reporting company. A
    simple statement in any speech by a SEC Chairman will do the job. This
    unequivocal statement will force the auditors to look into the question
    of both the independence and the competence of the audit committee.
    With respect to sitting directors, the auditors would necessarily send
    a memo to each one asking:

     How did you come to be elected to the Board?
     What social or business relations have you had or do you have
        with any officer or director of the company?
     What percentage of your annual income is derived from your
        service on this Board, and from any other boards on which you sit?
     What experience or education have you had that is relevant to
        the responsibilities of an audit committee?
     Who appointed you to the audit committee and who selected the
        Chairperson of the committee? Etc.

        When such a questionnaire is sent, the company's lawyers will
    undoubtedly advise the company that an independent nominating committee
    is necessary to both select new directors and to make appointments to
    the audit committee. If such does not occur, the SEC Chairman can make
    another speech.
        Second, the SEC should widely broadcast the significance of its
    December 12, 2001 release that gives ``Cautionary Advice Regarding
    Disclosure About Critical Accounting Policies.'' This release may be
    the most significant SEC step with respect to corporate governance in
    decades. In effect, this release requires the auditors to carefully
    explain the various accounting policies that have been selected by
    management, the estimates that management is making, and how the
    selection of different policies or estimates could cause the reporting
    of materially different financial results (Appendix C).
        This explanation is to be made to the audit committee and is to be
    placed in ``Management's Discussion and Analysis'' (the ``MD&A''). Had
    this rule been understood by Enron, its audit committee and Andersen
    years ago, the current Enron debacle may not have happened. It
    certainly would have been discovered years earlier.
        Third, the SEC must make it quite clear to audit committees that
    they have the responsibility of protecting the independence of the
    auditors. This is not a passive assignment. The audit committee must:

     Understand the fee negotiations.
     Lead any effort to select a new firm.
     Initiate interviews for a new audit partner in charge.
     Insist that all disagreements between the management and the
        auditor be exposed to them.
     Insist that they be made to understand any alternative
        presentations of the company's financial position that would lessen
        earnings or debt.

        In short, the audit committee's most important task is to make the
    independent attesting auditor believe that its retention depends solely
    on the decision of the audit committee.
        Audit committees must have latent authority to hire their own
    consultants with or without consultation with management. They must
    insist that all allegations of financial misconduct be conveyed to them
    immediately. The complaint by Ms. Watkins to Enron's CEO should have
    been given directly to the audit committee, which should have hired its
    own counsel to investigate her complaint.
        In short, the SEC must give the accounting profession the
    responsibility and the courage to tell management that: ``Its financial
    statements DO NOT fairly present the Company's financial position
    whether or not there is a rule preventing such presentation.''

    Action by the Profession
        The accounting profession must be made to trust the audit
    committee. Before taking a new engagement, a firm should be satisfied
    that their relationship is with the committee, and that all real
    problems must involve the committee. A firm should not take an
    engagement unless it is certain of the committee's independence and
    resolve. The accounting firms must understand that the failure to have
    an independent, competent audit committee constitutes a material
    weakness in a company's internal controls. They do not need to wait for
    the SEC to tell them.
        The profession must raise its sights with respect to the new hires.
    It must offer salaries that are competitive with other professions. The
    profession needs MBA graduates from our better business schools and it
    needs many of the better students that now go to law, investment
    banking, and management consulting.
        The stark fact that our business community must accept is that the
    profession needs to raise the cost of the audit to get better-educated
    personnel. However, until management and Wall Street analysts
    understand the need for a better trained accountant and the value of a
    ``better'' audit, it will be difficult to secure the needed talent for
    the accounting profession.
        Finally, the accounting firms must work with the SEC to create a
    materially different regulatory structure. Until that day comes, the
    firms must have the competence and the resolve to qualify their opinion
    when they believe that, notwithstanding the fact that all rules are
    satisfied, the financial presentation is lacking.

    Action by Audit Committees
        Audit committees do not need any releases from the SEC or
    legislative direction to substantially increase their role. As noted
    above, audit committees have both the authority and the responsibility
    to take over the audit process. Any audit committee that wishes to do
    so can assert that it is solely responsible for the selection and
    retention of the outside auditor.
        In short, all the weaknesses identified above in the manner in
    which audit committees are managed can be corrected with a simple
    change of direction.

    The Need for Legislation
        All the weaknesses referred to above could be corrected by a
    concerted effort of industry, the SEC, the FASB, and the AICPA. And
    there are current efforts to do so. Russell Palmer, the former Dean of
    Wharton and I, with the encouragement of Chairman Levitt, have formed a
    steering committee (Appendix D) to assist the American Assembly at
    Columbia University to conduct an Assembly on the future of the
    accounting profession.
        However, the pace of change for corporate governance has been
    painfully slow. It may well need a legislative push. Congress, with the
    Administration, could mandate the formation of an informed, effective
    commission to prepare a reform program within the year.
        Congress may wish also to require that:

     Corporations of a certain size with publicly-traded stock have
        an effective, independent audit committee in order to avoid a
        finding that there is a material weakness in the corporation's
        internal controls.
     Corporations of a certain size have an independent nominating
        committee with the authority to secure new directors and appoint
        all members of the audit committee.
     Audit committees be solely responsible for the retention of
        accounting firms and be responsible for the fees paid them.

    What Should Not Be Done?
        In recent days there have been calls for various legislative
    changes in our securities laws that, in my view, should not be made.
    They would:

     Prohibit any firm responsible for the annual audit of a firm
        from performing any consulting type services for the same firm.
     Place term limits on how long accountants can work for a
        client.
     Require that an independent organization pay for company
        audits.

        The principal objection to all three proposals is that each of them
    would erode the authority and the responsibility of the audit
    committee. For 26 years, audit committees have become more independent
    and more assertive. As a result, there has been a steady, albeit slow,
    improvement in corporate governance. Each of the above listed proposals
    would inevitably erode both the authority and the responsibility of the
    audit committee.
        The more specific objections to each proposal are these:

    Consulting
        There are four compelling reasons to resist efforts to ban
    accountants from doing any consulting work for their audit clients:

              (1) Such a rule will not help the problem and it will divert
            attention from action that will help. An audit partner who is
            threatened with the loss of his client is just as likely to
            yield to undue management pressure whether or not his firm is
            receiving large consulting contracts. If he or she loses that
            audit client his or her career is likely at an end. Twelve
            years ago, I felt compelled to launch a proxy fight to take
            control of a small NYSE company. I questioned the auditor after
            we prevailed in the proxy fight and learned from the auditor
            that there were a large number of questionable policies that he
            had accepted because of his fear that he would lose the client
            if he persisted in opposing them. The annual audit fee was
            under $500,000.
              (2) The profession is already having a difficult time in
            attracting qualified personnel. If college graduates are told
            that there is a blanket prohibition on all ``consulting work,''
            they will surely conclude that their work as an accountant will
            be limited.
              (3) There is no valid reason to restrict management from
            using its auditors where their experience with the company can
            be of real assistance. An alert audit committee can easily
            protect the company from the pressure of a management that
            implies that the accountant will lose lucrative consulting fees
            if it opposes the management's accounting policies. The audit
            committee should, of course, oversee all consulting work done
            by the external auditing firm. Each committee should require
            that its approval be necessary before any consulting contract
            of size is given to the external auditors.
              (4) We must have some patience. Just last year the SEC
            required considerable disclosure about consulting fees paid to
            the external auditor. That rule has caused companies to rethink
            the manner in which they engage consultants and auditors to
            decide what kinds of services they wish to offer. At the very
            least, we should wait to see how these new requirements work
            before we overtake them with new rules.

    Term Limits
        Forcing a change of auditors can only lower the quality of audits
    and increase their costs. The longer an auditor is with a company the
    more it learns about its personnel, its business and its intrinsic
    values. To change every several years will simply create a merry-go-
    round of mediocrity.
        An effective audit committee can mandate a rotation of partners in
    the same firm that can achieve the same result as changing firms.
    Payment of Audit Fees by an Independent Organization
        There are over 10,000 publicly-traded companies in the United
    States. The overwhelming number of them have a satisfactory
    relationship with their auditor and their financial statements are all
    anyone could ask for in terms of fair presentation. To force all these
    companies to change their relationship with their auditors because of
    the misbehavior of a relatively small number of companies would be
    foolish. We cannot possibly know now whether the change would produce
    better financial presentations. Again, the problem seen in cases like
    Enron can be dealt with if the role of the audit committee is carried
    out properly.

    Conclusion
        The accounting profession is of enormous importance to the United
    States and to the increasingly global economy in which we exist. It is
    an absolutely essential force in the evolution of so many companies in
    the emerging economies that seek capital from the developing world. As
    we acknowledge the deficiencies of the accounting profession, we should
    also acknowledge the responsibility we have to assist it reform itself.
    EXHIBIT A

                               RODERICK M. HILLS

    Government
    Chairman, Securities and Exchange Commission, 1975-77
    Counsel to the President of the United States, 1975
    Law Clerk to Justice Stanley F. Reed, the Supreme Court of the United
        States, 1955-1957
    Board of Directors (Present & Former)
    Orbital Sciences Corporation, Audit Committee Member, 2001-
    Regional Market Makers, Director, 2000-
    Chiquita Brands International, Inc., March 8, 2002-
    Federal-Mogul Corporation, Chairman Governance Committee and former
        Chairman of Audit Committee, Audit Committee Member, 1977-2002
    Per-Se Technologies, Chairman of Audit Committee, 1999-2001
    Waste Management, Inc. (merged with USA Waste and renamed Waste
        Management, Inc. in July 1998), Chairman of Audit Committee, 1997-
        2000
    Oak Industries Inc., Vice Chairman and Chairman of Audit Committee,
        1985-2000
    Mayflower Group, Inc., Audit Committee Member, 1993-96
    Sunbeam-Oster, Audit Committee Member, 1991-96
    Drexel Burnham Lambert, Inc., Member, Oversight Committee, 1989-90
    Alexander & Alexander Services, Inc., Chairman of Audit Committee,
        1978-87
    Anheuser-Busch Companies, Inc., Member, Audit Committee, 1977-89
    Santa Fe International, Chairman of Audit Committee, 1977-86
    Republic Corporation, Chairman, Audit Committee Member, 1971-75
    Beck Industries, Audit Committee Member, 1970
    Current Employment
    Founder and Partner, Hills & Stern, Attorneys at Law, 1996-
    Chairman, Hills Enterprises, Ltd. (formerly The Manchester Group,
        Ltd.), 1984-
    Academic Experience
    Distinguished Faculty Fellow & Lecturer (International Finance), Yale
        University, School of Organization & Management, 1985-87
    Professor, Harvard University, School of Law & School of Business,
        1969-70
    Lecturer in Law (Visiting), Stanford University School of Law, 1960-70
    Education
    Stanford University, B.A. 1952, LL.B. 1955; Order of the Coif, Comment
        Editor, Stanford Law Review, 1953-55.
    EXHIBIT B

                             FUNDAMENTAL CAUSES OF

                         THE ENRON ACCOUNTING DEBACLE:

                    ``Show Me Where It Says I Can't Do It''

        Imagine an asset [for the moment think of rights to use a patent on
    a drug that defeats anthrax] purchased by a dozen different companies
    for a total of $500 million. Now suppose that the Congress passes laws
    saying that any other company who so chooses can use that patent to
    produce the anthrax-defeating drug free of royalty to the owners.
        What do you suppose the accountants for the firms that had
    purchased those patents for $500 million would do? They would write off
    the assets to zero, recognizing a collective loss of $500 million,
    before taxes, on their income statements. Would you suppose that
    accountants would need to look into their GAAP rule books to find out
    if that write-off were necessary? [Not necessary, wouldn't you think--
    it is obvious.] If they did look and could not find such guidance, do
    you think they would write off the assets anyway, recognizing the
    attendant losses? [Of course.]
        What has this to do with the state of accounting reflected in the
    current Enron /Andersen shambles? A lot.
        In 1980, the events of the first two paragraphs happened: The
    Congress passed deregulating legislation liberalizing the granting of
    trucking rights, effectively given any trucker the right to carry any
    commodity between any two points. Prior to that deregulating
    legislation, Congress, acting through the Interstate Commerce
    Commission, had limited those rights. The issued rights traded in the
    marketplace and, once purchased by a trucking firm, appeared on the
    firm's balance sheet at cost. When Congress effectively destroyed the
    value of those rights by allowing any trucker the right to carry the
    goods previously protected by monopoly rights, what did trucking firms
    do? They wrote off the value of the trucking rights on the balance
    sheet, recognizing an amount of loss equal to their then-current book
    value.
        Did the trucking company accountants need a specific accounting
    rule telling them to write off those trucking right assets? You
    wouldn't think so, would you? But the Financial Accounting Standards
    Board [FASB] felt compelled to pass a rule [Statement of Financial
    Accounting Standards No. 44, 1980] saying just that. This was a first
    step on the road to the Enron accounting debacle. [The underlying
    economic debacle has little to do with accounting and a lot to do with
    gambling, although the accounting likely allowed the gambling to go on
    longer than it otherwise would have.]
        Since the early 1980's, an aggressive company's management engages
    in a transaction not covered by specific accounting rules, accounts for
    it as it chooses, and challenges the auditor by arguing, ``Show me
    where it says I cannot do it.'' The auditor used to be able to appeal
    to the first principles of accounting. Such principles suggest, for
    example, that post-deregulation trucking rights are no longer assets.
    Now the aggressive management can say, ``Detailed accounting rules
    cover so many transactions and none of them covers the current issue,
    so we can devise accounting of our own choosing.'' And they do.
        Accounting rulemaking has become increasingly detailed as auditors
    plead with the standard setters for specific rules to provide backbone:
    ``Dear FASB or EITF [Emerging Issues Task Force, created by the SEC and
    the FASB], give us a rule for this new transaction.''
        So, Enron transferred assets, reporting current profit and,
    simultaneously, and promised to give Enron shares to the purchaser if
    the transferred assets later turn into losers. Enron recognizes profits
    and challenges its auditor to ``Show me where it says I cannot do it.''
    The auditor cannot. The auditor considers nixing the profit recognition
    but simultaneously considers the consequences of saying, ``No'' to
    aggressive management: We might lose this client.
        The working majority of the rule-setting FASB comes from high-
    powered audit practice and those members bring to the Board a mindset
    that the accounting profession needs, and wants, specific guidance for
    specific transactions. Three of them can meet privately and can
    effectively, if not formally, guide, perhaps even set, the agenda for
    the Board. A minority of the Board has spent careers dealing with
    fundamental theory. This minority, with more faith in the conceptual
    basis for accounting, appears to prefer to set rules based on appeal to
    the fundamental axioms of accounting, which the FASB developed in the
    early 1980's in its conceptual framework. The majority from auditing
    practice, those with experience in asking for and applying detailed
    rules for specific problems, less interested in deriving rules from
    conceptual principles, appears to win most of the battles.
        The emphasis on specific rules for specific issues gets more
    pronounced over time. I concede these specific rules for specific
    issues leads to more uniform reporting of the covered transactions, all
    else equal, a good thing. That uniformity comes at the cost: Practicing
    accountants have less need for informed intelligence and judgment. I
    concede that part of the pressure on standard setters for specific
    rules for specific transactions comes from the current litigation
    environment. Auditors, in a rational pursuit of a full purse, want
    unambiguous rules to stand behind when, inevitably, the trial lawyers
    sue them for accountant judgments and estimates, made in good faith,
    that turn out to be wrong.
        That some good results from specific rules for specific
    transactions does not make such rules a good idea. These rules have a
    cost: Show me where it says I cannot do it, says management; give me
    more rules for these new transactions, says the auditor, so I can
    combat aggressive management; completing the cycle, the increasing
    number of specific rules for specific transactions strengthens
    aggressive management's belief that if a rule does not prohibit it,
    then it is allowed.
        I want accountants to use fundamental concepts in choosing
    accounting methods and estimates. I want accountants not to hide behind
    the absence a specific rule. Whatever the detailed rules accountants
    write, smart managers can construct transactions the rules do not
    cover.
        What else do we need to reduce the likelihood of more accounting
    debacles?
        I think that we need audit committees to exercise the power the SEC
    has given them. Thirty years ago, Rod Hills, then Chairman of the SEC,
    conceived the powerful modern audit committee. He has written that the
    audit committee's most important job is to make the independent,
    attesting auditor believe that the auditor's retention depends solely
    on the decision of the audit committee. Most often, it doesn't work
    that way.
        Most audit committees consist of independent, smart but financially
    illiterate members, with rarely more than one financial expert. [If you
    do not believe me, look at the accounting qualifications of the audit
    committee of any large company you follow. Then, look at how seldom the
    large corporations change auditors.] Audit Committees usually depend on
    management to recommend the independent auditor and changes in the
    auditor. The auditor learns to take its guidance from management, not
    from the audit committee. The SEC has empowered the audit committee;
    now, it should provide incentives to those committees to use the power
    and it should devise ways to discipline those committees who do not.
        Management typically views audits as adding no value, purchased
    merely because regulation requires them. Hence, management typically
    wants the most cost-effective job it can get to satisfy the
    regulations. This doesn't mean the cheapest audit. Capital markets will
    guide a Dow Jones Industrial firm not to hire me to do its audit, but
    to hire one of the Big 5. Once that firm decides it needs a Big 5
    auditor, it will prefer to spend less, not more, for the service. The
    auditor has the incentive to price the audit low, to get the
    engagement, and hopes to profit from consulting jobs that grow out of
    the expertise developed during the audit.
        The audit committee could say, ``We are going to pay top dollar for
    a high quality audit.'' To the auditor it could say, ``Make a decent
    profit on the audit; do not count on consulting fees to make up for
    thin margins on the audit.'' This will drive up the cost of both the
    audit and the consulting services, because the outside consultant will
    not have the head start in understanding the client's specifics that
    the auditor has. Management won't like this. The audit committee,
    charged to be concerned primarily with the audit, should be unconcerned
    about the higher cost of consulting fees. When did you last hear of an
    audit committee asking for a higher-priced audit?
        Does this require a regulation forbidding the auditor from
    consulting? No, we already have regulations empowering the audit
    committee to act, independent of management. Now, we need the
    incentives for it to do so.

                            Professor Roman L. Weil

        Roman L. Weil is V. Duane Rath Professor of Accounting at the
    Graduate School of Business of the University of Chicago and Director
    of its Directors' College, which aims to teach board members how to be
    more financially literate, thus better qualified for audit committee
    service. He served a 4 year term on the FASB's Financial Accounting
    Standards Advisory Committee.
    EXHIBIT C

                       SECURITIES AND EXCHANGE COMMISSION

    [Release Nos. 33- 8040; 34 - 45149; FR- 60]
    Agency: Securities and Exchange Commission

    Action: Cautionary Advice Regarding Disclosure About Critical
    Accounting Policies

    Summary: The Securities and Exchange Commission is issuing a statement
    regarding the selection and disclosure by public companies of critical
    accounting policies and practices.

    For Further Information Contact: Robert A. Bayless, Special Assistant
    to the Chief Accountant, 202-942- 4400.

    Supplementary Information:
        As public companies undertake to prepare and file required annual
    reports with us, we wish to remind management, auditors, audit
    committees, and their advisors that the selection and application of
    the company's accounting policies must be appropriately reasoned. They
    should be aware also that investors increasingly demand full
    transparency of accounting policies and their effects.
        The reported financial position and results often imply a degree of
    precision, continuity, and certainty that can be belied by rapid
    changes in the financial and operating environment that produced those
    measures, As a result, even a technically accurate application of
    Generally Accepted Accounting Principles (GAAP) may nonetheless fail to
    communicate important information if it is not accompanied by
    appropriate and clear analytic disclosures to facilitate an investor's
    understanding of the company's financial status, and the possibility,
    likelihood and implication of changes in the financial and operating
    status.
        Of course, public companies should be mindful of existing
    disclosure requirements in GAAP and our rules. Accounting standards
    require information in financial statements about the accounting
    principles and the methods used and the risks and uncertainties
    inherent in significant estimates.\1\ Our rules governing Management's
    Discussion and Analysis (MD&A) currently require disclosure about
    trends, events, or uncertainties known to management that would have a
    material impact on reported financial information.\2\
    ---------------------------------------------------------------------------
        \1\ See, e.g., Accounting Principles Board Opinion No. 22,
    ``Disclosure of Accounting Policies'' (April 1972); AICPA Statement of
    Position No. 94 - 6, ``Disclosure of Certain Significant Risks and
    Uncertainties'' (December 1994).
        \2\ The underlying purpose of MD&A is to provide investors with
    ``information that the registrant believes to be necessary to an
    understanding of its financial condition, changes in financial
    condition and results of operations.'' Item 303(a) of Regulation S-K
    [17 CFR 229.303(a)]. As we have previously stated, ``[i]t is the
    responsibility of management [in MD&A] to identify and to address those
    key variables and other qualitative and quantitative factors which are
    peculiar to and necessary for an understanding and evaluation of the
    company.'' Securities Act Rel. No. 6835 (May 18, 1989) [54 FR 22427]
    (quoting Securities Act Rel. No. 6349 (September 28, 1981) [not
    published in the Federal Register]).
    ---------------------------------------------------------------------------
        We have observed that disclosure responsive to these requirements
    could be enhanced. For example, environmental and operational trends,
    events, and uncertainties typically are identified in MD&A, but the
    implications of those uncertainties for the methods, assumptions and
    estimates used for recurring and pervasive accounting measurements are
    not always addressed. Communication between the investors and public
    companies could be improved if management explained in MD&A the
    interplay of specific uncertainties with accounting measurements in the
    financial statements. We intend to consider new rules during the coming
    year to elicit more precise disclosures about the accounting policies
    that management believes are most ``critical''--that is, they are both
    most important to the portrayal of the company's financial condition
    and results, and they require management's most difficult, subjective
    or complex judgments, often as a result of the need to make estimates
    about the effect of matters that are inherently uncertain.
        Even before new rules are considered, however, we believe that it
    is appropriate to alert companies to the need for greater investor
    awareness of the sensitivity of financial statements to the methods,
    assumptions, and estimates underlying their preparation. We encourage
    public companies to include in their MD&A this year full explanations,
    in plain English, of their ``critical accounting policies,'' the
    judgments and uncertainties affecting the application of those
    policies, and the likelihood that materially different amounts would be
    reported under different conditions or using different assumptions. The
    objective of this disclosure is consistent with the objective of MD&A.
        Investors may lose confidence in a company's management and
    financial statements if sudden changes in its financial condition and
    results occur, but were not preceded by disclosures about the
    susceptibility of reported amounts to change, including rapid change.
    To minimize such a loss of confidence, we are alerting public companies
    to the importance of employing a disclosure regimen along the following
    lines:

        1. Each company's management and auditor should bring particular
    focus to the evaluation of the critical accounting policies used in the
    financial statements. As part of the normal audit process, auditors
    must obtain an understanding of management's judgments in selecting and
    applying accounting principles and methods. Special attention to the
    most critical accounting policies will enhance the effectiveness of
    this process. Management should be able to defend the quality and
    reasonableness of the most critical policies, and auditors should
    satisfy themselves thoroughly regarding their selection, application,
    and disclosure.
        2. Management should ensure that disclosure in MD&A is balanced and
    is fully responsive. To enhance investor understanding of the financial
    statements, companies are encouraged to explain in MD&A the effects of
    the critical accounting policies applied, the judgments made in their
    application, and the likelihood of materially different reported
    results if different assumptions or conditions were to prevail.
        3. Prior to finalizing and filing annual reports, audit committees
    should review the selection, application, and disclosure of critical
    accounting policies. Consistent with auditing standards, audit
    committees should be apprised of the evaluative criteria used by
    management in their selection of the accounting principles and
    methods.\3\ Proactive discussions between the audit committee and the
    company's senior management and auditor about critical accounting
    policies are appropriate.
    ---------------------------------------------------------------------------
        \3\ See Codification of Statements on Auditing Standards, AU
    Sec. 380, Communication with Audit Committees or Others with Equivalent
    Authority and Responsibility (SAS 61). SAS 61 requires independent
    auditors to communicate certain matters related to the conduct of an
    audit to those who have responsibility for oversight of the financial
    reporting process, specifically the audit committee. Among the matters
    to be communicated to the audit committee are: (1) methods used to
    account for significant unusual transactions; (2) the effect of
    significant accounting policies in controversial or emerging areas for
    which there is a lack of authoritative guidance or consensus; (3) the
    process used by management in formulating particularly sensitive
    accounting estimates and the basis for the auditor's conclusions
    regarding the reasonableness of those estimates; and (4) disagreements
    with management over the application of accounting principles, the
    basis for management's accounting estimates, and the disclosures in the
    financial statements. Id.
    ---------------------------------------------------------------------------
        4. If companies, management, audit committees, or auditors are
    uncertain about the application of specific GAAP principles, they
    should consult with our accounting staff. We encourage all those whose
    responsibility it is to report fairly and accurately on a company's
    financial condition and results to seek out our staff 's assistance. We
    are committed to providing that assistance in a timely fashion; our
    goal is to address problems before they happen.

        By the Commission.

                                      Jonathan G. Katz
                                      Secretary

        Dated: December 12, 2001
    EXHIBIT D

                      AMERICAN ASSEMBLY STEERING COMMITTEE

     Roderick M. Hills, Hills Enterprises, former Chairman,
        Securities and Exchange Commission

     Professor Derek Bok, former President, Harvard University

     Robert E. Denham, former Chairman of Solomon Brothers Buffett
        and now a partner at Munger, Tolles & Olson; public member of the
        Professional Ethics Executive Committee of the American Institute
        of Certified Public Accountants

     William Henry Donaldson, Founder of DLJ and former Chairman of
        NYSE

     Arthur Levitt, former Chairman, Securities and Exchange
        Commission

     William J. McDonough, President, Federal Reserve Board of New
        York

     Russell E. Palmer, Chairman, The Palmer Group and former Dean,
        Wharton School

     Katherine Schipper, Member Financial Accounting Standards
        Board and former L. Palmer Fox Professorship of Business
        Administration at Duke University's Fuqua School of Business

     Washington SyCip, Founder of SGV & Company

     Sir David Tweedie, Chairman, International Accounting
        Standards Board

     Paul A. Volcker, former Chairman, Federal Reserve

     Clifton R. Wharton, Jr., former Under Secretary of State

     Roman L. Weil, Professor of Accounting at the Graduate School
        of Business of the University of Chicago
    ADDENDUM

                        HILLS & STERN--ATTORNEYS AT LAW

                                                              February 19,
    2002

    Mr. Steve Harris
    Majority Staff Director
    United States Senate
    Committee on Banking, Housing, and Urban Affairs
    534 Dirksen Building
    Washington, DC 20510

    Dear Steve:

        I offer these thoughts about a legislative/regulatory program that
    can, arbitrarily, be divided like Gaul into three parts: (1)
    Restructure of the regulatory system; (2) Strengthen the SEC's
    enforcement capacity; and (3) Reinforce both the authority and the
    responsibility of the audit committee.
    The Regulatory System
        FASB needs significant restructuring. Legislation is needed that
    will:

     Create a Federal Corporation with an initial board appointed
        by agreement between Congress and the Administration. Some members
        of FASB Foundation could be on the initial board. Their mandate
        would be to seek a FASB type agency that would have more neutrals
        than does FASB today.

     Funding for this new Corporation would be fixed either by a
        permanent surcharge on audit fees or SEC filings or, perhaps, by an
        endowment. Conceivably an endowment could be established with
        matching funds: The profession, the industry, and the Federal
        Government, for example, could each put up \1/3\ of the total.

     The legislation could establish policy guidelines that will
        aim for the establishment of fundamental concepts in choosing
        accounting methods and estimates rather than to continue the policy
        that causes auditors to rely upon a multitude of specific rules.

        The AICPA needs some burnishing:

     It needs to have an effective disciplinary system that will
        investigate claims of misconduct and provide sanctions. AICPA rules
        today may prevent the AICPA from ``auditing an audit.'' If so, a
        change is needed.

     It may be that AICPA can reform itself, but it may take
        legislative pressure to get it underway.
    The SEC
        The SEC has indicated that it will bolster its enforcement in
    accounting by taking three steps:

     Its December 12 release states that auditors will be required
        ``to discuss the likelihood of materially different reported
        results if different assumptions are used.'' The requirement that
        such alternate assumptions and estimates be displayed in the MD&A's
        will require significant attention to those filings by the SEC.

     On February 13 the Chief Accountant for the SEC's Enforcement
        Division was reported as stating: ``One can violate the SEC laws
        and still comply with Generally Accepted Accounting Principles.''
        In essence he is noting that accounting practices have moved away
        from the overriding principle of fairly presenting financial
        performance to a growing dependence on specific rules.

     Chairman Pitt has orally suggested that he believes a company
        must have an independent, competent audit committee or it will have
        a material weakness in its internal controls.

        I have every confidence that the SEC will establish these three
    principles, but the fact is that these principles are not in place now.
    I am reluctant to suggest legislation when the same result can come
    from regulatory action. Nonetheless, the three matters would go so far
    to eliminate Enron type problems that the strength of legislation is
    needed. There is some precedent for Congress endorsing with legislation
    action already taken by the SEC. In the mid-1970's, the SEC established
    the requirement of internal controls for the first time. Congress
    thereafter mandated that corporations must have such controls.
        The accounting profession will have an understandable concern about
    their need to qualify statements that the auditor believes does not
    fairly present a companies financial position even though it satisfies
    all rules. They will fear lawsuits from third parties claiming that in
    a given case the auditor should have said the presentation was not
    fair. That concern will be lessened if the legislation provided that
    only the SEC can bring an action for such a failure.
        I recommend also that the Senate Banking Committee request that the
    SEC develop guidelines for the regulation of consulting services
    performed by the external auditor. Such guidelines should have terms
    like the following:

     The external auditor may not perform work for a client if its
        audit tests the efficacy of such work.

     Consulting fees cannot exceed the audit fees 2 years in a row
        and cannot ever exceed them without a certification by the audit
        committee that it is in the company's best interest to allow such
        work.

     Consulting fees may never exceed 5 percent of the cost of the
        audit without an explicit approval by the audit committee that must
        be specific about the reason for selecting the external auditor to
        do such work.

        Significant time was spent during the hearing on February 12 about
    the need to provide added funding to the SEC. It is of critical
    importance that a significant amount of that funding be used to improve
    the capacity of the SEC to read and comment on filings such as the 10K.
    By mandating that the MD&A's be more explicit about alternative ways of
    showing the company's financial position, the SEC will need to
    effectively read far more 10K's then are now read.
        Accordingly, a specific amount of the new funding should be
    designated for the development of a computer driven capacity to sort
    out the companies that have the greatest risk of an accounting problem.
    Each of the Big 5 accounting firms has developed information systems
    that identify their ``high-risk'' clients. That methodology could be
    used by the SEC to identify the same companies.
        All companies so designated should have their 10K's read and the
    SEC should subject some to a targeted audit.

    The Audit Committee
        I particularly recommend that Congress mandate that independent,
    competent audit committees must be present on all boards of companies
    whose stock is held by more than some minimum number of shareholders.
    At 25 years of age, the audit committee deserves a legislative
    endorsement. As stated above, the SEC can be directed to secure
    guidelines from the audit committee on a number of issues; but, the
    audit committee's authority, as well as its responsibilities, needs the
    strength of legislation. That legislation can declare that auditors can
    only be fired or hired by the audit committee, with the requirement
    that the decision to hire an audit firm must be confirmed by a
    stockholder vote at the next annual shareholders' meeting.
        Because I believe it is highly unlikely that an audit committee
    will be sufficiently independent without an independent nominating/
    governance committee, I believe such a committee will also need a
    legislative mandate. Such committees would be responsible for
    establishing the board's policy with respect to director tenure,
    director replacement, and director performance. The committee would be
    required to judge the efficacy of the other board committees, designate
    which members will sit on which committees and either appoint committee
    heads or be certain that each committee select its own chair person.
        Such legislation should also state that a majority of directors of
    companies that have a minimum number of shareholders must be
    independent.

    Other Legislation
        While I oppose mandatory changes of auditors, I do believe that a
    more extensive examination of the performance of auditors is needed at
    regular intervals. The best idea advanced so far is a meaningful review
    of the auditor's performance every 3 years. Legislation could state
    that no firm of a certain minimum size can keep the same auditor for
    more than 3 years unless the audit committee has commissioned a
    thorough review of the auditor's work with competent outside assistance
    and has certified that the continuation of that auditor is in the best
    interests of the shareholders.
        Many have called for the imposition of a ``cooling off '' period
    before a company that is the auditor's client can hire an auditor's
    employee. I suggest that any such legislation should allow the SEC to
    waive the rule. An Andersen employee in Atlanta who has never worked on
    the audit of a client in Seattle should not have his or her job
    opportunities unnecessarily limited.
        Finally, accounting firms should be required to have independent
    directors on their board and to have an independent committee of the
    board responsible for investigating mishaps by the firm.
    Summary
        The above represents my own views of what can be done now to
    improve the performance of the audit process. I will read the written
    testimony of the other witnesses to see if there are other proposals
    that I can endorse.

                                              With best regards,

                                              Roderick M. Hills
    RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM RICHARD C.
                                BREEDEN

    Q.1. Regarding the issue of auditor independence, do you feel
    that there has been ample time to review the new SEC rules that
    went into effect just 1 year ago?

    A.1. Yes.

    Q.2. With changing technology and innovations in finance, what
    additional information would be useful to the investors when
    companies disclose financial information? Is enough currently
    being disclosed?

    A.2. I believe that the SEC is the proper body to define
    specific disclosure requirements. However, one positive change
    in current requirements would be comprehensive disclosure
    concerning ``off balance sheet'' instruments. Greater
    transparency regarding cash flows would also be desirable.

    Q.3. Can information be put in terms that the average investor
    would be able to understand?

    A.3. It is possible to write a clear description of anything,
    and information that is being disclosed should be set forth in
    clear and straightforward terms. At the same time, complex and
    hard to understand information is also important, even if every
    individual investor may not be able to understand it, Good
    disclosure needs to provide comprehensive information to the
    market, where it can be factored into the price discovery
    process. 10K's and prospectuses are never going to be as simple
    as comic books, though every effort should be made to require
    information to be presented in the most understandable form.

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM DAVID S.
                                 RUDER

    Q.1. Regarding the issue of auditor independence, do you feel
    that there has been ample time to review the new SEC rules that
    went into effect just 1 year ago?

    A.1. As I indicated in my testimony, I believe the
    responsibility for reviewing the effect of the new SEC rules on
    auditor independence should rest with the SEC. I believe there
    has not yet been ample time for the SEC to review those rules,
    particularly in light of the public concern expressed regarding
    Enron.

    Q.2. With changing technology and innovations in finance, what
    additional information would be useful to the investors when
    companies disclose financial information? Is enough currently
    being disclosed?

    A.2. Changing technology will permit companies to disclose
    information on a relatively current basis. The SEC is currently
    considering the possibility of requiring such disclosure, but
    it must cope with problems relating to the definition of
    materiality and with liability concerns. Each company should be
    required to make greater disclosure about its significant
    accounting policies and about its plans and visions for the
    future. The SEC should review its disclosure policies to
    determine what other additional disclosures should be required.

    Q.3. Can information be put in terms that the average investor
    would be able to understand?

    A.3. Information can be put in terms that the average investor
    can understand, and the SEC has already initiated a ``plain
    English'' policy. However, there are some areas that are
    inherently technical and complicated that may not lend
    themselves to simple explanations.

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM HAROLD M.
                                WILLIAMS

    Q.1. Regarding the issue of auditor independence, do you feel
    that there has been ample time to review the new SEC rules that
    went into effect just 1 year ago?

    A.1. Yes, I do. Further, I do not believe that the new rules
    are adequate to address the problem.

    Q.2. With changing technology and innovations in finance, what
    additional information would be useful to the investors when
    companies disclose financial information? Is enough currently
    being disclosed?

    A.2. Current disclosure is inadequate. The standard should be
    that the economic substance of the transaction should be
    disclosed and that technical compliance with the rules is not
    acceptable. When alternative methods of accounting are equally
    acceptable, the one elected should be disclosed.

    Q.3. Can information be put in terms that the average investor
    would be able to understand?

    A.3. I believe so. However, the reality is that it is investing
    on the part of sophisticated institutional investors that
    largely determines the market and the evaluation of securities.
    Information that serves to fully inform them would go a long
    way toward solving the problem.

    RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM RODERICK M.
                                 HILLS

    Q.1. Regarding the issue of auditor independence, do you feel
    that there has been ample time to review the new SEC rules that
    went into effect just 1 year ago?

    A.1. I do not believe we have given the new rules time to work.
    I do know from my service on four different boards during this
    period that the new rules have had a substantial effect on
    boards of directors. Much more scrutiny is being given to
    consulting contracts given the external auditor and all four
    boards now require audit committee approval of any contract to
    the external auditor that is more than a minimal amount.
        The Senate Banking Committee may wish to ask the SEC to
    require all reporting companies to set forth in their 10K their
    policy with respect to consulting work done by the external
    auditors and to require that audit committee approval is needed
    for any payments for consulting work that exceed something like
    10 percent of the fee for the external audit.

    Q.2. With changing technology and innovations in finance, what
    additional information would he useful to the investors when
    companies disclose financial information? Is enough currently
    being disclosed?

    A.2. On December 12, 2001 the SEC issued a release that
    requires auditors and reporting companies to both consider and
    display any alternative ways in which the company's financial
    position can be depicted if an alternative would produce a
    materially different financial result. This requirement should
    substantially reduce the possibility of future Enron type
    debacles.
        The Enforcement Division of the SEC has also stated
    recently that auditors and reporting companies cannot satisfy
    the securities laws and regulations simply by complying with
    all rules. They must also be certain that their financial
    statements fairly present the companies financial position
    whether or not all rules have been satisfied. This new emphasis
    on a fundamental principle of the law will also substantially
    reduce the possibility of future Enrons.

    Q.3. Can information be put in terms that the average investor
    would be able to understand?

    A.3. Yes, but the task will not be easy to complete. We
    appointed a blue ribbon group 26 years ago to attempt the task.
    The group included Warren Buffet, a long-time champion of plain
    reading. I believe we improved the system somewhat but there is
    still much to be done. The current Chairman of the SEC, Harvey
    Pitt, has the capacity, experience, and resolve to improve
    reporting. I am optimistic about his chances for success.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                          THURSDAY, FEBRUARY 14, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:10 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, the Senate Committee on Banking, Housing, and
    Urban Affairs holds the second in a series of hearings which we
    will be carrying on for the balance of this month and well into
    next month, on accounting and investor protection issues which
    have been brought into sharp focus by the collapse of Enron
    Corporation.
        But these issues affect other public companies as well, as
    we are learning daily, and many of the issues that are posed
    are not new issues.
        They include, of course, the integrity of certified
    financial audits and corporate financial disclosure, accounting
    principles, the regulatory oversight system for accountants,
    auditor independence, questions of conflicts of interest, and
    corporate governance.
        As we heard on Tuesday, when we had a panel of five former
    Chairmen of the Securities and Exchange Commission, we need to
    fundamentally reexamine these subjects, and there is, I think
    it is fair to say, a crisis of confidence.
        Today's witnesses are especially well placed to assist us.
    I think it is fair to say that Paul Volcker needs no
    introduction to Members of this Committee. Few combine the
    perspectives which he can bring to bear on economic issues.
    Consumers of financial reports know him as the former Chairman
    of the Federal Reserve Board. He now Chairs the Trustees of the
    International Accounting Standards Committee Foundation. And he
    has recently undertaken, without compensation, I understand, to
    head up an outside oversight board to examine Arthur Andersen.
        Sir David Tweedie is an experienced national accounting
    regulator, who is now leading the international effort to
    formulate meaningful cross-border accounting standards for the
    global economy. In 2000, he became Chairman of the
    International Accounting Standards Board, the IASB, which is
    funded and overseen by the International Accounting Standards
    Committee Foundation. Before that, Sir David spent 10 years
    heading the Accounting Standards Board of the United Kingdom.
        In little more than two decades, the world's capital
    markets have been transformed by the global expansion of
    business and technology. Companies now can pursue capital in
    securities markets the world over. Well over 1,300 foreign
    companies are now listed on U.S. securities exchanges. This
    compares with a figure of just over 300 in 1986, 15 years ago.
    The force of this expansion is revealed in the proliferation of
    new business arrangements, the securitization of credit and
    novel financial instruments. All of these developments make
    corporate structures more intricate and traditional accounting
    notions more difficult to apply.
        Given the global market's critical need for timely and
    trusted
    financial information, Chairman Paul Volcker stated recently
    that, ``the problems besetting the accounting and auditing
    professions, building over a period of years, have now exploded
    into a sense of crisis.''
        This, as I note, was already a common theme expressed on
    Tuesday by the five former SEC Chairmen.
        Two years ago, the SEC listed four essential elements for
    any financial reporting system: High quality accounting and
    auditing standards, audit firms with effective quality
    controls, profession-wide quality assurance, and active
    regulatory oversight, including rigorous interpretation and
    enforcement of accounting and auditing standards.
        If any of these elements is lacking or is perceived to be
    lacking efforts must be made to restore them.
        The Committee, in the course of these hearings, must
    consider the best practices and most advanced thought worldwide
    as we examine the challenge of reforming our own system. And
    this is particularly why we welcome Chairman Volcker and Sir
    David this morning. We are looking forward to their testimony.
        But before I turn to them, I yield to my colleagues for any
    statements they may have.
        Senator Gramm.

                     COMMENTS OF SENATOR PHIL GRAMM

        Senator Gramm. Mr. Chairman, thank you very much.
        Paul, we are very happy to have you in front of the
    Committee. I want to thank you very much for your life-long
    service to America. If I started making a list of people who
    had made contributions to this country, the list would not be
    very long before your name would be on it.
        Sir David, we are very happy to have you before the
    Committee.
        I have always believed that it was important to have
    homogeneous accounting standards, at least in the developed
    world, and ultimately, worldwide. A question I have always had
    is how do we get from where we are to there.
        I guess like most Americans, Sir David, you won't be
    surprised to hear me say that I always thought that the
    quickest way to do it was to adopt American standards
    worldwide.
        [Laughter.]
        But in any case, I applaud what you are doing.
        Let me also say, having just asked Paul if he was an
    accountant--he assured me he wasn't--but I did want to say
    since we have one CPA on this Committee, and an important part
    of our jurisdiction has to do with accounting standards.
        I would say in this era, when one normally speaks of the
    troubled accounting profession, that if I had to choose between
    a preacher and a politician and an accountant, selected at
    random in America, to protect the sanctity and safety of my
    children and my wife, I would choose an accountant.
        [Laughter.]
        So, I wanted to be sure I got that on the public record
    here.
        [Laughter.]
        Chairman Sarbanes. All preachers and politicians take note.
        [Laughter.]
        Senator Gramm. I am not saying there are not some good
    ones.
        [Laughter.]
        But you are being selected at random in my example and on
    that basis, I will take an accountant.
        In any case, Mr. Chairman, I am awfully proud of your
    leadership as we try to deal with this issue. There are many
    committees holding many hearings on many subjects that brush
    around our jurisdiction. But at the end of the day, when we
    decide to do something in looking at accounting standards, it
    is going to be this Committee that does it. And your leadership
    and our ability to work together on a bipartisan basis gives me
    confidence that we are going to do more good than harm.
        Chairman Sarbanes. Thank you very much, Senator.
        Senator Stabenow.

                  COMMENTS OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Thank you, Mr. Chairman.
        I would submit my full statement for the record.
        Let me just thank you for this second day of hearings. When
    we had the former SEC Chairmen with us, it was extremely
    insightful and I know today's hearing will be insightful as
    well.
        We are in a global economy. We need to be looking globally
    at our approaches. I appreciate the fact that you are with us.
    We want to do everything possible to make sure that we have
    rules and oversight that make sure that debacles like the Enron
    situation cannot happen, or at least we do everything possible
    for them not to happen.
        We appreciate your input as we look at this globally today.
        Chairman Sarbanes. Senator Enzi.

                  STATEMENT OF SENATOR MICHAEL B. ENZI

        Senator Enzi. Thank you, Mr. Chairman. I appreciate your
    holding this hearing. I do have to note that on Senator Gramm's
    list, that he did not even have attorneys on it.
        [Laughter.]
        Senator Gramm. Well, that went without saying.
        [Laughter.]
        Senator Enzi. This is a time of financial concern, and
    particularly a crisis for accountants. But it is also a
    particular time of opportunity for accountants because there is
    hardly anybody in the United States that understands what they
    do and how they do it and how important that is. And they are
    coming to realize a little bit of the importance now. If the
    accountants take advantage of this opportunity, they will also
    come to understand exactly what the job is.
        Rather than promote the normal accountant outlook or
    viewpoint of accountants, I think it will bring more people
    into the profession and actually strengthen it, as we work our
    way through this crisis. Of course, I guess you have to realize
    that in order to be in the U.S. Senate, you have to be an
    eternal optimist.
        I do appreciate the willingness of the Chairman to have
    this hearing and the two distinguished witnesses that we have
    testifying today.
        As we know, the economy is becoming more globalized all the
    time. Multinational companies are operating in hundreds of
    countries, which requires them to be subject to different laws,
    regulations, accounting standards in each jurisdictions. And
    that provides for an extremely inefficient use of resources.
        Efforts to streamline this process is needed. The
    International Accounting Standards Board is the product of that
    realization that these standards must become more uniform.
    However, they must have the support of the leading nations when
    setting their standards. Without this support, the Board will
    be unable to complete the most difficult task of standardizing
    these rules.
        Each nation is going to have to show willingness to
    compromise their individual rules for the betterment of all
    societies as a whole. I think it is a prime time to be talking
    about that.
        I firmly believe that the IASB should look to countries
    whose policies have been at the forefront and whose economies
    have reacted positively. They should follow the rule of, if it
    is not broken, do not fix it. I think this mentality would go
    far in expediting their process and improving the rules as they
    are proposed and as they are implemented.
        As we have seen through the Enron debacle, we may need to
    do a review of current accounting standards or requirements.
        I believe the United States should look to other countries
    to see if we can find ways to improve our current methods of
    accounting and regulation of accounting.
        I do appreciate your holding this hearing today and I look
    forward to working with you and the Members of the Committee as
    we continue to oversee these issues dealing with accounting,
    and I look forward to the great experience of these witnesses.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you very much, Senator Enzi.
        Senator Bayh.

                     COMMENTS OF SENATOR EVAN BAYH

        Senator Bayh. Thank you, Mr. Chairman.
        My appreciation to our panelists for being here today.
        I listened with interest and amusement to Senator Gramm's
    comments. And Phil, I would only momentarily rise to the
    thankless task of defending the honor of Congress by quoting
    Will Rogers, who I think once said, ``Not to forget that every
    so often, an innocent man is sentenced to do time in the United
    States Congress.''
        [Laughter.]
        So, we do good work from time to time as well, which I know
    you would agree with.
        Just briefly, Mr. Chairman, I would say two things. First,
    this hearing is important. We exist in a global economy today
    and transparency and reliability of financial data is
    critically important to the functioning of the global economy.
        This has significant effects upon the United States. Our
    standards must be consistent with those abroad if we are going
    to do business with our trading partners. We are affected by
    the reliability--or lack thereof--of financial accounting
    standards abroad. And our country, as we have seen several
    times in the last decade, can be affected by financial shocks
    abroad, occasionally brought on by a lack of financial
    transparency in some other markets.
        So this is an important topic. I look forward to having the
    benefit of your thoughts. It is something that I am keenly
    interested in, and I thank you for your time.
        Chairman Sarbanes. Thank you.
        Senator Crapo.

                     COMMENTS OF SENATOR MIKE CRAPO

        Senator Crapo. Thank you very much, Mr. Chairman.
        I too want to thank our witnesses for being willing to come
    and help us work through these issues today.
        It seems to me that as we go through the details of the
    Enron crisis and focus on that, that we must remember what our
    role here is, which is to assure, at least with regard to this
    Committee, that the financial management and standards that are
    adopted and followed in this country are those that can give
    investors the confidence and assurance that they are getting
    accurate and timely data, so that their investment decisions
    can be made in an arena in which there is a level of confidence
    that can justify the strong markets that we hope to maintain.
        It seems that one of the most significant impacts of the
    entire Enron crisis is a lack of confidence in the investing
    public in the information that they are now having to face to
    deal with in making their investment decisions.
        I thank the Chairman for being alert to this issue and
    bringing in you as witnesses and focusing this hearing and
    other hearings on the critical issues that we must face
    relating to what level of regulation is necessary and how
    should we approach the question of regaining the confidence of
    the investing public in the information that is transmitted in
    financial markets.
        I look forward to the information, suggestions, and
    recommendations that I am sure you will be able to provide us
    with today.
        Thank you.
        Chairman Sarbanes. Thank you very much.
        Senator Bunning.

                    COMMENTS OF SENATOR JIM BUNNING

        Senator Bunning. Thank you, Mr. Chairman.
        First of all, I want to thank you for holding this
    important hearing and I would like to thank our two
    distinguished witnesses for testifying today.
        You cannot turn on a TV today without hearing someone talk
    about the bankruptcy of Enron and, to a lesser degree, Global
    Crossing. The collapse of these two large companies has shaken
    a lot of confidence.
        A stockbroker told me the other day that when he made a buy
    suggestion to his client, that client asked him who the
    company's auditor was. It was the first time in 35 years in the
    business that a client had ever asked that question before.
        We also have had substantial market losses in the beginning
    of last week. Analysts have blamed the losses on a lack of
    confidence, especially by our mutual funds in financial
    statements.
        We need to restore the Nation's confidence in our markets.
    Investors from large mutual funds to college kids who put their
    summer earnings into high-growth stocks must not even have the
    slightest fear that investing in a listed company might be akin
    to putting their money into some Ponzi scheme.
        Critical to the overall confidence is the trust in our
    accounting industry. I think we are getting a good idea of what
    happened at both Enron and Global Crossing, but we are still
    unsure on how that could have happened.
        Hopefully, our witnesses today will be able to shed some
    light on what we can do to make sure that nothing like this
    happens again, and keep confidence in our markets.
        Once again, I would like to thank the witnesses for coming
    before us today. It is always good to see our good friend and
    distinguished former Fed Chairman, Paul Volcker. I listened to
    him many times in the House Banking Committee. I am also
    pleased to get the international perspective from Sir David. I
    look forward to hearing their testimony.
        Thank you again, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Bunning.
        We would now be happy to hear from our panel. Chairman
    Volcker, why don't we start with you.
        Welcome back before the Committee.

                      STATEMENT OF PAUL A. VOLCKER

              CHAIRMAN, INTERNATIONAL ACCOUNTING STANDARDS

                          COMMITTEE FOUNDATION

                CHAIRMAN, ARTHUR ANDERSEN'S INDEPENDENT

                            OVERSIGHT BOARD

                FORMER CHAIRMAN, FEDERAL RESERVE SYSTEM

        Mr. Volcker. Mr. Chairman and Senators, I certainly
    appreciate the opportunity to meet with you this morning.
        Chairman Sarbanes. I think you need to draw that microphone
    in closer to you.
        Mr. Volcker. And join with Sir David Tweedie, who Chairs
    the International Accounting Standards Board.
        I want to congratulate all of you for looking beyond the
    immediate crisis for what the implications are for legislation
    or otherwise, in this area that is so important to the
    operation of financial markets and capitalism.
        Senator Enzi referred to the importance of young people
    coming into what we used to think of, anyway, as a noble
    profession. I think that this kind of captures the heart of the
    issue because I hear a lot of complaints that young people do
    not want to come into this particular profession right now,
    relative to the attractions of others. I think if we are going
    to have a sound auditing and accounting system, it has to be
    something that people do want to come into and serve.
        When this session was arranged some weeks ago, the
    intention was to concentrate mainly on the relevance of the
    work of the IASB and its associated bodies to the evident
    problems besetting the accounting and auditing professions.
        Those problems, building over a period of years, have now
    exploded into a sense of crisis. That crisis is exemplified by
    the Enron collapse. But Enron is not the only symptom. We have
    had too many restatements of earnings, too many doubts about
    ``pro forma'' earnings, too many sudden charges of billions of
    dollars to ``good will,'' too many perceived auditing failures
    accompanying bankruptcies to make us at all comfortable. To the
    contrary, it has become clear that some fundamental changes and
    reforms will be required to provide assurance that our
    financial reporting will be accurate, transparent, and
    meaningful.
        Those qualities, as some of you have emphasized, are
    essential attributes of a capital market and financial system
    in which investors can place confidence and which can
    efficiently allocate capital. The implications extend far
    beyond the shores of the United States.
        We have long seen our markets, and our accounting systems,
    as models for the world, as Senator Gramm indicated, a world in
    which capital should be able to move freely to those places
    where it can be used most effectively and it can become a
    driving force for economic growth and productivity. In fact, a
    large portion of international capital now flows through our
    markets. We have been critical of the relative weakness of
    accounting and auditing standards in many other countries,
    arguing that those weaknesses have contributed to the
    volatility, inefficiency, and breakdown of the financial
    systems of so-called emerging economies.
        How ironic that, at this point in economic history when the
    performance of the American economy and financial markets has
    been so seemingly successful, we are faced with such doubts and
    questions about a system of accounting and auditing in which we
    have taken so much pride, threatening the credibility and
    confidence essential to well-functioning markets.
        To my mind, we can extract some good news in all of this.
    Our eyes have been opened to festering issues that have for too
    long been swept aside or dealt with ineffectively. We now have
    the opportunity for bringing our performance to a level that
    matches our words--to practice what we preach.
        For most of my professional life, I have been a consumer--
    sometimes a very critical consumer--of accounting and auditing
    reports rather than a participant in the process. That began to
    change when I agreed to Chair the newly restructured
    International Accounting Standards Committee some 18 months
    ago. The main responsibilities of that Committee--modeled
    substantially on the Financial Accounting Foundation in the
    United States--are to appoint the standard setting body Chaired
    by Sir David, to obtain finance for its work, and to exercise
    broad oversight over the effort.
        The Committee I Chair does not engage in the technical
    work--we do not set, or advise on, the standards themselves. I
    am not and never have been an auditor. But as Yogi Berra once
    said, ``you can observe quite a lot just by watching,'' and
    there has been a great deal to watch.
        I have attached to this statement excerpts from two earlier
    statements of mine that reflect my growing concerns. The fact
    is the accounting profession has been hard-pressed to keep up
    with the growing complexity of business and finance, with its
    mind-bending complications of abstruse derivatives, seemingly
    endless varieties of securitizations, and multiplying off
    balance sheet entities. The new profession of financial
    engineering is exercising enormous ingenuity in finding ways
    around established accounting conventions or tax regulations.
    In the rapidly globalizing world of finance, different
    accounting standards and methods of enforcement in different
    jurisdictions present increasing hazards.
        Underneath it all, many have a sense that I share: In the
    midst of the great prosperity and boom of the 1990's, there has
    been a certain erosion of professional, managerial, and ethical
    standards and safeguards. The pressure on management to meet
    market expectations, to keep earnings rising quarter by quarter
    or year by year, to measure success by one ``bottom line'' has
    led, consciously or not, to compromises at the expense of the
    public interest in full, accurate, and timely financial
    reporting.
        I think of good financial reporting as resting on three
    pillars: First, accounting standards setting out with clarity
    logically consistent and comprehensive ``rules of the game''
    that reasonably reflect underlying economic reality. Second,
    accounting and auditing practices and policies able to
    translate those standards into accurate, understandable, and
    timely reports by individual public companies. Third, a
    legislative and regulatory framework capable of providing and
    of maintaining needed discipline.
        It is the first of those pillars with which I have been
    directly involved over the past 18 months.
        The general case for international accounting standards has
    been clear for a long time. In a world of global finance, we
    have strong interest in encouraging high-quality standards
    every place our companies do business. We want to be sure
    foreign-based companies desiring access to our well-developed
    market provide the kind of information that our investors want
    and need. We also want to avoid distortions in the
    international flow of capital because of misinformation or lack
    of information. Not least, a single set of standards would
    minimize compliance costs for companies and, I believe, assist
    enforcement.
        Our American view has been that those objectives could be
    substantially attained simply by insisting all companies
    approaching our markets use U.S. GAAP--that is, American
    accounting principles. But that approach could, in my judgment,
    never be fully adequate. Other countries will not easily agree
    ``Made in America'' is necessarily best. Coverage will not be
    complete or uniform. For instance, Europe will insist on
    international standards, and many countries will simply be
    incapable of, or drag their feet on, good quality national
    standards.
        Recent events drive home another point. Taken as a whole,
    the U.S. standards may, indeed, still be the most comprehensive
    and best quality in the world. But plainly, the auditing
    processes and the standards in this country themselves need
    review.
        Much has been made of the time that standard setters take
    adapting their standards to current business developments and
    needs. Conversely, there are claims of inadequate consultation,
    and those perceiving harm to their interests threaten
    withdrawal of financial support or lobby their legislators for
    preemptive action. In such a charged environment, one can see
    that in the United States, as well as elsewhere, that change is
    too slow and suspicions of political compromise damage
    confidence in the process.
        In this context, there is a real opportunity for a
    reinvigorated international effort. A new highly professional
    organization is in place, symbolized and led by Sir David here.
    It has strong backing from industry and governments around the
    world. Given its strong staffing and organizational safeguards,
    the IASC framework should be able to maintain high credibility.
    In its key components--the oversight committee I Chair, the
    standard setting board Chaired by Sir David, its advisory
    council and interpretations committee--it can command the best
    professional advice, international representation, and not
    least, appropriate independence.
        Sir David will speak more directly to the substance and
    priority of the work. However, I personally want to assure you
    that our intent is to move beyond compromise among existing
    standards or convergence for convergence's sake. Instead, we
    will work with the FASB and standard setters in other countries
    to choose among, and to adapt the best of, what exists. When
    necessary, we will innovate and develop new approaches.
        Time is a luxury that we cannot afford. We have known for
    some time, the European Union will require publicly-traded
    European Union companies to report their consolidated financial
    statements according to international accounting standards by
    2005. In other countries, there is an evident need for faster
    progress. And now American experience underscores the urgent
    need for a fresh look in some crucial areas.
        As Sir David will report, the IASB already is considering
    many of the items in the headlines today-- consistency in
    defining operating earnings and pro forma statements, special
    purpose entities, mark-to-market or ``fair value'' accounting,
    and stock options.
        You might ask where the FASB fits into the process I
    describe. I do not believe that we face an ``either/or''
    proposition between U.S. GAAP and international standards. In
    fact, the FASB and IASB are working together on many of these
    issues with the objective and expectation of reaching the same
    conclusion. The result should be convergence and significant
    improvement in both bodies of standards.
        Broadly accepted, up-to-date international standards will
    help discipline the auditing process and encourage effective
    and consistent enforcement by national and international
    authorities.
        Yet there is no escaping the fact, in the end, the accuracy
    and reliance of financial reporting lies in the hands of the
    auditors themselves. They are the ones who must interpret and
    apply the standards and protect their integrity. They are the
    ones to which the investing public must look to ask the tough
    questions, to demand the answers and to faithfully certify that
    at the end of the day--or the quarter or year--the financial
    results of a company are fully and clearly reported.
        As you are aware, I have recently agreed with Andersen
    International to Chair an Independent Oversight Board, with
    broad responsibilities to work with the company in reviewing
    and reforming its auditing practices and, if necessary, to
    mandate such auditing practices and policies.
        My hope is that, out of the current turmoil and
    questioning, Arthur Andersen will again assume a position of
    leadership in the auditing profession right around the world.
        I do not minimize the challenge. Auditors individually and
    in the auditing profession generally have been subject to
    strong and conflicting pressures. Company management urgently
    wants to meet market expectation to present results in the most
    favorable light and to demonstrate a consistent pattern of
    earnings.
        Too often the emphasis is on finding ways to meet the
    letter of the technical accounting requirements at the risk of
    violating the spirit. Large and profitable consulting
    assignments may, even subconsciously, affect auditor judgment.
    Companies want to minimize accounting costs. Directors and
    auditing committees may not be sufficiently knowledgeable or
    attentive--that is, until it is too late.
        All this raises questions of the internal management and
    policies of auditing firms, matters with which I am only
    beginning to grapple. How can the auditing functions and the
    ``technical'' accounting decisions be protected from extraneous
    influence? Can strong safeguards be put in place against other
    business interests intruding on the auditing process? What are
    the appropriate limits on nonauditing services performed by an
    auditing firm to avoid the perception or reality of an
    unacceptable conflict?
        Finally, high-quality standards and improved audit
    practices should go a long way toward easing enforcement.
    However, there are areas where it may be difficult or
    impossible for any one firm to proceed alone. Hence, there is a
    need for official regulation.
        The United States has a framework for regulation and
    enforcement in the SEC. Over the years, there have also been
    repeated efforts to provide oversight by industry or industry/
    public member boards. By and large, I think we have to conclude
    that those efforts at self-regulation have been very
    unsatisfactory. Thus, experience strongly suggests that
    governmental oversight, with investigation and enforcement
    powers, is necessary to assure discipline.
        I can assure you in my roles both at the IASC and Andersen
    that I will continue to work closely with Government officials
    here and abroad in order to encourage more effective
    enforcement. One imperative is for governments, including the
    United States, to provide adequate financial resources to
    regulators. I also believe this Committee will want to explore
    means for providing more backbone for industry oversight,
    either through legislation or by encouraging exercise of SEC
    regulatory authority. Better means of identifying professional
    misconduct, with the possibility of meaningful fines and
    withdrawal of professional licenses, appears essential.
        A positive step in this direction is being taken by the
    European Union in its effort to rationalize their securities
    laws and centralize their enforcement. We should encourage
    other countries, through the International Organization of
    Securities Commission and otherwise, to bolster enforcement
    mechanisms in other countries, developed and emerging alike.
        The crisis in the accounting and in the auditing
    professions is not a matter of the failure of a single company
    or perceived problems in a single audit. It demands attention
    to fundamental flaws basically reflecting the growing
    complexities of capital markets and pressures on individuals
    and their companies to improve financial results.
        To fail to respond to that challenge would, indeed, have
    serious implications for maintaining confidence in markets, for
    the cost of capital and for the global economy.
        The United States has long had a leading role among the
    world financial markets, in financial reporting, and in the
    regulation and surveillance of these markets. Constructive work
    of your Committee and the Congress will be vital in maintaining
    that leadership. I also urge that you recognize, in an open and
    interdependent world economy with increasingly fluid capital
    markets, effective leadership, must necessarily involve close
    cooperation with others interested in full, accurate, and
    timely financial reporting. The development of truly
    international accounting standards--building on the best that
    now exists and responsive to new needs--can be and should be a
    key element in the needed reforms.
        The restructured IASC is in large part a result of
    initiatives taken by the SEC itself and supported by the
    leadership of FASB.
        I trust that support will not weaken. Rather, as you
    examine the implications of the current crisis and the range of
    appropriate remedies, I hope that you will help reinforce the
    effort to reach international convergence, recognizing its
    potential for improving accounting and auditing practices in
    the United States, as well as in other countries.
        Thank you very much, Mr. Chairman.
        Chairman Sarbanes. Thank you very much, Chairman Volcker.
        Sir David, we would be happy now to turn to you. We very
    much appreciate the very comprehensive statement you have
    submitted to the Committee. The entire statement will be
    included in the record. If you could summarize it so that we
    can get to the question period, we would appreciate that very
    much. I know that a great deal of effort went into it, and we
    are most appreciative for that work.

                     STATEMENT OF SIR DAVID TWEEDIE

                                CHAIRMAN

                INTERNATIONAL ACCOUNTING STANDARDS BOARD

                            FORMER CHAIRMAN

              UNITED KINGDOM'S ACCOUNTING STANDARDS BOARD

        Sir David Tweedie. Thank you, Mr. Chairman, Senators.
        May I say what a great pleasure it is to be back in the
    Colonies, and to----
        [Laughter.]
        --have an opportunity now to share my thoughts on----
        Chairman Sarbanes. The witness's time has expired.
        [Laughter.]
        Sir David Tweedie. And to have an opportunity to share my
    thoughts on some accounting matters that obviously have become
    the focus of much recent attention.
        As you say, sir, I have submitted a written document that
    provides background information on the International Accounting
    Standards Board, how we inherited the international standards
    of our predecessor body, the International Accounting Standards
    Committee, and how that body was converted into the
    International Accounting Standards Board, due, as Mr. Volcker
    has already said, in no small measure to the initiatives of the
    FASB and the SEC. In fact, the Board would not exist without
    those two bodies pressing for its creation.
        Both of these organizations recognize that no matter how
    good the U.S. accounting standards were, the international
    community would be unlikely to accept that seven highly skilled
    Americans sitting in Connecticut and subject to American
    domestic considerations could set the rules for the rest of the
    world.
        If I could paraphrase a phrase of your own history, ``no
    accounting without representation.''
        [Laughter.]
        For the sake of time, I hope you will excuse me if I do not
    speak directly from my written submission, but I will just
    mention one or two points and obviously be happy to answer any
    questions.
        Our objective is very straightforward. It is to work toward
    a single set of high-quality global accounting standards
    produced in the private sector and the principles of
    transparency, open meetings and full due process.
        We should make it clear that we have absolutely no
    intention to water down existing standards in any jurisdiction,
    and that of course includes the United States. Instead, we plan
    to build a set of financial reporting standards that come to be
    viewed as the gold standard worldwide.
        Why did we set up the International Accounting Standards
    Board?
        Well, as the former Chairman of the United Kingdom's
    Accounting Standards Board, and now as Chairman of the IASB, I
    think that there are four reasons that led to the new
    organization.
        First, the existence of multiple and sometimes unknown sets
    of accounting standards increases uncertainty and drives up the
    cost of capital. Even if there were no systematic increase in
    the overall cost of capital, the uncertainty created by
    multiple sets of financial reporting standards would be likely
    to lead to a misallocation of capital among market
    participants. Capital tends to gravitate to the familiar.
        Second, no individual national standard setter has a
    monopoly on the best solutions to accounting problems.
        Third, no national standard setter driven as it must be by
    domestic considerations is really in a position to set
    accounting standards that gain acceptance around the world.
        Fourth, there are many areas of financial reporting in
    which a national standard setter, because of political
    pressure, finds it difficult to act alone.
        We are under no illusion. Reaching broad agreement on high-
    quality standards that are globally accepted is going to be
    difficult. It will require a lot of work, consultation with all
    of the interested parties, and will need to be guided by sound
    reasoning to avoid the temptation for compromise for the sake
    of satisfying our constituents. Out of our 14 board members, 12
    are full-time and they have had to resign from their
    occupations with no return guaranteed, just as they have to do
    in the FASB. That is to safeguard their independence.
        We should note that we are not immune from national
    political pressures. We have just begun our work, but some
    common refrains have already been heard.
        Some commentators have argued that if an issue has been
    debated in America, then it has been resolved and we should not
    look at it. Others have decided that we cannot have standards
    that are tougher than the American standards. We are going to
    ignore both arguments.
        American accounting standards cannot impose a ceiling on
    our efforts. If we have perceived deficiencies in American
    standards, we intend to ensure that the international one does
    not have the same weaknesses.
        We must be able to assess with open minds the major issues
    facing accounting today and base our solutions on sound
    reasoning, not political and national concerns. If we did not,
    there is no reason to have an independent international
    standard setter.
        We have said if the U.S. standards are the ceiling, then
    they should become the international standards because all we
    could do is match them or even be worse. And we intend to do
    better.
        We are not going at this alone. National standard setters,
    including the FASB, are a critical part of our activities. We
    are looking to them and, in particular, seven of them. In our
    board, we have a liaison member with each of the standard
    setters of the United States, Canada, United Kingdom,
    Australia, Japan, France, and Germany.
        The American representative, Mr. Leisenring, is sitting
    behind me on my left, unnervingly close, I might say, and he is
    going to take our views from the international board into FASB,
    discuss them with FASB, bring FASB's views back, and so we hope
    to have an interaction with the national standard setters.
        We are looking to the national standard setters for
    research and counsel, to alert us to particular problems and to
    help in our due process.
        We are also going to ask them to be our partners in several
    of our projects, enabling us to make use of their resources.
    This is a worldwide, collaborative effort to improve financial
    reporting in all countries, the USA included.
        Of our 14 members, five are from the United States--two, I
    may say, are British rejects, having been born in the United
    Kingdom. But the United States is obviously heavily
    represented.
        How do international standards differ from American
    standards?
        Many stories in the press are focused on whether standards
    other than those of the FASB would have stopped Enron's
    collapse. I do not plan to comment on specific accounting and
    auditing issues surrounding Enron, although there are many.
    None of us in the United Kingdom knows enough about the
    specifics of the transactions, the information available to the
    auditors, the judgments involved, to form a solid professional
    opinion.
        As we learn more, we may find that the U.S. standards
    should be improved. But we may find that the standards were
    perfectly satisfactory and had not been implemented properly.
    If so, we plan to learn from the case if improvements are
    needed and to make sure that the international standards do not
    have similar problems.
        Many international standards are similar to U.S. GAAP. Both
    international and American standards strive to be principle-
    based, in that they both look to a body of accounting concepts.
        American standards, however, tend on the whole to be more
    specific in requirement and include much more detailed
    implementation guidance. That is partly because of the
    litigious nature of the USA. Auditors have demanded extra rules
    to help them protect themselves. Companies have asked for rules
    so that they know exactly where they stand. Regulators have
    often liked bright lines so that they can regulate with
    certainty.
        For better or worse, many observing the standard setting
    scene, have described this as the difference between principles
    and rule-based standards.
        The IASB has concluded that a body of detailed guidance
    encourages a rulebook mentality of ``where does it say that I
    cannot do that?'' We take the view that this is counter-
    productive and helps those who are intent on finding ways
    around standards more than it can help those seeking to apply
    standards in a way that gives useful information. Put simply,
    detailed guidance may obscure rather than highlight the
    underlying principle.
        To illustrate, it is often easier if you are trying to deal
    with a particular transaction not to make a rule for that
    transaction. If, for example, you said if A, B, and C happens,
    the accounting is X, we know that before long, someone will
    invent B, C, and D and say that they are not covered by the
    standard. Rather, it is better to have a principle and use A,
    B, and C as merely an example, and by that way, hopefully, you
    will catch the following transactions.
        We favor an approach that requires the company and its
    auditor to step back and consider whether the accounting
    suggested is consistent with the underlying principle. This is
    not a soft option.
        Writing standards in that manner requires a strong
    commitment from preparers that their accounts provide a
    faithful representation of all transactions and a strong
    commitment from auditors to resist client pressures to accept
    accounting that does not give a fair presentation. It won't
    work without those commitments, commitments that can be
    strengthened by a top-class enforcement organization such as
    the SEC.
        Under our system, there will be more individual
    transactions and structures that are not explicitly addressed.
    We hope that a clear statement of the underlying principles
    will allow companies and auditors to deal with these situations
    without becoming entangled in a web of detailed rules, rules
    which can allow the unscrupulous to game the standards.
        In the international standards, fair presentation is the
    key. You can, as the standards are presently written, depart
    from an international standard if obeying it would give false
    and misleading presentation. But that is only in the unique
    situation of the company, not because it prefers another method
    which is not in the standard. The problem is policing that. In
    some jurisdictions, companies may try to use that allowed
    departure to avoid standards. We have to make sure that it is
    complete exception rather than a common occurrence.
        Our agenda--we began work officially in April 2001, but,
    actually, by the time we got staff, in September of last year.
    We intend to move in our work program rapidly.
        In our first year, we are focused on improving the existing
    corpus of standards. We are clarifying many to respond to
    comments from securities regulators and national standards
    setters.
        We are removing alternatives where they weaken reporting
    requirements. And we are trying, therefore, to bring the
    standards we inherited into line with best international
    practice.
        We have a particular urgency, as Mr. Volcker has
    highlighted, by the fact that European companies will have to
    conform to these standards by 2005.
        Other projects on our agenda aim toward leadership and
    offer convergence or provide easier application of existing
    standards. Many of the issues feature prominently in today's
    headlines--business combinations, performance reporting, share-
    based payments, including employee options, and insurance
    contracts.
        Our research agenda deals with 16 other subjects that are
    being dealt with by one or more of our partner national
    standard setters. We are working with them, monitoring their
    efforts in order to ensure that differences among national
    standard setters and with the IASB, are identified and resolved
    as quickly as possible.
        We expect to move several of these issues onto our active
    agenda as time and resources permit. My written statement
    elaborates on these research projects.
        We are shortly to set up what we call a convergence working
    party, which will look at the main differences in particular
    between the American standards and international standards, to
    see if we can agree which method is the better and, if not, if
    neither are very good, finding another one.
        There are common threads that run through most of the
    topics in our active and research agenda. Each represents a
    broad topic that has occupied the best accounting minds in many
    countries for several years. It is now time to come to closure
    on many of these issues.
        The accounting issue that is prominent in people's minds is
    the topic of off balance sheet items. During the last 20 years,
    a number of attempts by companies have been to remove assets
    and liabilities from balance sheets through transactions that
    may obscure the economic substance of the company's financial
    position. This is not just related to special-purpose entities,
    but also to leasing transactions, securitizations, and
    pensions.
        Similarly, there are off income statement items. Under
    existing accounting standards in many jurisdictions, a company
    that pays for goods and services through its own stock or
    through options does not record any cost for those goods or
    services. The most common form of this is employee share
    options.
        In 1995, after what it called an extraordinary
    controversial debate, the FASB issued a standard that in most
    cases in the United States required disclosure of the effect of
    employee stock options, but doesn't require a charge through
    the income statement.
        Most jurisdictions have no standards on accounting of
    share-based payments, and use of this technique is growing
    outside of the United States. We have still to reach
    conclusions on this issue, but our early indications are that
    we do believe that this is an expense that has to be charged to
    the income statement.
        Under existing accounting standards in most jurisdictions,
    assets and liabilities are reported in amounts based on a
    mixture of accounting measurements. Some are based on
    historical transaction prices, perhaps adjusted for
    depreciation. Others on fair values, using either amounts
    observed in the marketplace or estimates.
        Accountants refer to this as a mixed attribute model. It is
    becoming increasingly clear that this mixed attribute model
    creates complexity and opportunities for accounting arbitrage.
    Some have suggested that financial reporting should move to a
    system where all financial instruments are at fair value, and
    we are obviously going to have to examine that.
        Under existing accounting standards, the cost of an
    intangible asset, a copyright or the like, purchased from a
    third party is capitalized as an asset. This is the same as for
    required tangible assets, buildings, and machines.
        Existing accounting standards extend this approach to self-
    constructed tangible assets, so a company creating its own
    building capitalizes the costs. We do not, however, do that
    with intangible assets. Many have criticized this
    inconsistency, especially at a time when intangibles are
    drivers of performance.
        In conclusion, sir, as I said at the outset, our objective
    is to work toward a single set of high-quality international
    financial reporting standards. The international financial
    markets clearly want a single set of standards that apply
    worldwide.
        We do not intend to water down existing standards in any
    jurisdiction. This is not the lowest-common denominator.
    Instead, we plan to build a set of financial reporting
    standards that, as I said, are the gold standard. We intend to
    pick the best of the available standards produced by national
    standard setters.
        No single group has a monopoly on the best of accounting.
    We expect to learn from our colleagues. To the extent that the
    underlying rationale in U.S. GAAP is the best available, we
    intend to incorporate it into international standards.
        To the extent that another standard has a superior
    approach, we intend to adopt it. If no national standard
    adequately addresses the problem, as may be the case of
    accounting for leases or share-based payments, we plan to work
    toward a new international standard that does.
        We want to base our standards upon clear principles rather
    than rules that attempt to cover every eventuality. I hope that
    we can keep to the plan, but success will depend upon the
    professionalism and judgment of financial statements'
    preparers, auditors and securities regulators.
        Our work is going to require tough decisions and unpopular
    standards. Assets and liabilities that companies have moved off
    balance sheet will more than likely move back on. Expenses that
    today go unrecognized may be recognized in companies' income
    statements. Measurements may move gradually from historical to
    more current information.
        The United States and, indeed, the whole world, has been
    shocked by the scale and speed of the Enron collapse. We who
    are on the outside learn a little more every day, but it still
    remains to be seen whether financial reporting that preceded
    Enron's collapse was the result of flawed accounting standards,
    incorrect application of accounting standards, auditing
    mistakes, or plain deceit.
        We have an obligation to the investors, to the employees,
    and to the others who suffered to ensure to the best of our
    ability that the lessons are learned. If there are weaknesses
    in accounting standards, we have to acknowledge that fact and
    come forward with improvements.
        In partnership with the FASB and the SEC and others, we
    intend to change financial reporting. In some cases, that
    change is going to be dramatic, especially for countries
    without the advanced standards and financial infrastructure
    found in the United States.
        Most of those changes are going to be controversial, even
    in this country. You and your colleagues will be asked to stop
    their implementation, I am absolutely sure, in the United
    States. I hope that you can resist these requests. Global
    accounting standards do not create a national disadvantage and
    we have to work toward solid, robust standards, not partial
    compromises that investors can trust. The markets in the United
    States and worldwide require and deserve no less.
        Thank you, sir.
        Chairman Sarbanes. Thank you very much, Sir David.
        We have been joined by a number of our colleagues and I am
    going to yield to them for their opening statements before we
    go to the questioning.
        Chairman Sarbanes. Senator Shelby.

                 COMMENTS OF SENATOR RICHARD C. SHELBY

        Senator Shelby. I will be real brief. I was very interested
    and I just want to repeat what was part of my opening
    statement, what Dr. Volcker said.
        He said: ``We have had too many restatements of earnings,
    too many doubts about pro forma earnings, too many sudden
    charges of billions of dollars to goodwill, too many perceived
    auditing failures accompanying bankruptcies to make us at all
    comfortable. To the contrary, it has become clear that some
    fundamental changes and reforms will be required to provide
    assurance that our financial reporting will be accurate,
    transparent, and meaningful.''
        I could not say it as well as you have, Dr. Volcker.
        Thank you.
        Chairman Sarbanes. Thank you, Senator Shelby.
        Senator Carper.

                  COMMENTS OF SENATOR THOMAS R. CARPER

        Senator Carper. I have no opening statement. But I just
    want to say welcome to Sir David and to Sir Paul. It is great
    to have both of you here and we are delighted you are here.
        Sir David, thank you for bringing your sense of humor with
    you on this side of the pond.
        Chairman Sarbanes. We cannot call him Sir Paul. Rudy
    Guliani went over there and was knighted, but he cannot be
    called Sir Rudy. It is contrary to American statute.
        [Laughter.]
        Senator Gramm. Sir Rudy does not sound right.
        [Laughter.]
        Chairman Sarbanes. I am not going to get into that
    argument.
        [Laughter.]
        Senator Akaka.

                  COMMENTS OF SENATOR DANIEL K. AKAKA

        Senator Akaka. Thank you, Mr. Chairman.
        Across the country, expanded participation in the financial
    markets has provided increased opportunities for individuals to
    build wealth. In my State of Hawaii, like other places, over
    half of all households own stock. Investing decisions are
    already extremely complex. When information provided by
    companies is false, investors are not given the opportunity to
    make informed decisions. False information can lead to losses
    which destroy the wealth of the investors.
        Protecting investors from misleading financial statements
    must be a global effort as direct investment barriers have
    fallen and international markets provide additional
    opportunities for capital appreciation and diversification.
    Special purpose entities, pro forma profits, and opaque
    bookkeeping practices have the potential to confuse and mislead
    United States and foreign investors.
        We must all work together to improve the transparency of
    corporate activities and to ensure that investors are provided
    reliable information to use in making their investment
    decisions.
        I want to thank Chairman Paul Volcker and Sir David Tweedie
    for joining us today. I look forward to the questions and to
    the recommendations on what can be done to restore the shaken
    confidence of investors.
        Thank you very much, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Akaka.
        Chairman Volcker, I am looking at a newspaper headline
    right here, a dangerous thing to look at on occasion: ``Volcker
    Sought Enron Funds For Accounting Board.'' It is your effort to
    obtain contributions to the International Accounting Standards
    Board's Foundation to carry on its work. Of course, that
    obviously raises the question, how do we fund these boards and
    how do we gain their independence? Why don't you tell us a
    little bit about this process and what your thoughts are?
        Mr. Volcker. The basic question is how we fund these
    boards.
        The international arrangements were set up pretty much on
    the model of FASB. There are two sources of income, including,
    selling the standards themselves, and an explanation in our
    case such sales are limited at this stage. In FASB, it accounts
    for more than half of that revenues. Since many, many
    accountants and auditors need to have these, it is a source of
    revenue. The rest of it is financed by contributions from
    industry.
        We started fresh with contributions from industry. Just to
    give you a picture of what we have done, we started at the end
    of 2000, the beginning of 2001. We solicited approximately 300
    of the largest companies around the world. I wrote to them, or
    my associate trustees wrote to them in other countries. We are
    in the process of soliciting actually an additional 150 now,
    another tier. We have had a pretty good response.
        Our expenses we estimated at about $15 million a year. We
    have that covered in the early years from these initial
    solicitations. About 150 almost, corporations have contributed.
    The major accounting firms are picking up about a third of the
    tab.
        I might point out in connection with the interest in this
    effort, we have contributions from over 30 central banks and
    international institutions that are interested in this effort
    and wanted to indicate their support with relatively small
    contributions.
        But together, that comes to over a million dollars.
        We have a wide variety of contributors. We will be
    publishing the list of contributors in our annual report that
    will be out shortly.
        Enron was one of the companies, as a big American company
    that was routinely solicited in, apparently, the first wave of
    letters that I sent out.
        As it turns out, about a third of our funding comes from
    the United States, about a third from Europe, about a third
    from Japan, Latin America, and others.
        I think it is apparent that it is pretty diffuse.
        Consistent with what I said in the statement, I have always
    looked at this international effort as providing better
    protection against so-called special interests than even the
    American approach, because of the variety of support and the
    variety of the different countries participating. It is
    supported by the official community very vigorously.
        The concern about financing is kind of ironic because the
    concern of the trustees during most of this period has not
    been, whether we were sufficiently independent and insulated
    from special interests, but whether there, in fact, would be
    adequate consultation with preparers, users, and all the
    interested parties.
        We have gone to considerable efforts to make sure that the
    Board, before acting, does extensive consultation. And there is
    a particular official advisory body. We started out thinking
    that would be about 30. These are industry people--preparers,
    users, academics, and others. We started out thinking we might
    appoint about 30 in an advisory body. We ended up with 50
    because we wanted to make sure that people with a legitimate
    interest will be heard and will interact with the Board so that
    all points of view can be reflected.
        I think that is essentially the story, Mr. Chairman.
        Chairman Sarbanes. Let me ask both of you this question.
        Shouldn't we give some thought to some way of financing
    these activities that has an automatic nature to them. Some
    levy that may be placed on one or another of the economic
    transactions or economic activities that takes place which
    would automatically engender a revenue stream, rather than rely
    on contribution?
        The FASB has to do the same thing. They go around with a
    tin cup soliciting contributions and then, of course, you get
    this sort of perception on the part of some, as some of the
    Enron people obviously had, that this was going to give them
    special access and special influence.
        Mr. Volcker. I must say, I have gotten the answer since
    yesterday. Enron, I understand, finally agreed to give us one
    half of what we asked them for and suggested we send them along
    an invoice. We sent them along an invoice. We have not gotten
    any money.
        [Laughter.]
        I do not think there will be any undue influence on that
    avenue.
        [Laughter.]
        The question you ask has obviously been on my mind. Some
    people like to raise money. I find it distasteful when I have
    to send out a lot of letters. But it raises the question, what
    can you do?
        I do not think the idea of official financing as a matter
    of, say, Congressional appropriations, has seemed really
    appropriate. I do not think we want a UN kind of situation.
        The only other thing that anyone has thought of, I think,
    is some kind of listing contributions--stock exchanges
    contribute depending upon their listings or companies listing
    might have a mandatory contribution.
        I am not sure that this has been explored as much as it
    might. But I will tell you there is no enthusiasm on the part
    of stock exchange or listing companies to do it. And to do it
    fairly, you would have to do it pretty comprehensively around
    the world.
        I think that is an avenue that could be explored.
        Ultimately, we thought we would get effective financing
    over a period of time from sale of the publications. We have
    had a big hole blown in that possibility because the European
    Union, which wants to adopt international accounting standards
    and put it in European law, says once it is in European law, we
    cannot charge--we cannot have our companies required to follow
    the standard and have to pay to find out what the standard is.
        We have had some rather elaborate negotiations with the
    European Union as to how to preserve some kind of a copyright,
    which are ongoing. But that will have an important influence on
    our funding in the future.
        Chairman Sarbanes. Sir David, how did the UK fund your
    activities when you did the UK work?
        Sir David Tweedie. Well, sir, the International Accounting
    Standards Board, was funded from three main sources. The
    government gave a third. That did not buy them influence. The
    Chancellor, Gordon Brown, and I clashed on numerous occasions,
    but there was never any threat to withdraw the money. A third
    came from the accounting institutes, the equivalent of the
    AICPA. And one third came from the City of London. That was
    about half from the Bank of England, which is the central bank,
    who collected it from the other banks. And the rest mainly from
    the stock exchange. And I think they put a small levy on the
    listing fees.
        Chairman Sarbanes. I am interested in that small levy on
    the listing fees. I am going to give heart pain to some of my
    colleagues, but we just lifted fees to the tune of $15 billion
    over 10 years. That is about $1\1/2\ billion a year if you
    assumed it was constant. It may not be altogether a correct
    assumption. A fairly tiny portion of that on a regularized
    basis would fund these activities.
        It seems to me that the UK arrangement sounds more likely
    to produce independence and removal from either private
    interest pressure or public pressure reflecting private
    interest influence. We have seen that happen here.
        Private interests go hard at FASB and if they do not seem
    to be getting anywhere, then they go hard at the Congress to
    get the Congress to go hard at FASB.
        So, I think this is something that we need to give a lot of
    thought to because if we can get a structure that sustains
    independence, in terms of how it is chosen and who serves, and
    a financing that maintains independence, it would be an
    important contribution. That is one of the things that we have
    to look at.
        I have run over my time.
        Senator Gramm.
        Senator Gramm. Thank you, Mr. Chairman.
        I want to thank both of you for your testimony. I thought
    both testimonies were excellent.
        When I was an accounting student, now a long, long time
    ago, these issues seemed very simple. But when I came to the
    Senate and started dealing with the question, at least hearing
    from constituents and talking to FASB and my colleagues about
    how you account for stock options. Should that be charged
    against current income? Is it a dilution of ownership, and if
    it is, how do you account for it?
        The whole question of derivatives--closed-in or open-ended,
    depending on whether the derivative is related to another
    potential liability you have. And then the whole question of
    auditor independence. These issues turned out to be a lot more
    complicated than that accounting class I took in 1961 might
    have suggested going in. Maybe I should have taken more
    courses, but I hated that practice set you had to do in the
    second course.
        [Laughter.]
        That determined that I did not want to be an accountant. My
    mother did not think I had the personality for it.
        [Laughter.]
        But in any case, one of the positions that I have taken
    consistently is that I have not always agreed with FASB, but I
    have always believed that whatever FASB thought, I was more
    confident in FASB setting standards than I was confident in
    Congress setting standards.
        I have not always agreed with the SEC. I thought our dear
    friend, Arthur Levitt--and very few people who served in
    Government I respect more than Arthur Levitt--was too involved
    in accounting standards.
        He once told me that he talked to the head of FASB all the
    time, had his home number. I said to him, Arthur, the fact that
    you know his home number to me I think is probably an
    indication of a problem.
        But I always made it very clear to Arthur Levitt that if it
    came down to a choice between setting accounting standards in
    Congress or having Arthur Levitt set it, whether I agreed with
    it or not, I would rather Arthur Levitt set it than Congress.
        So here is my question.
        As we begin to look at reforms, ultimately, we are going to
    have to ask ourselves how are we going to implement these
    accounting reforms? Are we going to mandate new standards of
    accounting in Congress?
        I think there is one CPA in Congress. If there is more than
    one, I do not know it. And that is our dear colleague here.
        So are we going to try to give a directive to the SEC and
    are they going to set accounting standards? Are we going to try
    to find a way to insulate FASB so that they might be more
    independent in setting standards? I would like to get your
    thoughts on that. I do not think it is a trivial question. I
    think it is one that we are going to have to come to grips with
    as we get into this, and it is one that I have some concern
    about.
        Mr. Volcker. Let me take a crack at it. But, first, your
    own experience reminds me I have a little card from my old
    college roommate saying, finally, that course in Accounting 101
    is paying off.
        [Laughter.]
        But it is not paying off very well because it was much
    simpler, as you say, than what we have here.
        [Laughter.]
        Look, I think you need some mechanism for getting an
    independent board, institute, whatever, to set the standards.
    It is a very complicated matter. If what is going on now
    doesn't illustrate anything else, it illustrates how
    complicated this stuff is. And so, you need some kind of an
    independent board. I do not know if anybody has come up with a
    better framework than FASB. But now, on an international level,
    which I do think gives by its very nature additional levels of
    protection.
        I have, maybe wrongly, not been so worried or worried at
    all about influence of individual companies, which are so
    diluted. But to the extent I, as Chairman of the Trustees of
    this effort, have been under any pressure at all, it has come
    through the political process.
        And so, the international dimension I think does provide
    some protection. We have kind of layers of protection. We as
    Trustees are supposed to be protecting the independence of Sir
    David's Board. The nature of the Board itself is experts. The
    Constitution emphasizes again and again independence and
    expertise. That is the basis for choosing these people.
        I think by any evidence, people on the Board that Sir David
    Chairs are accounting experts. As I say, part of our concern
    was that these experts not be off there in an ivory tower so
    insulated from the rest of the world, they are not listening to
    the real problems of users and preparers.
        So, we seek some kind of a balance. If we can get a better
    financing system that makes people feel more comfortable and
    requires me to write fewer letters, I would be all in favor of
    that.
        Senator Gramm. I appreciate your comments about
    consultation versus independence. There are some people who
    naively believe that the best way to have independence is to
    have these decisionmakers never talk to anybody. That does
    produce independence. On the other hand, it produces an
    intolerable, unworkable system.
        Mr. Volcker. Their meetings are in public and the meetings
    with the advisory board are in public, which is I think an
    additional element of protection that leads to cumbersomeness,
    no doubt. But it is meant to provide additional degrees of
    protection.
        Chairman Sarbanes. Sir David, could you give the Committee
    a short memo on the funding of the United Kingdom's Accounting
    Standards Board, that we discussed right at the end of that
    question. If it is not too much of an imposition, if you could
    send us a piece of paper detailing it, I think that would be
    helpful to us.
        Sir David Tweedie. Certainly.
        Chairman Sarbanes. Senator Carper.
        Senator Carper. Thank you, Mr. Chairman.
        Senator Gramm mentioned that he had taken that one
    accounting course and his mom just said he did not have the
    personality to be an accountant. I took one accounting course
    myself in business school a few years ago, about the same time
    that Phil Gramm was taking his course. I did not find it
    especially simple at the time and God knows, it has gotten more
    complex as time has gone by.
        We are, for the most part by nature, generalists here in
    the Senate, as you know. We have some people who do bring
    particular expertises and, in the case of Senator Enzi, it is
    in accounting and auditing. In the case of Senator Bunning, it
    is a good fastball. And Senator Zell Miller over here is a
    great writer. We all have our special strengths, but we are
    generalists, for the most part.
        I listened to your testimony and we are grateful for the
    time and the thought that you have put into it. But we have to
    assimilate what you are saying and what we are receiving from a
    lot of other sources, and try to decide and convince our
    colleagues what is the right thing to do.
        And the incident, the focus of our attention, is Enron. But
    as you know, there is a world of companies that have investors
    nervous and the practices of auditing firms have us concerned.
        Let me ask you to put yourselves in our shoes for a moment,
    and just make it real simple for us. If you were in our role,
    in our shoes, what would you do? Some are saying that we ought
    to act regulatorily. The industry should police itself. There
    are some things that maybe we should do legislatively. What
    would you do, particularly with respect to the work of the
    accounting firms of the world as it pertains to these issues.
    How would you address them if you were in our shoes?
        And Chairman Volcker, you said earlier, you were talking
    about raising money from the firms around the country for a
    good cause, and you mentioned how distasteful it was. I sat
    here thinking, boy, he sure doesn't want to run for the U.S.
    Senate.
        [Laughter.]
        Mr. Volcker. That is true.
        [Laughter.]
        Let me say what you can do. One thing is, it seems to me,
    fairly obvious. I am not sure the SEC itself is sufficiently
    funded and has a sufficient staff to do the review process that
    it needs to do over reviewing accounting statements of
    companies. That is my impression. You can look at it a little
    further, but that is my clear impression. And that is something
    Congress can do fairly immediately.
        Chairman Sarbanes. I think that is absolutely right. And
    the Chairmen who were here on Tuesday said as much. In fact, I
    have written to both the President and to Chairman Pitt about
    this very matter to see if we cannot immediately get a boost in
    the SEC's funding, and get the funding of the provision to get
    pay parity to the SEC employees with other Federal banking
    regulators. They are hemorrhaging very experienced and
    qualified staff because they do not have the pay parity.
        Mr. Volcker. Second, I mention in my statement the need for
    I think a stronger oversight board. I am no expert in this
    area, but I get kind of dizzy reading reviews of the past
    efforts. Whenever there has been an accounting problem in the
    past, a new board is appointed and then another problem comes
    along and we have another board. None of them seem to be very
    effective by demonstrable lack of results, I guess.
        I do think either by charge to the SEC or by direct
    legislation, that there should be teeth put in an oversight
    board that is not dominated by the industry, and that the board
    has to have some kind of authority for punishment--for both
    investigation and punishment to a degree that has not been true
    in the past.
        Whether the Congress should legislate on this other
    controversial matter of what services should be provided by a
    firm that does auditing, I think that is a critical issue, and
    it is one that I have to struggle with a bit with my Andersen
    hat concerns.
        Some things may be fairly easy to say, but drawing the
    margin between what is acceptable and desirable and what is not
    is very subtle, I suspect.
        I do not know how you legislate on it, but you may want to
    legislate in that area and at least set some general
    guidelines. But I think it is going to require administration
    by other than a law because the precise guidelines are
    difficult to define.
        But those are the three areas I think of--money, oversight,
    draw guidelines at least on what services and consultation
    practices are appropriate and what are not.
        I do not think you can legislate standards or you would be
    in real trouble--complications, difficulties, freezing them in
    place, all the rest. There may be other areas, but those are
    the three that I can think of.
        Senator Carper. Good, thank you.
        Sir David.
        Sir David Tweedie. Well, sir, I have been out of the
    auditing firms for some 12 years. But the key question that I
    think you have to look at is the independence of the auditor in
    terms of the appointment.
        Now who appoints an auditor? They are appointed normally by
    the board of directors. Have they too much power in firing
    them? What about the audit committee? Who appoints the audit
    committee? Who is on the audit committee? How do you get on the
    audit committee?
        I think there is a big area, not just in the United States,
    but a big area of corporate governance that has to be looked
    at.
        These problems have been around for 20 years. We have had
    almost the perfect storm in Enron that suddenly, everyone is
    looking at this issue.
        I do not necessarily have the answers for you. We have had
    similar problems in the United Kingdom. We have just newly set
    up a new auditing foundation which has a majority of outsiders
    on it. Previously, it was run by the profession and the
    institutes. They have then set up a review board, which I think
    is like your public oversight board, and underneath that comes
    the auditing standards board, the ethics board, and the
    discipline board, all of whom, if I remember rightly, have a
    majority of outsiders.
        So it is not as we used to call it in the UK, chaps
    regulating chaps. It is actually outsiders looking at the
    profession fairly hard, although there is obviously input from
    the profession.
        While there has been a great question mark perhaps over
    U.S. standards, I think you probably need to know from the
    outsiders' point of view that the United States has the best
    corpus of accounting standards in the world.
        That grieves me to say so, especially as I have been very
    rude about some of them in the past. But, nonetheless, I think,
    while not every single standard is the best, on balance, you
    have a very good set of standards.
        The International Board was modeled on the FASB. We have
    the same due process, the same openness, and the same
    independence rules. We will meet with individual companies, but
    if there is more than, I think it is six board members, we must
    meet in the open, so we cannot have a majority of members
    present at a private meeting.
        Another area that I think is very important, and I think
    the Chairman rightly pointed to it, it is better if you can
    keep the politics out of standards setting.
        One of the advantages of an international board is we are
    not subject to national political pressures. So if there were
    to be a campaign, let's say, in Britain or the United States
    against an accounting standard, it could not really affect us.
    But it does affect the national standards setter.
        I think FASB and probably the SEC regrets the situation in
    1995 when they did not go ahead with what they thought was the
    right standard for share options. From what I have gathered,
    there was a similar problem over the savings and loans issues
    where there were concessions made to the industry, which I
    think independent people looking in would not have made. That
    is one of the issues.
        I do think it is important to keep an independent standard
    setter who is going to come to the right answers, if he can. He
    might get it wrong occasionally, we all do. But he is going to
    try and do it without any pressure behind him. And if you can
    preserve that, it is very, very important.
        Mr. Volcker. I wonder if I can make just another point
    here.
        Chairman Sarbanes. Certainly.
        Mr. Volcker. Because it occurs to me, there is an area
    where you cannot legislate. Fundamentally, we are dealing with
    a problem of attitudes and ethics. Why have we gotten off the
    track?
        It seems to be evident in the Enron situation and
    elsewhere, there is great management pressure to cut corners.
    How can you legislate against cutting corners?
        You have a big problem of attitude here, which partly goes
    to the organization of accounting firms themselves--and I put
    on my Andersen hat here--this is part of what I am concerned
    about, anyway. How is that company going to operate in a way
    that, through its own internal attitudes and priorities, puts
    emphasis on good accounting, good auditing, first and only.
        Now, you just cannot pass a law and say that. You have to
    have internal procedures. You have to have attitudes in that
    company and attitudes by the companies that they audit.
        But I would like to see growing out of this crisis a
    reversal of what I think has been happening. Instead of a kind
    of competition in laxity here, a competition in quality. People
    should feel that they had better have a good auditing report or
    the market is going to be suspicious of them and the accounting
    firms that have the best reputation will get the business,
    instead of the feeling you are looking for some way to cut
    corners.
        Senator Carper. Again, our thanks to both of you. Let me
    just say in brief response to what you said, Mr. Chairman,
    there is a temptation to cut corners. The leaders of our
    businesses are under, in some cases, enormous pressure to
    report earnings and report profits, and there just need to be
    consequences when people do cut corners.
        There could be consequences that could be legislative or
    regulatory, but, maybe more appropriately, should be
    consequences that will be brought by the market. There needs to
    be consequences.
        Thank you.
        Chairman Sarbanes. Thank you very much, Senator Carper.
        Chairman Volcker, I might note that, it seems to me the
    kind of attitude you are seeking was reflected by Arthur
    Andersen himself, the founder, when he established this firm.
    He brought very high standards and had a vision about the role
    of the accounting profession, which, unfortunately, the
    institution he put into place appears to have departed from.
        Before I yield to Senator Enzi, Sir David, I just want to
    say, you are being very kind about U.S. standards and so forth.
    But I am prompted to quote The Economist of January 19, just
    not too long ago, that said: ``There is a lesson from British
    experience in the 1980's when several audit scandals led to
    both tougher regulation and more rigorous accounting standards.
    The Enron scandal shows that America can no longer take the
    preeminence of its accounting for granted.'' And I think that
    is one of the challenges we are facing right now.
        Senator Enzi.
        Senator Enzi. Thank you, Mr. Chairman.
        I want to thank both of you for your outstanding
    presentation. I also noticed from looking at the full text of
    your testimony that there was some excellent coordination which
    saves us a lot of time in reading it, but also gives us some
    different insights.
        Of course, as far as a question, my preference would be to
    have Mr. Volcker just repeat what he said about ethics just a
    minute ago because I think that has been one of the key
    messages that has been underplayed in this whole process.
        I do appreciate that both of you made comments about the
    Enron situation, as far as Enron was concerned, that none of us
    knows enough about the specifics of the transactions. That does
    not stop the Congress from reacting, of course. I have noticed
    some rules which is, if there is publicity involved, it is
    worth reacting to. And then a further rule is that if it is
    worth reacting to, it is worth overreacting to.
        [Laughter.]
        I appreciate that some actual information is being gathered
    before our overreaction so we might place some constraints on
    it.
        I also want to congratulate the International Accounting
    Standards Board for the 16 topics that are on their research
    agenda and the fact that they made accounting by small and
    medium entities and emerging economies one of those categories.
        I do not think there is enough emphasis placed on small
    business. And one of the things that I fear from what we are
    doing here is that we are going to react to big business in
    such as way that we are going to put small business out of
    business.
        And, of course, Government I think has forced business to
    get bigger in order to meet governmental regulations and that
    has led to some of the problems.
        I always appreciate the special emphasis when it is given
    for small business.
        Sir David, I want to ask you, you mentioned the way that
    IASB as opposed to FASB does their standards. Could you give us
    a little more insight into the principle and example that you
    mentioned, rather than the 800 pages of detail? I think that
    was a point that you were making. Could you give us some more
    insight on that?
        Sir David Tweedie. Well, sir, the sort of situation that we
    are thinking about is that, if you look at some, say, the
    special purpose vehicles, now I do not know whether the U.S.
    standards had a problem in that. We are not sure that the
    international standards might not have a similar problem. We
    are looking at that to see if we would have done that.
        We certainly wouldn't claim for one minute that Enron could
    not have happened under international standards.
        I think the difference would be, perhaps, that when we are
    looking at what we mean by the principle, when we try to
    consolidate under international standards, as in the United
    States, we go for the principle of control. Do you control the
    company?
        Now, in the United States, that is mainly looked upon, do
    you have majority ownership?
        We tend to go a bit further than that because we would say,
    well, we are actually after control. So it is not just majority
    ownership. Is there an agreement by which you have control? You
    may have less than 50 percent of the voting shares. Even if
    there is no agreement, do you have power to control the
    financial and operating policies of the company? Do you control
    a majority of the board appointments, the majority of the votes
    on the board? If you have that, you have control and you
    consolidate.
        Similarly, we have situations whereby companies, as we
    discovered in the United Kingdom, ran on auto-pilot. They would
    give away the shares in an off balance sheet subsidiary to some
    charity. The charity would have all the shares.
        So, technically, the company did not own the so-called
    subsidiary, but in fact, control was predetermined. The
    shareholders could do nothing about it and got a minor
    donation. And the aim was to go past the requirements, if you
    like, of the law. We had then to say the principle is control--
    if you run this, it is yours.
        Now it does lead to subjectivity, and that is the issue.
    So, you can have your choice, in a sense. Is it enough to say,
    if you get the benefits, if you run the risks, it is yours? Or
    do you have to say, what exactly do you mean by that?
        And once you get into, what exactly do you mean by that,
    well, if somebody has so many percent of the residual, their
    equity, then it is off balance sheet. There is the rule.
    Instantly, people game it.
        We have a problem, if you like, with lease accounting. The
    lease accounting standards worldwide are converged and none of
    them work.
        You have all been in aircraft, but none of you will have
    been in an aircraft that is on an airline's balance sheet. They
    look more like taxi companies than airlines. The reason leased
    aircraft are not on balance sheets is that worldwide, the
    standard more or less says, if you have the rights and benefits
    of the asset over its lifetime, then it is on your balance
    sheet.
        We put a rule in which says, that means if you look at the
    payments that you are going to make under the lease and the
    present value of these equals 90 percent of the fair value of
    the asset at the beginning of the lease, then it is on balance
    sheet. Well, they all come in at 88 percent. So, they are off
    balance sheet.
        [Laughter.]
        If we dropped it to 80, they would come in at 79, because
    the leases are designed that way. That is the problem of a
    rule. And that is not blaming the USA because we have it as
    well.
        When you look at it, the airlines, for example, they do not
    lease an aircraft for its life. It is probably 7 years and a
    penalty clause if they do not do another 7 years and so on. And
    they can legitimately say, we are nowhere near 90 percent. We
    only have 7 years.
        But if you come back to the principles of accounting, and
    we adopted these from the United States, from FASB, it is what
    is a liability? Well, it is an obligation that leads to
    resources leaving the organization. And you can then say to the
    airline, well, have you an obligation to pay? Sure. I have 7
    years to pay. Can we measure it and set it out in a contract?
    Of course, we can measure it.
        Well, you have a liability and on the other side, the
    rights to a 747 for 7 years.
        Now the leasing industry thinks this would be the end of
    Western civilization as we know it. But basically, what it
    would do is show you the liability that is at present off
    balance sheet. That is the principle we should have.
        Have you an obligation? Book it. Ninety percent rules do
    not work. And we are in the UK as guilty as anybody else. That
    is the thing that we are trying to change.
        Senator Enzi. I really appreciate that. That was just about
    as exciting as ESPN to me.
        [Laughter.]
        I did notice there were a few eyes that were glazing over
    here.
        [Laughter.]
        Sir David Tweedie. We are sad people, Senator.
        [Laughter.]
        Senator Enzi. You made the statement in your testimony that
    IASB was going to be going with principles and listing examples
    and then asking the overall question of do you meet the
    principle or not? I think that is some of the testimony that we
    had the day before yesterday from the SEC Chairmen as well.
        I really appreciate that approach and the effort that you
    put into it. I see that my time is expired.
        Chairman Sarbanes. Thanks, Senator Enzi.
        Senator Akaka.
        Senator Akaka. Thank you very much, Mr. Chairman.
        Chairman Volcker, I know you have been in very high places
    in the industry and in our country, so let me ask you this
    simple question which goes out to the average investor. What
    can be done to make financial statements easier for the average
    investor to understand and utilize when making investment
    decisions?
        We have discussed, in prior meetings here, the need for
    financial literacy and a greater understanding of the language
    of the industry. My question is what can be done to make
    financial statements easier for the average investor to
    understand?
        Mr. Volcker. That is a very good question that I have been
    struggling with because I get that question from the auditors
    when I think about reform of auditing. And they say, there is a
    great conflict. Everyone wants simplicity. They want an answer
    and they want a black and white answer. You either get whatever
    the rote expression is about conforming with Generally Accepted
    Accounting Principles, or you do not.
        You may be conforming only in some technical or even
    stretched interpretation, and it sounds just like if you are
    the A-plus company in the world and full conformity. You both
    pass. And if the accountant says you do not pass, the company
    is probably sunk.
        So there is a certain incentive to give you a passing mark,
    but it does not give you the whole story. But that is
    simplicity. And you look at the one profit figure.
        I think the answer I have to give you in this world is that
    the auditing cannot be simple, that and its more and more have
    to reflect--they are going to give you an overall mark--but
    they are going to more and more have to reflect in the various
    notes and footnotes some of the subtleties and complexities.
        Take this off balance sheet question.
        Suppose something is off balance sheet. I do not think that
    excuses the auditor or the company from giving a full
    explanation of what the potential liability or risks may be of
    participation in that off balance sheet entity. I take it from
    some of the news reports that the Enron reports were not
    reflecting that. That makes it more complicated.
        Then, I think you have to rely upon the analyst who will
    have better information and can take all the complexities into
    account to give you the honest evaluation of the company, and,
    of course, that has been an issue, too.
        But I think it has to be a two-step process. I do not think
    the auditors themselves can be expected to give you a go or
    stop answer. That is not good enough. And to give something
    other than go or stop, it gets more complicated. Somebody else
    has to interpret that for you.
        That is not a very satisfactory answer, maybe, but I think
    that is reality.
        Senator Akaka. Thank you for that, Mr. Chairman.
        Sir David, I have been reading something about your country
    and about the industry there. Again, my question is a simple
    one, but it is of interest to me and the Committee. The
    question is how does the collapse of the British coal mining
    company, Burnett & Hallamshire, compare with the collapse of
    Enron?
        Sir David Tweedie. Well, sir, the scale, of course, is
    rather different. But that certainly shook us. That was in the
    late 1980's when that happened. That was caused by off balance
    sheet deals. There were several of them. They were all hidden
    in the accounts. There was off balance sheet investments of
    various descriptions.
        One of the problems we had was that the deals were
    perfectly legal. I often use the example of the whiskey
    distilleries. It was not the Burnett & Hallamshire issue. But
    one of the things that you cannot do, at least I do not know
    what bourbon is like, but real whiskey from Scotland----
        [Laughter.]
        You cannot drink it after 1 year because if you do, you
    lose the bouquet and the flavor, but more likely, your power of
    speech.
        [Laughter.]
        Basically, what happens, the distillery will sell it to a
    bank, and the bank will have an option to put it back to the
    distillery at the price it paid, plus interest at normal
    lending rates up to the time of repurchase. And the company
    would have a call option to call it back under exactly the same
    terms.
        A legal sale, the inventory would disappear, cash would
    appear, there would be a small profit. And yet, if you looked
    at what had happened, and this is where we leaned on the United
    States and the FASB's concept statements, where does the
    benefits lie in this asset?
        Well, if the price rises, the distillery is going to take
    it back to get the gain. If the price falls, the bank will
    shove it back to avoid the loss. It never left the distillery
    and they paid the interest quarterly. And yet, the lawyers
    would tell you it was a sale.
        That was just a loan secured on inventory. And that is in a
    way where we had to come past and say, well, what is actually
    happening here? What are the economics? Never mind the
    legality.
        Accounting has moved in that direction, I think, the same
    way in America as it has in the United Kingdom. Burnett &
    Hallamshire was a wake-up call to us, as Enron is for all of
    us. We have to check and make sure that what we are doing is
    right.
        We are cooperating with the FASB on these special purpose
    vehicles. We are looking to see what they are doing. We are
    going through a series of cases that the FASB has produced to
    say, would our standards stop these problems?
        We may find those weaknesses, in which case we will have to
    fix it. But we will almost certainly do it together.
        Senator Akaka. Thank you very much. My time is expired.
        Chairman Sarbanes. Thank you, Senator Akaka.
        I am now going to yield to Senator Bunning for his
    questions. Sir David, I would just note that Senator Bunning is
    from the State of Kentucky, the home of bourbon.
        [Laughter.]
        Senator Bunning. Scotch, what?
        [Laughter.]
        Sir David Tweedie. Nectar.
        [Laughter.]
        Senator Bunning. Earlier, we discussed Accounting 101 and
    102. I was also forced to take those classes to get an
    economics degree out of Xavier University, the most boring two
    classes that I have ever had in my life. Thank God there were
    other things that interested me.
        We quoted Yogi Berra earlier. He also has a quote: ``It
    ain't over 'til it's over.'' And that is what we are trying to
    get to, past what we have in front of us, past the Enron, and
    past the accounting.
        And in dealing with human beings, we have fraud, we have
    greed, and we have plain dishonesty.
        Now, I do not know how in the world that we are going to
    legislate against that. I think we can come up with an
    international or national standard and make them much tougher
    and make, as you said, Mr. Volcker, penalties for doing those
    things.
        Sir David, how long do you think it would take to implement
    international accounting principles and educating the Mike
    Enzi's and all of those who have CPA degrees here in the United
    States of America, to come up to standard, in other words? My
    daughter-in-law, for instance, is a CPA. Could you give me a
    clue to how that could be done and how we could come up to
    standard that we could live by?
        Sir David Tweedie. Well, sir, I think you are absolutely
    right. We can have as many standards as we like. If there is
    dishonesty and deceit, then we are in trouble. A lot of the
    issue that is before us today is corporate governance, and that
    is a big area, partly on the control of companies within audit
    committees.
        I remember when I was an auditor, sir, we had terrible
    trouble with one of our major clients, one of the top 100
    British companies. And as the technical partner of what was a
    Big Eight in those days, firm, I remember the chairman of the
    audit committee, he was an outside nonexecutive director,
    asking a very sensible question, such as, where do the
    accounting policies of this company fall on a scale from
    totally unacceptable to the best?
        We said, just within acceptable. We had a terrible fight
    within the company to make sure that they did come within
    acceptability. We were asked to leave. What had happened was,
    the nonexecutives, well-known British industrialists, had
    threatened to resign unless the company fixed the problem. So,
    they fired the CFO. We had no problems the next year.
        I think a lot of it is very difficult.
        While you have hidden numbers in the accounts, too, I think
    there are problems because part of the issue is, are you
    actually reflecting what happens?
        In response to your question, how long would it take, we
    are identifying the differences, if you like, between American
    standards and international. Now because of the U.S. work in
    the 1970's and 1980's, the fundamental foundations of
    accounting worldwide are based on the conceptual bases laid
    down in the USA.
        We adopted them in the UK. Internationally, they have been
    adopted. And because of that, we have a common philosophical
    core. That makes it a lot easier.
        But we do have differences. What we are trying to do now is
    we have highlighted probably the top six differences. We want
    to try and kill those off in 3 years. And a lot of it, quite
    frankly, is getting away from the old accounting, you might
    have learned in your courses, which is what is called defer and
    match. It is the sort of thing that leads to a situation
    whereas, if, for example, a company has a final salary pension
    scheme and suddenly, the stock market falls and ends up with a
    deficit in the scheme, under present-day accounting in the
    United States and around most of the world, you would only see
    a fraction of that appearing in the accounts because it is
    spread, say, over 10, 15 years.
        In the UK, you would see it all, bang, very volatile.
        Now that has caused a fair amount of disquiet in the UK,
    but actually, it is what has happened. What I think accounting
    has to do more is to tell it as it is, so we get away from
    these smooth numbers, which you could not explain to your
    grandmother. We have to have something that you can explain.
        Show what has happened. Now let the company then say, but
    this deficit in the pension fund is a temporary blip. The stock
    market is going up next year. Well, let's see if people believe
    them.
        I think we could do quite a lot by 2005, bringing the two
    sets of standards together, though, if I want to be blunt, it
    does take the United States to move, as well as the
    international community.
        It does not have to be one way. Some of your standards are
    not as good as others worldwide and we are not going to take
    them.
        Where does the United States go? You have to come our way
    if we are going to get these harmonized. I cannot force you.
    That is really entirely up to you.
        But the intention is there. We have certainly had great
    expressions of support from the FASB and the SEC that this
    should happen. We still have to see it because we are only just
    starting to produce our standards. It could be done fairly
    quickly. And I think you would find that, okay, there will be
    six or seven major changes. But your whole world is not being
    torn apart because you have a very good set to start with.
        Senator Bunning. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator.
        Senator Miller.

                    COMMENTS OF SENATOR ZELL MILLER

        Senator Miller. Thank you, Mr. Chairman, and thanks to our
    witnesses this morning.
        My first question--I hope I can get two in here--my first
    question is to Mr. Volcker.
        As you probably know, we heard from the former SEC
    Commissioners on Tuesday. One of them suggested a new division
    within the SEC, not another private-sector body. What do you
    think about that?
        Mr. Volcker. I do not think I really know enough about it
    to comment, what is meant by that. I was thinking more along
    the lines of a Nasdaq regulatory authority which I think has
    some advantages of bringing in practitioners. But it has to
    have a strong public backbone. There is no question about that
    in my mind. But I do not know enough about that particular
    proposal to comment intelligently.
        Senator Miller. I guess what he was getting at is that one
    of the things that you would not have to do, it would not have
    to be funded by the industry. It would be within the SEC. But
    let me ask you this because this really is something that I
    wanted to get at.
        I did not hear your testimony, and I apologize for it, but
    I have read both your statements. Sir David, in your statement
    that I read, you said that the auditing process requires a
    strong commitment from auditors to resist client pressures. I
    think we could all agree with that.
        Mr. Volcker, in your statement, you asked the key question,
    can strong safeguards be put in place against other business
    interests intruding on the auditing process?
        May I ask you just in a few minutes, both of you, to
    elaborate on that a little bit more, still looking at this
    auditor independence, this subject of auditor independence? I
    know you have already talked about it a lot. I would like to
    hear some more.
        Mr. Volcker. Well, I do not know just what to add, except
    that I do believe, and the only reason I am involved in this
    thing with Andersen, for instance, is that we have to restore
    the status and honor, so to speak, priority to the auditing
    profession, as a really indispensable ingredient in a well-
    functioning financial market.
        To the extent that this priority is distorted, diverted,
    weakened, softened, by other interests in the firm, we have a
    problem.
        Just how to define that and draw the precise borderlines is
    something I guess I am going to be pretty deeply involved in. I
    do not know the answer in great detail, but I know this is a
    problem. I sense it is a problem. It is something that, by
    their self-interest, by what I think is a national interest,
    whether it is a matter of legislation is another thing, has to
    be paid attention to.
        Let me just put this in its widest context. Again, when I
    was listening to the Senator over here, I think we have a
    societal problem. We have been through the greatest boom in all
    of history maybe, a great bubble. And it creates--it is nothing
    new in the history of the world, I guess--you get a great brew
    of greed and hubris and excesses and financial wishful
    thinking, and that adds up to a weakening of the auditing
    process.
        So all of this is kind of contrary to conservative
    auditors. They have been infected. And we have to reverse that
    process.
        I think the behavior of markets is helping that and this
    kind of scandal opens our eyes to it, so we have a chance of
    creating a better balance. And that is what this is all about,
    I think.
        Senator Miller. Thank you, sir.
        Chairman Sarbanes. Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman.
        I welcome the witnesses. I have great respect for their
    contributions both nationally and internationally and I respect
    their judgments. Let me also apologize for not being here. We
    have three hearings going at the same time. If I ask questions
    that have been asked, I apologize for that.
        Chairman Sarbanes. It is to Senator Corzine's credit,
    though, that when he has three hearings at the same time, he
    tries to get to all three of them. Some just throw up their
    hands and do not go to any of them.
        [Laughter.]
        Mr. Volcker. But this must be the most interesting one.
        [Laughter.]
        Senator Corzine. Absolutely.
        Chairman Sarbanes. It may be the most important, I think.
        Senator Corzine. I identify with this culture of
    gamesmanship or erosion of culture and a need for ethics as
    much as anyone.
        I would love to hear your general comments with regard to
    corporate governance rules in the United States, because we
    have different structures than you do in Britain, and whether
    there has been a discussion comparing and contrasting about the
    disciplines that are associated with that, which apparently
    have broken down in some serious way, at least in the most
    visible cases, and one can question whether they work
    appropriately.
        Then I would like to ask rapid-fire: How do you feel about
    the separation of auditing from consulting? Do you feel that
    rotations of auditors makes sense? Is a cooling-off or time-out
    period between auditors working at an auditor and going to work
    for the client something that, good thing/bad thing?
        I would also love to hear your views about option
    accounting. We certainly hear a lot about the erosion of
    quality of income statements based on income recognition, but
    expense recognition is almost equally an important issue.
        And if that is not enough, I would love to hear Chairman
    Volcker talk about derivative accounting.
        [Laughter.]
        Chairman Sarbanes. That is a good list. If you could run
    through it, we are at the end of our rounds, so go ahead and
    take the time now to respond to each of those, if you could.
        Mr. Volcker. I will take a first crack at some of them. And
    Sir David I am sure can do those and others.
        On separation, it is obviously an issue. I think there
    should be some separation, somehow or another, within the firm,
    or in some cases, prohibited for a firm. Where you draw that
    line is going to occupy me in my work at Andersen and it may be
    a matter of legislation or otherwise, too.
        Senator Corzine. Do you think it is too early to call?
        Mr. Volcker. Pardon me?
        Senator Corzine. It is too early?
        Mr. Volcker. It is too early for me. I know there is a
    problem. Where you exactly draw the line--the whole tax area,
    which has been a long-term business, quite legitimately, I
    think, of auditing. But when has it not become auditing or
    related to auditing and when does it become something else
    which may conflict with auditing, is one of the many subtle
    questions that arise here.
        On this time-out question, I think that is something I
    would be willing to look at in that context, too. What should
    the rule be? I think, just as a matter of industry practice, or
    auditing company practice, I do think there ought to be some
    kind of limitation on it. What it is precisely is something we
    are looking at.
        When you look at rotation, an interesting structural
    question which I would like to see debated. It is nothing for
    Andersen to decide by itself. I think that is an industry
    question and maybe a legislative question, and something you
    might want to look at.
        I know there are arguments on both sides. There is a very
    clear argument, this is a way to deal with a lot of these
    problems because you know you are going to have another auditor
    looking over your shoulder pretty promptly, you are going to be
    pretty careful about what you do.
        There are arguments on the other side that in big,
    complicated companies, it is very difficult to change auditors.
    The auditors take a long time to learn the company. You will
    have a lapse of knowledge and institutional knowledge if you do
    that.
        So there are arguments on both sides and I really think
    that this is one that should be looked at on an industry-wide
    basis.
        Those are some of the things that I notice you asked for.
        Senator Corzine. How about option accounting?
        Mr. Volcker. Option----
        Senator Corzine. Expense recognition of options. Do you
    have a view on that?
        Mr. Volcker. You have a favorite subject? This is a very
    controversial area which my associates who I appointed felt
    they had to deal with right away.
        It is a problem. There is not any question about it. Sooner
    or later, they are going to have to deal with it. I have made
    some observations entirely apart from the accounting, but not
    unrelated. I say entirely apart, but it is not unrelated to the
    accounting issue.
        I must say in the United States, I think the use of options
    has gotten to the point where it is abused as much as used
    correctly. I think we have seen examples of excesses in the
    fashion of giving options and you see it in the Enron
    situation.
        I cannot quite understand how executives can make tens of
    millions of dollars in options in the same year that the
    company goes bankrupt. I mean there is something that seems to
    be a kind of disconnect there.
        Chairman Sarbanes. Well, it loads the whole system, doesn't
    it, toward manipulating or affecting the stock price of the
    company.
        Those people have an incredible interest in getting that
    stock price up, so it just drives them, it seems to me, to do
    one and another thing in order to accomplish that because it
    means very large amounts of money for key individuals in the
    management structure of the company.
        Mr. Volcker. I think there is a legitimate question in some
    cases as to whether the slogan of aligning the interests of
    management to the stockholder is not reversed and the interests
    of the stockholder is being aligned with the interests of the
    management, which is not the way it is supposed to be.
        For instance, why do we pay so little dividends now on
    stocks? Well, there is a tax reason. I know all the rationales
    that investment bankers can give. There is no doubt in my mind
    that if you have a choice between pushing up the price of the
    stock and paying a dividend, you push up the price of the stock
    if you have a lot of options.
        Now, you have a great boom in the stock market, the good
    managers benefit, the bad managers benefit. You get a down in
    the stock market and nobody benefits from the options.
        It is a very artificial, capricious kind of result in many
    cases when they are used to excess. I think there is a
    legitimate use for stock options, but I really raise the
    question, whatever the accounting treatment is, whether they
    haven't gone overboard.
        Sir David Tweedie. Well, sir, if I could just add one or
    two things to that.
        I think the key issue right from the start is, who is the
    auditor's client? Now, I probably made the mistake in my own
    submission of doing what many of the firms do, thinking the
    client is the company. Of course, it is the company's investors
    and, if you like, the investing society at large. And that is
    really what we have to get back to.
        I think that there are various ways that we can do that. I
    do not know what you do in the United States, but government
    officials certainly are not allowed in the UK simply to walk
    into other companies as soon as they finish. There is a
    cooling-off period. They cannot go into a company in an
    industry with which they have been dealing, so they have to
    stay away for a certain period.
        The questions that you pose have been around for many, many
    years and there are no solutions on the table as yet. Rotation
    has been asked, yes. There are dangers in the first year or two
    as auditors learn the ways in which the new companies that they
    are dealing with work.
        But, ultimately, it comes down once more to who appoints
    the auditors. If the auditors are protected, we have a better
    chance to ensure that these sorts of situations do not occur.
    If the auditors are frightened of management and feel they are
    going to be fired if they stand against them, then we have a
    real problem. And that may be happening in certain cases.
        In that sense, the appointment of auditors has to be
    removed from management, so you have a better way of appointing
    them.
        What that has to be is a matter for debate. There has been
    lots of discussion about that in the UK, should there be some
    form of commission or what have you? But it is something that
    we do not have an answer for, but certainly, it is worth
    looking at.
        The other way, of course, is to hit them by discipline
    procedures. We have European laws that ask whether or not an
    auditor is a fit and proper person to do an audit.
        Now if you fail in an audit and come before the discipline
    committee, the chances are then that you can be thrown out of
    the profession. So there is discipline the other way.
        I do not know what the discipline rules are in the United
    States. One of the problems we do have, though, and I think, as
    Paul has said, is the aligning of management's interests and
    shareholders'. Share options has, as the Chairman also said,
    caused many problems. There are huge awards being made.
        The numbers are big. The figures I have seen quoted from
    American analysts is that if the figure that the FASB proposed
    were to be charged in the income statements, then American
    profits would fall by somewhere on average, 8 to 9 percent. But
    in some industries, it is much, much bigger than that. So there
    could be a misallocation of resources going on, too.
        It is a big issue. And it was Congress that forced that
    rule not coming through as a charge. That was one of the
    problems of political influence. It is a difficulty.
        The other problem, if I remember rightly, and Mr.
    Leisenring will correct me if I am wrong, the performance
    options perversely do lead to a charge in American accounts,
    and therefore, you have very few of them.
        The reward for good work does not come through because you
    have a penalty in the accounting. And there is something wrong
    with that and that is something we should just not have.
        So it is perverse the way it works.
        Senator Corzine. I would only say that the very first
    statement that you made in response to the question: Who do the
    auditors work for? I think is one of the very important key
    points that needs to be understood as this debate gets away
    from the headlines into how we structure this.
        How do we get information into the hands of those that need
    to analyze the information the best as possible, what is going
    on in the company?
        I think this whole question of what the options are about
    how auditors are appointed, is a fundamental question that is
    actually off the headlines, but real.
        Mr. Volcker. In that connection, you may have noticed, the
    idea was not spelled out, but the Secretary of the Treasury
    made some comments at the World Economic Forum about an
    approach toward this problem that got at the essence of it,
    would be to hold the chief executive officer responsible for
    what goes on in financial reporting or auditing, very clear. If
    something goes wrong, it is his fault. And that will give a
    certain incentive to make sure that the auditing is given
    proper attention.
        Senator Corzine. Mr. Chairman, I wonder if I could ask just
    for some comment----
        Chairman Sarbanes. Certainly. Then I know, Senator Enzi,
    you probably have some follow-up as well, or I invite you to
    enter into the discussion as we go, since there are only the
    three of us here.
        Go ahead, Jon.
        Senator Corzine. The derivative accounting issue and
    supervision issue is embedded in many of the repetitive nature
    of problems that we have seen in the financial system, whether
    it was Enron, which some would say was a financial institution
    as opposed to an energy company, and similarly, long-term
    credit. I do not need to go back into history, but it repeats
    itself over and over again, the unregulated arenas where there
    is financial engineering cause significant elements. Do you
    have some initial thoughts to help frame us in how we should
    look at that as we address some of these, both accounting and
    regulatory issues?
        Mr. Chairman.
        Mr. Volcker. I do not have an answer. I am told that the
    FASB rule on derivatives and its explanation runs to 650 pages,
    of which no single human being understands.
        [Laughter.]
        I do not know whether that is true or not, but it sounds
    like it may be because this, as you know, concerns me in its
    complexity, and opportunities for a degree of financial
    engineering boggles the mind and leads to sometimes unexpected
    results.
        If I understood correctly, it does not go to the
    accounting, but this fashion of banks and other financial
    institutions repackaging their loans, selling them in the
    market, securitizing them, then they end up in the market
    buying back some of them through a derivative, which they did
    not even realize that they were buying back, and find out that
    their exposure, in this case, to Enron, was twice as big as
    they thought it was because they bought some of it back in a
    derivative that they thought was protected, but it turns out to
    be nonprotected.
        I do not know all the facts, but that is what the newspaper
    made it sound like. But it is illustrative, I think, of the
    extreme complications of evaluating the value and the credit
    standing of derivatives. I do not know. I wish them good luck.
        [Laughter.]
        I do not know the answer. We will let Sir David Tweedie
    answer the question.
        Sir David Tweedie. I think two of the questions that you
    raise, sir, create serious problems because one of the key
    issues facing us is when is something actually sold and when do
    we get rid of it?
        Now securitization, you start to ask questions if you
    securitize 100 loans. But somehow, they can be put back to you
    if you are not too good. It starts to make you think, well,
    maybe they are not really sold in the first place.
        There is a big argument going on now in accounting about
    whether we should try and say, well, the fact that I have
    guaranteed these loans means perhaps we should put a liability
    for the guarantee on the balance sheet.
        Now, we have questions how you measure that.
        The way that we look to be going, which is incredibly hard
    line and we will probably meet a lot of opposition, and where
    we are still debating whether we are right or not, is simply to
    say, if you have any continuing involvement, you haven't sold
    it.
        So if I have guaranteed the whole lot, none of them come
    off.
        Now that will cause probably bankers all over America to
    have heart attacks when that gets out.
        Chairman Sarbanes. It just got out. It just got out.
        [Laughter.]
        Sir David Tweedie. There is a question. That is going to be
    one of our big discussion features, that we have to solve this
    problem. It is not an easy one.
        The derivatives, Paul mentioned that there are 600-odd
    pages in the U.S. standard. I read over our revised one, which
    is based on the American standard, yesterday, and it does read
    like a pile of rules. It really does.
        Now the reason for that is we actually divide the
    derivatives into three different categories--those that you
    hold to maturity, which you keep at cost--financial
    instruments, I should say--those that you trade which you mark-
    to-market and take through the income statement, and then
    another category which is available for sale, but you mark-to-
    market and do not take through the income statement. Why we do
    that, I have not the foggiest idea, but that is what happens.
    And that was the result of a compromise.
        The alternative suggestion is, you can slash through all of
    this, and this is where Paul will have a heart attack, if you
    mark all financial instruments to market. Now, fortunately,
    Paul is not allowed to say anything about technical matters,
    but I certainly know what he thinks about this one.
        Basically, it is simple, though we do have the subjectivity
    of the values to look at now. That is the next question. But
    these two issues that you have hit on are two of the biggest we
    are going to face.
        Senator Corzine. Well, there is an equally important one,
    not only how we account for them, but also whether they fall
    under some rubric of regulation because there are some places,
    and apparently, that was the case with regard to some energy
    derivatives and formats for this, where there is no oversight,
    and whether there is any common oversight of financial
    derivatives is a whole genre of other issues and it is for
    another hearing, but it is one that I think is just as
    important because it merges with the accounting issue.
        So much of the financial dislocations that we have seen, if
    one looks at the last 15 or 20 years, surrounds some element,
    some derivative of derivatives in one form or another because
    it is a way to get enormous leverage into the system. And
    people with unchecked ability to do that, as you just described
    it, you have brought all the securitized assets onto balance
    sheets, we would have a whole different look at what the
    leverage characteristics of some of our great financial
    institutions would be.
        Sir David Tweedie. I could not agree more.
        Chairman Sarbanes. Senator Enzi.
        Senator Enzi. Just briefly----
        Senator Corzine. I know you were glazing over, Senator.
        [Laughter.]
        Senator Enzi. No, no, no. I am finding all of this
    fascinating.
        [Laughter.]
        We are down to the hard-core right now.
        [Laughter.]
        Because, as all of the controversies go on, it is only
    fascinating to the media and to the public as long as there is
    some crime or fraud or ability to point fingers and figure out
    who is at fault. As you get into the details like some of the
    ones that Sir David has been talking about, there are few
    people here that are really absorbing what he is saying. Many
    of us will have to go back and look at the text of it to see.
        Chairman Sarbanes. Those details are very important in
    terms of what the system and structure is. This is serious
    business.
        Senator Enzi. Absolutely.
        Chairman Sarbanes. Because if we can get a proper system
    and structure in place, we can, I think, markedly diminish the
    likelihood of such things occurring.
        Senator Enzi. That is absolutely correct. But if we asked
    the next hundred people that we saw what auditing is, which is
    not detail, we would not get an answer that would be usable in
    anything. And that is the level of education that we are at in
    the whole process.
        One of the things we are working on is auditor
    independence, which is essential. But in looking at the Enron
    situation, I was trying to figure out, if I were heading up an
    auditing team--now I am beyond the Accounting 101 that we
    talked about, and you even get some continuing education and
    those sorts of things. But that is not enough.
        When you are talking about a company that is as complex as
    Enron, and the different kinds of businesses that they were in,
    there is outside expertise that you have to have on that.
        If an auditor, regardless of how many years he had spent on
    it, did not hire somebody to help with the audit that had some
    more of the economic principles of the kind of structures that
    were involved there, they would be negligent in their job.
        If we have auditor independence, now would that be hiring a
    consultant? If we hire a consultant, is that crossing the line
    of auditor independence?
        I am trying to figure out how we can structure the rules so
    that we can have this independence, but the expertise that
    would result in a bona fide audit would still be available. Can
    either of you give me any insight into how we do that?
        Mr. Volcker. This is a question that I have begun to
    struggle with myself because of what I have to look at. And the
    argument is made that consulting helps maintain that kind of
    expertise.
        My sense of that is yes and no. A lot of consulting does
    not and that there is no movement of personnel that is
    significant. Other elements of consulting, it may.
        But there is the consulting, what the firms have already
    dealt with, at least in part, of installing very large computer
    systems, information technology systems, the high-ticket items.
    My impression is it is pretty independent from the auditing.
    There may be a conflict because of the interest in getting the
    business. There is that kind of conflict, but there is not much
    movement of personnel or very much movement of expertise, at
    least my initial impression.
        But in other areas of so-called consulting, it may actually
    overlap with an effective auditing function. And where that may
    be true, for instance, is in some tax areas, tax preparation,
    tax advice.
        When does that overlap into a different kind of advice as
    to how to evade or avoid taxes, which is not an ordinary role
    of an auditor, who is supposed to be keeping you on the
    straight and narrow. I am not sure I should do that with the
    right hand and with the left hand, tell you how to skirt around
    it.
        It is that kind of problem.
        Sir David Tweedie. I think, sir, one of the difficulties
    you have with audit, if we look at the pure audit, the auditor
    should be presented with management's representation of what a
    fair presentation is and just simply check them. What he should
    not be doing is auditing his own work, and that is obviously a
    key role.
        You raised the question of how do they go around valuing
    these derivative instruments? And that is a problem because
    these are very complicated, very technical issues.
        One of the problems that auditing firms will face,
    certainly if they cut away some of the activities that they
    have at the moment, I suspect the consequence of that might be
    the audit costs might have to rise because one of the things
    that the firms have to be able to do is to attract the type of
    graduate that can compete with some of these people in the
    merchant banks who dream up these schemes.
        You can certainly go outside for expert advice. In the
    United Kingdom, we revalue fixed assets. But we have a
    profession of valuers, surveyors, with their own rules, their
    own discipline procedures, and we then, sort of in a way, hand
    over to them, although, ultimately, the auditor has to stand
    back and say, does that make sense to him as an auditor? Are
    the numbers somewhere in the region he would expect?
        But the valuer takes a great deal of the responsibility.
    The auditor still has to see that it is reasonable.
        Whether we get into areas where we ask these people, such
    as pension liabilities, the actuaries could help and do up to a
    certain point. But the firms tend to have these people, the
    accounting firms tend to have these people within their ranks.
        It is going to be an issue because, certainly, I think you
    raise the same issue about how do you actually calculate some
    of these numbers? They are very, very complicated. And it is an
    issue for us as standard setters, how do we try and guide
    people, how they might be doing it?
        Senator Enzi. Well, the big firms may have that expertise.
    But the closer you get to where I am from, the less likely you
    are to have that level of expertise in a firm. And they are not
    dealing with the major firms. They are not even dealing with
    people that have to register with the Securities and Exchange
    Commission. They might be just auditing a school.
        What happens is that whatever we do at the national level
    here seems to drift down as a requirement. That is why I am so
    glad that you have that small business provision in there
    because I am featuring one of my small businessmen having his
    firm audited and then having the exit interview and saying to
    him now, did we do anything wrong? He says, well, no, you did
    not do anything wrong. And then he asks the next logical
    question, is there anything that we should be doing better?
        At that point, having the auditor say, oh, I am sorry. That
    would be consulting and you will have to hire another firm to
    do that. Otherwise, I am breaching ethics here.
        That would be the small business paying twice for the same
    service, and we do not want to get into that position. I do not
    know at what level that gets to be a conflict.
        I really appreciate both of you and your answers today.
        Mr. Volcker. Let me say that this is a question that should
    be always asked of auditors. What else should we be doing?
        Senator Enzi. Yes.
        Mr. Volcker. I think there is a question of whether to get
    a good audit, people are ordinarily paying as much as a really
    good audit costs. There is a human tendency to want to reduce
    that cost. But if we are going to not get involved in other
    services so heavily, it makes even more of a point, are we
    paying adequately for the audit itself ?
        I do not know how we deal with that. You have a system in
    this country, I do not know what other system you could have,
    where the person being audited pays for the audit and chooses
    the auditor, which I suppose you could argue, in a most general
    sense, is already a conflict. But it is important that the
    audit fee not be squeezed to the point where you get an
    inadequate audit.
        Senator Enzi. One of the things I have always been proud of
    the accounting profession for is that they do not work on a
    contingency basis.
        [Laughter.]
        Mr. Volcker. That is I do not think an irrelevant comment.
        [Laughter.]
        Because that is one way that you deal with some of these
    other services because I think they have an anxiety that, if it
    is forbidden to have something called a contingency fee, they
    find some way to have its equivalent. And that is the
    temptation.
        Chairman Sarbanes. I would note to my colleagues, there is
    a vote underway and the second set of lights has gone on. I am
    just going to try to draw this to a conclusion. I want to put a
    couple of questions here.
        Sir David, is the International Accounting Standards Board
    setting the standards that the EU will adopt by 2005? Is that
    correct?
        Sir David Tweedie. It is, sir. The EU has the right to
    reject one, although they say that they almost certainly won't,
    because we are not inclined to write another one for them.
        But, no, they are going to take--for listed companies, for
    consolidated accounts, they are going to use the international
    standards. That is 7,000 listed companies.
        Chairman Sarbanes. And by when will they do that?
        Sir David Tweedie. The year 2005 is the target. The law is
    still going through in the European parliament, but they expect
    it to go through in the next couple of months.
        Chairman Sarbanes. The end of 2005?
        Sir David Tweedie. The calendar year 2005. That is the
    first of January when it starts.
        Chairman Sarbanes. The first of January 2005?
        Sir David Tweedie. Year beginning 2005, first of January.
        Chairman Sarbanes. Well, of course, I would just note that
    the EU--I was looking at a pamphlet here--its GDP now is almost
    comparable to the United States' GDP. Of course, its population
    is larger by about 100 million.
        You are going to have this very significant economic
    factor, which is, in effect, going to adopt this international
    standard, which I think really raises a very important question
    for the United States in terms of the importance of harmonizing
    with the international standard because you are going to have a
    significant economic block that has standards and a standard
    setting procedure. The question is, how do you relate to that?
        It is one thing for the United States, when it was a large
    economy being compared with individual countries, to hold to
    sort of a self-focused thing. But I think it is a very
    different challenge here as we deal with the EU, we do not have
    a lot of time on that front.
        Presumably, your work harmonizes or correlates with the
    work of national standard setting bodies, like FASB or others
    that exist in other countries. And in fact, in a way, they need
    to intensify their own activities. Would that be correct?
        Sir David Tweedie. It is, sir. The standard setters in
    Germany, France, and the United Kingdom are going to have to
    accept our standards by 2005 because that will be the European
    law.
        Australia is trying to work toward them. The other
    countries, Japan is nominally going to work toward them, though
    it has its own problems. I think they are quite concerned with
    some of the changes that we are proposing, which is bringing
    Japan into line with international and American rules.
        The United States and Canada are going to be the real key
    to whether we have a single set of standards. They have said
    that they are very enthusiastic about doing a harmonization
    exercise. And, anyway, it is going to be tested in the next 2
    or 3 years.
        Chairman Sarbanes. Of course, to the extent that the United
    States moves now in the near future to correct deficiencies in
    its standards that Enron has reflected, which, in effect, would
    be moving to a higher standard, that would enhance the chances
    of harmonization, would it not, given the way you have
    outlined, that your objective is to take things, as I
    understand it, to the highest denominator, not to the lowest
    denominator.
        Sir David Tweedie. Indeed so, sir. And of course, we are
    not sure whether it was accounting standards that were involved
    in Enron yet. But whatever comes out of that, if we do find
    that there are deficiencies, clearly, we must look at them,
    too, and must make sure that, internationally, we cannot have
    that mistake. And that is one of the advantages of
    international standards because if we find a situation such as
    the Burnett & Hallamshire that was mentioned, or Enron, we
    could try to stop it from happening in other countries as well.
        So it may be in the future that a disaster that might have
    happened in America is averted because we have had signals from
    another country that it is an issue there.
        Chairman Sarbanes. Let me be very candid about it. I am
    just trying to knock out of the box an argument that says, we
    should not do something here in the United States right now
    because we really ought to be trying to harmonize with the
    international standards, and that is what we should focus on.
        I am trying to establish the point that if we correct it
    here, now, or in the near future, under our own national
    standard setting, that this is not only not inconsistent with
    the international harmonization, but also actually is conducive
    to it, because we then move to a better standard. It should
    make the harmonization easier, not more difficult. Would you
    agree with that statement?
        Sir David Tweedie. I would. And one of the reasons that it
    will lead to harmonization, I would suspect is Mr. Leisenring's
    job to make sure that we know that what is going on in the
    FASB, the same way he has to take to FASB what we are doing.
        And if, for example, the FASB are looking at special
    purpose entities, we will be looking at them, too.
        So the idea is, any ideas that we have that are an
    advantage to FASB goes in there, and if they have ideas that
    are of advantage to us, they come to us. Ideally, we end up
    with the same rule.
        That is the whole object.
        Mr. Volcker. I think certainly in the case you cite, we
    would be wanting to work together in the hope that you arrive
    at a common conclusion.
        Chairman Sarbanes. Gentlemen, thank you very much. You have
    been a very helpful panel and we very much appreciate your
    coming and the obvious work that went into the preparation of
    your statements. Presumably, we will be back in touch with you
    as we move ahead on this challenge.
        Sir David Tweedie. Thanks, sir.
        Chairman Sarbanes. The hearing is adjourned.
        [Whereupon, at 12:30 p.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]

                    PREPARED STATEMENT OF SENATOR PHIL GRAMM

        With us this morning is Mr. Paul Volcker, the former Chairman of
    the Federal Reserve and current Chairman of the Trustees of the
    International Accounting Standards Board and Arthur Andersen's
    Independent Oversight Board. Thank you, Paul for your life-long service
    to America. If I started making a list of who had made contributions to
    this country, it would not be very long before your name was on it. We
    are also very happy to have Sir David Tweedie here with us, who is
    Chairman of the International Accounting Standards Board, and former
    Chairman of the United Kingdom's Accounting Standards Board.
        I have always believed that it was very important to achieve
    homogeneous accounting standards, at least in the developed world and
    then ultimately worldwide. The question I have is, how do we get from
    where we are to there. I guess, Sir David, you won't be surprised to
    hear me say, like most Americans, that I always thought the quickest
    way to get there was to adopt American standards worldwide. In any
    case, I applaud what you are doing.
        A very important part of the Banking Committee's jurisdiction has
    to do with accounting standards. In this era, some may say that
    accountants are a big part of a troubled profession. But if I had to
    choose among a preacher, a politician, or an accountant someone
    selected at random in America to protect the sanctity and safety of my
    family, I would choose an accountant to do the job.
        Mr. Chairman, I am proud of your leadership as we try to deal with
    this issue. There are many committees holding hearings on several
    issues that brush with and around our jurisdiction, but at the end of
    the day when Congress decides to do something about accounting
    standards, it is going to be the Banking Committee that does it. Your
    leadership and our ability to work together on a bipartisan basis give
    me confidence that we are going to do more good then harm.
        When I was an accounting student, a very long time ago, these
    issues seemed very simple. But when I came to the U.S. Senate, and I
    began hearing from constituents, talking to my colleagues and speaking
    with FASB on how to deal with and account for these stock options, I
    realized that these accounting issues were not simple. Should stock
    options be charged against current income, or are they merely a
    dilution of ownership? And how do you account for them? Then there are
    the questions of accounting for derivatives. Are they closed end or
    open ended, and how should the accounting treatment depend upon whether
    the derivative is related to another liability you have. Then there is
    the question of auditor independence.
        These issues turn out to be a lot more complicated than they were
    in the accounting class I took in 1961. One of the positions I have
    taken consistently is that I have not always agreed with FASB, but I
    have always believed that whatever FASB thought, I was more confident
    in letting FASB set standards than in letting Congress set standards.
        I have not always agreed with the SEC. I thought our dear friend
    Arthur Levitt was too involved in accounting standards. He once told me
    that he talked to the head of FASB all the time and had his home phone
    number. To me, the fact that he had his home phone number is an
    indication of a problem. But I always made it clear to Arthur Levitt
    that if it came down to the Congress or to the SEC making decisions on
    accounting standards, that I felt more comfortable with the SEC making
    them.
        Here is my question. As we begin to look at reforms, ultimately we
    are going to look at how are we going to implement these accounting
    reforms. Are we going to mandate new standards of accounting in
    Congress? Are we going to try and give a directive to the SEC? Are they
    going to set accounting standards or are we going to try and insulate
    FASB so that they might be more independent in setting standards. These
    are all questions that we are going to have to come to grips with.
        Thank you.
                                   ----------

                 PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

        Mr. Chairman, I am glad to be back here for the second day in your
    series of hearings examining accounting and investor protection issues.
        The hearing that was held on Tuesday, I believe, was extremely
    helpful as this Committee deliberates what reform measures it should
    take up.
        Having all of the former SEC Chairmen together was enormously
    insightful, and I know that the witnesses today--well-respected for
    their expertise --are also going to provide a wealth of insight as we
    grapple with these important issues.
        At the hearing on Tuesday, we heard a great deal from the Chairman
    about what needed to be done in several areas including: Revisiting the
    current system of self-regulation; establishing a financially
    independent oversight board; ensuring that accounting firms sever
    inappropriate mixing of accounting with certain consulting services;
    and, expediting and depoliticizing the development of accounting
    standards--just to name a few.
        I know that the comments of the SEC Chairmen will be instrumental
    in helping us to develop legislation to ensure that a debacle like
    Enron never happens again.
        Today's hearing will be another important piece of this careful
    deliberative process. As we begin to review accounting standards, in
    light of Enron and other failed companies, it is absolutely essential
    that we do so with a global perspective.
        As the Chairman and others have pointed out, the world's economy is
    increasingly linked by corporations seeking both capital and business
    in foreign companies. This raises important questions about which
    accounting principles should be applied to those companies.
        What makes this additionally challenging, however, is the fact
    that, as several of the SEC Chairmen pointed out, the other day, it is
    increasingly hard for the accounting industry to keep up with new
    financial instruments, novel business arrangements, and special
    accounting procedures.
        This challenge is further confounded because too often basic
    principles of accounting get lost in attempts to comply with, or in
    some cases unfortunately, in attempts to evade the rules. We need to
    put a stop to this rampant gamesmanship.
        Mr. Chairman, I look forward to hearing from our witnesses today as
    they testify on international accounting standards and I look forward
    to continuing to work with all of my colleagues in examining these
    important investor and consumer protection issues.
        Thank you.
                                   ----------

                 PREPARED STATEMENT OF SENATOR DANIEL K. AKAKA

        Expanded participation in the financial markets has provided
    increased opportunities for individuals to build wealth. In my home
    State of Hawaii, over half of all households own stock. Investing
    decisions are already extremely complex. When information provided by
    companies is false, investors are not given the opportunity to make
    informed decisions. False information can lead to losses which destroy
    the wealth of investors.
        Protecting investors from misleading financial statements must be a
    global effort as direct investment barriers have fallen and the
    international markets provide additional opportunities for capital
    appreciation and diversification. Special purpose entities, pro forma
    profits, and opaque bookkeeping practices have the potential to confuse
    and mislead United States and foreign investors.
        We must all work together to improve the transparency of corporate
    activities and ensure that investors are provided reliable information
    to use in making their investment decisions.
        I thank Chairman Paul Volcker and Sir David Tweedie for joining us,
    and I look forward to their testimony and recommendations on what can
    be done to restore the confidence of investors.
        Thank you, Mr. Chairman.
                                   ----------

                   PREPARED STATEMENT OF SENATOR TIM JOHNSON

        Mr. Chairman, thank you for holding today's hearing. We are honored
    today with two distinguished witnesses, who will be helpful to our
    Committee as we sort out what changes we should consider to our
    accounting and financial reporting rules.
        As we move forward in our investigation of issues related to the
    recent collapse of Enron and accounting standards generally, we must
    remain mindful that we live in a global economy. I am pleased that you,
    Mr. Chairman, have had the foresight to include an international
    component in our deliberations.
        America deserves a full investigation of the recent events that
    have shaken our markets, and further economic recovery depends on
    maintaining the confidence of investors. Our economy has flourished
    under the democratization of our capital markets, and we must take
    every possible measure to ensure that Americans have the information
    they need to continue investing in our Nation's businesses.
        I look forward to today's testimony, and thank the witnesses for
    their willingness to appear before our Committee. In particular, I
    would like to thank Chairman Volcker for his many years of service to
    America.
        Our Nation's strength is due in no small part to the talent and the
    determination of our citizens who are willing to serve in the public
    sector. Mr. Volcker provided valuable leadership at the helm of the
    Federal Reserve during the 1980's, and has continued his leadership
    role in the area of accounting and finance.
        Thank you, Mr. Chairman.

                                   ----------

                     PREPARED STATEMENT OF PAUL A. VOLCKER

       Chairman, International Accounting Standards Committee Foundation
            Chairman, Arthur Andersen's Independent Oversight Board
                    Former Chairman, Federal Reserve System
                               February 14, 2002

        I appreciate this opportunity to meet with you this morning,
    joining with Sir David Tweedie, the Chairman of the International
    Accounting Standards Board (IASB).
        When this session was arranged some weeks ago, the intention was to
    concentrate mainly on the relevance of the work of the IASC and its
    associated bodies to the evident problems besetting the accounting and
    auditing professions.
        Those problems, building over a period of years, have now exploded
    into a sense of crisis. That crisis is exemplified by the Enron
    collapse. But Enron is not the only symptom. We have had too many
    restatements of earnings, too many doubts about ``pro forma'' earnings,
    too many sudden charges of billions of dollars to ``good will,'' too
    many perceived auditing failures accompanying bankruptcies to make us
    at all comfortable. To the contrary, it has become clear that some
    fundamental changes and reforms will be required to provide assurance
    that our financial reporting will be accurate, transparent, and
    meaningful.
        Those qualities are essential attributes of a capital market and
    financial system in which investors can place confidence and which can
    efficiently allocate capital. The implications extend far beyond the
    shores of the United States.
        We have long seen our markets, and our accounting systems, as
    models for the world, a world in which capital should be able to move
    freely to those places where it can be used most effectively and become
    a driving force for economic growth and productivity. In fact, a large
    portion of international capital now flows through our markets. We have
    been critical of the relative weakness of accounting and auditing
    standards in many other countries, arguing that those weaknesses have
    contributed to the volatility, inefficiency, and breakdown of the
    financial systems of so-called emerging economies.
        How ironic that, at this point in economic history when the
    performance of the American economy and financial markets has been so
    seemingly successful, we are faced with such doubts and questions about
    a system of accounting and auditing in which we have taken so much
    pride, threatening the credibility and confidence essential to well-
    functioning markets.
        To my mind, we can extract some good news in all of this. Our eyes
    have been opened to festering issues that have for too long been swept
    aside or dealt with ineffectively. We now have the opportunity for
    bringing our performance to a level that matches our words--to practice
    what we preach.
        For most of my professional life I have been a consumer (sometimes
    a critical consumer) of accounting and auditing reports rather than a
    participant in the process. That began to change when I agreed to Chair
    the newly restructured International Accounting Standards Committee
    some 18 months ago. The main responsibilities of that Committee --
    modeled substantially on the Financial Accounting Foundation in the
    United States--are to appoint the standard setting body Chaired by Sir
    David, to obtain finance for its work, and to exercise broad oversight
    over the effort.
        The Committee I Chair does not engage in the technical work--we do
    not set, or advise on, the standards themselves. I am not and never
    have been an auditor. But as Yogi Berra once said, ``you can observe
    quite a lot just by watching,'' and there has been a great deal to
    watch.
        I have attached to this statement excerpts from two earlier
    statements of mine that reflect my growing concerns. The fact is the
    accounting profession has been hard-pressed to keep up with the growing
    complexity of business and finance, with its mind-bending complications
    of abstruse derivatives, seemingly endless varieties of
    securitizations, and multiplying off balance sheet entities. The new
    profession of financial engineering is exercising enormous ingenuity in
    finding ways around established accounting conventions or tax
    regulations. In the rapidly globalizing world of finance, different
    accounting standards and methods of enforcement in different
    jurisdictions present increasing hazards.
        Underneath it all, many have a sense that I share: In the midst of
    the great prosperity and boom of the 1990's, there has been a certain
    erosion of professional, managerial, and ethical standards and
    safeguards. The pressure on management to meet market expectations, to
    keep earnings rising quarter by quarter or year by year, to measure
    success by one ``bottom line'' has led, consciously or not, to
    compromises at the expense of the public interest in full, accurate,
    and timely financial reporting.

    The Three Pillars
        I think of good financial reporting as resting on three pillars:

     Accounting standards setting out with clarity logically
        consistent and comprehensive ``rules of the game'' that reasonably
        reflect underlying economic reality.
     Accounting and auditing practices and policies able to
        translate those standards into accurate, understandable, and timely
        reports by individual public companies.
     A legislative and regulatory framework capable of providing
        and of maintaining needed discipline.
    Standard Setting
        It is the first of those pillars with which I have been directly
    involved over the past 18 months.
        The general case for international accounting standards has been
    very clear for a long time. In a world of global finance, we have
    strong interest in encouraging high-quality standards every place our
    companies do business. We want to be sure foreign-based companies
    desiring access to our well-developed market provide the kind of
    information our investors want and need. We want to avoid distortions
    in the international flow of capital because of misinformation or lack
    of information. Not least, a single set of standards would minimize
    compliance costs for companies and, I believe, assist enforcement.
        Our American view has been that those objectives could be
    substantially attained simply by insisting all companies approaching
    our markets use U.S. GAAP--that is American accounting principles. But
    that approach could, in my judgment, never be fully adequate. Other
    countries will not easily agree ``Made in America'' is necessarily
    best. Coverage will not be complete or uniform. For instance, Europe
    will insist on international standards, and many countries will simply
    be incapable of, or drag their feet on, good quality national
    standards.
        Recent events drive home another point. Taken as a whole, the U.S.
    standards may, indeed, still be the most comprehensive and best quality
    in the world. But plainly, the auditing processes and the standards
    themselves need review.
        Much has been made of the time that standard setters take adapting
    their standards to current business developments and needs. Conversely,
    there are claims of inadequate consultation, and those perceiving harm
    to their interests threaten withdrawal of financial support or lobby
    their legislators for preemptive action. In such a charged environment,
    one can see that in the United States, as well as elsewhere, that
    change is too slow and suspicions of political compromise damage
    confidence in the process.
        In this context, there is a real opportunity for a reinvigorated
    international effort. A new highly professional organization is in
    place. It has strong backing from industry and governments around the
    world. Given its strong staffing and organizational safeguards, the
    IASC framework should be able to maintain high credibility. In its key
    components--the oversight committee I Chair, the standard setting board
    Chaired by Sir David, its advisory council and interpretations
    committee --it can command the best professional advice, international
    representation, and appropriate independence.
        Sir David will speak more directly to the substance and priority of
    the work. However, I personally want to assure you that our intent is
    to move beyond compromise among existing standards or convergence for
    convergence's sake. Instead, we will work with the FASB and standard
    setters in other countries to choose among, and to adapt the best of,
    what exists. When necessary, we will innovate and develop new
    approaches.
        Time is a luxury that we cannot afford. We have known for some
    time, the European Union will require publicly-traded EU companies to
    report their consolidated financial statements according to
    international accounting standards by 2005. In other countries, there
    is an evident need for faster progress. And now American experience
    underscores the urgent need for a fresh look in some crucial areas.
        As Sir David will report, the IASB already is considering many of
    the items in the headlines today-- consistency in defining operating
    earnings and pro forma statements, special purpose entities, mark-to-
    market or ``fair value'' accounting, and stock options.
        You might ask where the FASB fits into the process I describe. I do
    not believe that we face an ``either/or'' proposition between U.S. GAAP
    and international standards. In fact, the FASB and IASB are working
    together on many of these issues with the objective and expectation of
    reaching the same conclusion. The result should be convergence and
    significant improvement in both bodies of standards.

    Restoring Confidence in the Auditing Profession
        Broadly accepted, up-to-date international standards will help
    discipline the auditing process and encourage effective and consistent
    enforcement by national and international authorities.
        Yet there is no escaping the fact, in the end, the accuracy and
    reliance of financial reporting lies in the hands of the auditors
    themselves. They are the ones who must interpret and apply the
    standards and protect their integrity. They are the ones to which the
    investing public must look to ask the tough questions, to demand the
    answers and to faithfully certify that at the end of the day-- or the
    quarter or year--the financial results of a company are fully and
    clearly reported.
        As you are aware, I have recently agreed with Andersen
    International to Chair an Independent Oversight Board, with broad
    responsibilities to work with the company in reviewing and reforming
    its auditing practices and policies.
        My hope is that, out of the current turmoil and questioning, Arthur
    Andersen will again assume a position of leadership in the auditing
    profession right around the world.
        I do not minimize the challenge. The auditors individually and in
    the auditing profession generally have been subject to strong and
    conflicting pressures. Company management urgently wants to meet market
    expectation to present results in the most favorable light and to
    demonstrate a consistent pattern of earnings. Too often the emphasis is
    on finding ways to meet the letter of the technical accounting
    requirements at the risk of violating the spirit. Large and profitable
    consulting assignments may, even subconsciously, affect auditor
    judgment. Companies want to minimize accounting costs. Directors and
    auditing committees may not be sufficiently knowledgeable or
    attentive --that is, until it is too late.
        All this raises questions of the internal management and policies
    of auditing firms, matters with which I am only beginning to grapple.
    How can the auditing functions and the ``technical'' accounting
    decisions be protected from extraneous influence? Can strong safeguards
    be put in place against other business interests intruding on the
    auditing process? What are the appropriate limits on nonauditing
    services performed by an auditing firm to avoid the perception or
    reality of an unacceptable conflict?

    The Enforcement Challenge
        High-quality standards and improved audit practices should go a
    long way toward enforcement. However, there are areas where it may be
    difficult or impossible for any one firm to proceed alone. Hence, there
    is a need for official regulation.
        The United States has the framework for regulation and enforcement
    in the SEC. Over the years, there have also been repeated efforts to
    provide oversight by industry or industry/public member boards. By and
    large, I think we have to conclude that those efforts at self-
    regulation have been unsatisfactory. Thus, experience strongly suggests
    that governmental oversight, with investigation and enforcement powers,
    is necessary to assure discipline.
        I can assure you in my roles both at the IASC and Andersen that I
    will continue to work closely with Government officials here and abroad
    in order to encourage more effective enforcement. One imperative is for
    governments, including the United States, to provide adequate financial
    resources to regulators. I also believe this Committee will want to
    explore means for providing more ``backbone'' for industry oversight,
    either through legislation or by encouraging exercise of SEC regulatory
    authority. Better means of identifying professional misconduct, with
    the possibility of meaningful fines and withdrawal of professional
    licenses, appears essential.
        A positive step in this direction is being taken by the European
    Union in its effort to rationalize their securities laws and centralize
    their enforcement. We should encourage other countries, through the
    International Organization of Securities Commission (IOSCO) and
    otherwise, to bolster enforcement mechanisms in other countries,
    developed and emerging alike.

    Concluding Comment
        The crisis in the accounting and auditing professions is not a
    matter of the failure of a single company or perceived problems in a
    single audit. It demands attention to fundamental flaws basically
    reflecting the growing complexities of capital markets and pressures on
    individuals and their companies to improve financial results.
        To fail to respond to that challenge would have serious
    implications for maintaining confidence in markets, for the cost of
    capital and for the global economy.
        The United States has long had a leading role among world financial
    markets, in financial reporting, and in the regulation and surveillance
    for these markets. Constructive work of your Committee and the Congress
    will be vital in maintaining that leadership. I also urge that you
    recognize, in an open and interdependent world economy with
    increasingly fluid capital markets, effective leadership, must
    necessarily involve close cooperation with others interested in full,
    accurate, and timely financial reporting.
        The development of truly international accounting standards--
    building on the best that now exists and responsive to new needs--can
    be and should be a key element in the needed reforms.
        The restructured IASC is in large part a result of initiatives
    taken by the SEC and supported by the leadership of FASB.
        I trust that support will not weaken. Rather, as you examine the
    implications of the current crisis and the range of appropriate
    remedies, I hope that you will help reinforce the effort to reach
    international convergence, recognizing its potential for improving
    accounting and auditing practices in the United States, as well as
    abroad.

                                 *  *  *  *  *
                       Excerpts from Notes for Remarks at
                 Financial Executives International Conference
                              on November 12, 2001
                               by Paul A. Volcker

       Chairman, International Accounting Standards Committee Foundation
        I come before you as a relative neophyte to the world of
    professional accounting, but I am learning.
        I am learning something that I could have sensed long before I
    became directly involved--that obtaining a strong global consensus on a
    single set of accounting standards will be very difficult. . . .
        It is obvious I would not be here if I did not think that a
    standard set of technically sound accounting standards is an important
    ingredient for an efficient and effective global financial system. Good
    and consistent information is essential if the allocation of financial
    capital is to truly reflect comparative advantage, is to encourage
    appropriately diversified investments, and is to minimize costs of
    capital. Competition will be enhanced, not least by facilitating
    foreign access to the highly developed American market and by better
    assuring a ``level playing field.'' Not so incidentally, the potential
    savings for many of your companies operating in different countries,
    and required to conform to different national standards, can be
    significant. That alone justifies your financial support.
        As I have gotten more immersed in these issues, another fact has
    impressed itself on me. Let me state my concern bluntly.
        The profession of auditing and accounting is in crisis. The
    challenges go far beyond the question of achieving international
    convergence on standards. They arise in part from the nature of
    business today--the simple fact that so much of the value of business
    reflects intangibles and human capital that are not captured--at least
    not accurately or consistently captured--by standard accounting models.
    At the same time, the complexities arising from derivatives and the
    extraordinary convolutions of ``financial engineering'' (engineering
    the very raison d'etre of which often lies in circumventing tax or in
    accounting conventions) challenge our collective understanding. Sadly,
    we read almost daily here in the United States of failures in enforcing
    accounting standards that we proudly cite as the best, the clearest,
    and the most comprehensive in the world. If that is true in the United
    States, what of other countries?
        All of that raises large issues beyond the effort to reach global
    standards. But neither are they unrelated. I hope and believe The
    International Accounting Standards Board--the group charged with
    working toward convergence on the international standards--will be
    capable not just of achieving a compromise of varying national views
    but of making an intellectual contribution to new standards. I also
    trust that a clearer understanding and agreement on international
    standards will lead to more effective and consistent enforcement within
    auditing firms themselves and among national authorities.
                                 *  *  *  *  *
                   Excerpts from Statement of Paul A. Volcker
                 Before The Securities and Exchange Commission
                               September 13, 2000

        [There is] a special responsibility for American leadership in
    auditing practices. We need to make sure we practice what we preach.
    Yet, I must state clearly that my own experience suggests, and even
    casual reading of the press reinforces the impression, that there are
    weaknesses in our auditing practices and even serious lapses in the
    objectivity and integrity of audits that need attention.
        Surely, a number of factors can and do impair the quality of
    auditing: The sheer complexity of international businesses and global
    markets, lack of sufficient skill and diligence, inadequate training in
    the face of changing technology, poorly defined or enforced standards,
    and inadequate staffing among others. Good accounting and auditing
    demands adequate resources.
        But beyond the question of quality is the nagging issue of loss of
    objectivity and independence. My sense is that, too often, auditors,
    consciously or not, do not challenge management accounting, reporting,
    and control practices as fully and as aggressively as required by their
    public mandate. Too often we are surprised by business failures or
    control breakdowns when the symptoms should have been detected and
    reported. . . .
        Conflicts of interest are inevitable in any professional practice
    and certainly in large and complicated business organizations. Strong
    legal and professional standards are necessary to help resolve those
    conflicts. What is true generally is especially pertinent for the
    auditing profession.
        Its mandate, in law and public expectation, is clear and
    unequivocal: The interests of investors (and other users of financial
    statements) come first. Maintenance of that single principle has, in my
    judgment, been increasingly placed in question by the extent to which
    auditing firms have undertaken extensive and highly remunerative
    consulting or other assignments for auditing clients. That is, the
    essential justification, it seems to me, for action to limit
    nonauditing activities by auditing firms and to more clearly determine
    what is appropriate and what is not. . . .
        The extent to which the conflict has in practice actually affected
    a distorting auditing practice is contested. And surely, instances of
    overt and flagrant violations of auditing standards in return for
    contractual favors--an auditing capital offense so to speak--must be
    rare. But more insidious, hard-to-pin down, not clearly articulated or
    even consciously realized, influences on audit practices are another
    thing.
        It is clear that within large auditing firms there has been
    considerable tension between ``auditing'' and ``consulting'' partners,
    tension rooted in the division of revenues and the marketing of
    services. An increasing number, voluntarily or by force of
    circumstance, have taken action on their own to end that internal
    conflict by separating lucrative consulting practices. . . .
        Based on my experience as a regulator, I am certain that review of
    these concerns is warranted.

                                   ----------
                    PREPARED STATEMENT OF SIR DAVID TWEEDIE

               Chairman, International Accounting Standards Board
          Former Chairman, United Kingdom's Accounting Standards Board
                               February 14, 2001

        Mr. Chairman, Members of the Committee, I appreciate having this
    opportunity to share my thoughts on some accounting matters that have
    become the focus of much attention in recent weeks. I am the Chairman
    of the International Accounting Standards Board (IASB). I ask that my
    full submission, including an appendix that provides some background on
    the International Accounting Standards Board and its procedures, be
    entered into the record.
        The Chairman of our Trustees, Paul Volcker, has already spoken
    about the accounting profession, the need for reform, the rationale for
    international standards, and how we can improve financial reporting. I
    cannot overemphasise the importance of high-quality accounting rules
    that give investors confidence that published financial statements show
    a full and accurate picture of a company's performance and position.
    The IASB's objective is to work toward a single set of high-quality
    global financial reporting standards, produced in the private sector
    under principles of transparency, open meetings, and full due process.
    We have no intention to ``water down'' existing standards in any
    jurisdiction. Instead, we plan to build a set of financial reporting
    standards that are the ``gold standard.''
        I do not plan to comment on specific accounting and auditing issues
    surrounding Enron, although there are many. None of us knows enough
    about the specifics of the transactions, the information available to
    the auditors, and the judgements involved to form a solid professional
    conclusion. As we learn more, we may find the U.S. accounting standards
    should be improved.
        If so, we plan to learn from this case and to make sure that
    international accounting standards do not have similar problems.
        I would, however, offer two observations. First, history is full of
    examples of those who said ``it could not happen here'' and came to
    regret it. I do not plan to repeat that mistake. Second, long
    experience as a Chartered Accountant and as an accounting standard
    setter tells me that business failures seldom have a single simple
    cause. They are usually much more complex than they first seem and the
    rush to a single easy answer is usually wrong.
        Let me turn then to answer some questions that you may have about
    the future of standard setting and the role of the IASB and
    international financial reporting standards in assuring investor
    confidence.

    Why Have An International Accounting Standard Setter?
        There are four answers to that question--points that Chairman Paul
    Volcker has already touched on. My comments build on what he has
    already said.
        First, there is a recognised and growing need for international
    accounting standards. A large number of sets of national standards,
    each different from the others to some (often significant) degree,
    imposes an unacceptable cost on the capital markets. Some of that cost
    is direct and is borne by companies that must meet multiple standards
    if they seek to raise capital in different markets. There is a more
    important cost--a systematic increase in the cost of capital. Markets
    demand a price for uncertainty, including uncertainty about the
    accounting standards that govern reported information. The existence of
    multiple, and sometimes unknown, sets of accounting standards increases
    that uncertainty and drives up the cost of capital. We have seen
    situations in which a lack of confidence in reported financial
    information causes investors to leave markets and refuse to invest at
    any price. Even if there was no systematic increase in the overall cost
    of capital, the uncertainty created by multiple sets of national
    financial reporting standards would be likely to lead to a
    misallocation of capital among market participants.
        Second, no individual standard setter has a monopoly on the best
    solutions to accounting problems. Taken as a whole, U.S. Generally
    Accepted Accounting Principles (GAAP) are the most detailed and
    comprehensive in the world. However, that does not mean that every
    individual U.S. standard is the best, or that the U.S. approach to
    standards is the best. At the IASB, our goal is to identify the best in
    standards around the world and build a body of accounting standards
    that constitute the ``highest common denominator'' of financial
    reporting. We call this goal convergence to the highest level.
        Third, no national standard setter is in a position to set
    accounting standards that can gain acceptance around the world. There
    are several excellent national standard setters, including the United
    States Financial Accounting Standards Board (FASB). Before accepting my
    current post, I was Chairman of another, the United Kingdom Accounting
    Standards Board, for 10 years. However, each of the national standard
    setters operates in its own national setting. Leaders of the accounting
    world have come to see that international standards must be set by a
    group with an international makeup and an international outlook. I
    should acknowledge the work of two Americans who recognised that point
    and were instrumental in bringing the IASB to its present position--
    Arthur Levitt, former Chairman of the U.S. Securities and Exchange
    Commission,\1\ and Edmund Jenkins, Chairman of the FASB.\2\
    ---------------------------------------------------------------------------
        \1\ For example, in a January 25, 2001 release, Chairman Levitt
    said, ``Strong and resilient capital markets cannot function without
    high-quality information. Efficient capital allocation depends on
    accurate, timely and comparable financial reporting. The [IASB] Board
    members who have been appointed today carry an enormous burden. It is
    up to them, working in cooperation with our Financial Accounting
    Standards Board and other accounting standards setters, to create
    global accounting standards that will support effectively the
    imperatives of a global marketplace.'' (www.sec.gov/news/press/2001-
    17.txt)
        \2\ For example, the FASB publication, International Accounting
    Standard Setting: A Vision for the Future, includes this comment:
    ``However, the FASB believes that, for the long term, if the future
    international accounting system is to succeed and, ultimately, result
    in the use of a single set of high-quality accounting standards
    worldwide for both domestic and cross-border financial reporting, the
    establishment of a quality international accounting standard setter to
    coordinate and direct the process is key.''
    ---------------------------------------------------------------------------
        Last, there are many areas of financial reporting in which a
    national standard setter finds it difficult to act alone. Constituents
    often complain that a ``tough'' standard would put local companies at a
    competitive disadvantage relative to companies outside of their
    jurisdiction. Local political pressures and policies may work against
    individual national standard setters. An international standard setter
    can establish financial reporting standards that would (we hope) apply
    to all companies in all jurisdictions, thus eliminating perceived
    disadvantages.
        Having explained the need for an international standard setter, I
    should also explain that national standard setters are a critical part
    of our activities. We look to the national standard setters for
    research and counsel, for help in alerting us to particular local
    problems, and for help in our due process. Most important, we look to
    the national standard setters as partners in several of our projects,
    enabling us to make use of their resources. Seven of our Board members
    have direct responsibility for liaison with the national standard
    setters in Australia, Canada, France, Germany, Japan, the United
    Kingdom, and the United States. We expect that our liaison Board
    members will spend as much as half their time in direct contact with
    their assigned national standard setter, thus bringing the collective
    wisdom of each country's financial community to our debates.

    How Do International Financial Reporting Standards Differ from
    U.S. Standards?
        Many International Financial Reporting Standards (IFRS) are similar
    to U.S. GAAP. Both international standards and U.S. GAAP strive to be
    principles-based, in that they both look to a body of accounting
    concepts. U.S. GAAP tends, on the whole, to be more specific in its
    requirements and includes much more detailed implementation guidance.
        In my view, the U.S. approach is a product of the environment in
    which U.S. standards are set. Simply put, U.S. accounting standards are
    detailed and specific because the FASB's constituents have asked for
    detailed and specific standards. Companies want detailed guidance
    because those details eliminate uncertainties about how transactions
    should be structured. Auditors want specificity because those specific
    requirements limit the number of difficult disputes with clients and
    may provide a defence in litigation. Securities regulators want
    detailed guidance because those details are thought to be easier to
    enforce.
        The IASB has concluded that a body of detailed guidance (sometimes
    referred to as bright lines) encourages a rule-book mentality of
    ``Where does it say I cannot do this?'' We take the view that this is
    counter-productive and helps those who are intent on finding ways
    around standards more than it helps those seeking to apply standards in
    a way that gives useful information. Put simply, adding the detailed
    guidance may obscure, rather than highlight, the underlying principle.
    The emphasis tends to be on compliance with the letter of the rule
    rather than on the spirit of the accounting standard.
        We favour an approach that requires the company and its auditor to
    take a step back and consider whether the accounting suggested is
    consistent with the underlying principle. This is not a soft option.
    Our approach requires both companies and their auditors to exercise
    professional judgement in the public interest. Our approach requires a
    strong commitment from preparers to financial statements that provide a
    faithful representation of all transactions and a strong commitment
    from auditors to resist client pressures. It will not work without
    those commitments. There will be more individual transactions and
    structures that are not explicitly addressed. We hope that a clear
    statement of the underlying principles will allow companies and
    auditors to deal with those situations without resorting to detailed
    rules.

    What is the IASB's Work Plan?
        The IASB is a small organisation. We must therefore set our
    priorities with care. We have 12 full-time and 2 part-time Board
    members, including 5 from the United States. We have a professional
    staff of 17 that includes highly skilled people from Australia,
    Bermuda, Canada, France, Japan, New Zealand, Russia, Sweden, the United
    Kingdom, and the United States.

    The Active Agenda
        Our agenda includes nine active projects that we divide into three
    groups.

        Projects intended to provide leadership and promote convergence
    include:

     Accounting for insurance contracts.
     Business combinations.
     Performance reporting (joint project with the United Kingdom's
        standard setter).
     Accounting for share-based payments.

        Projects intended to provide for easier application of
    International Financial Reporting Standards include:

     Guidance on first-time application of international financial
        reporting standards (a joint project with the French national
        standard setter).
     Financial activities: Disclosure and presentation.

        Projects intended to improve existing International Financial
    Reporting Standards include:

     Preface to International Financial Reporting Standards.
     Improvements to existing International Financial Reporting
        Standards.
     Amendments to IAS 32, Financial Instruments: Disclosure and
        Presentation, and IAS 39, Financial Instruments: Recognition and
        Measurement.

        Details of the projects on our agenda, including a summary of all
    tentative decisions to date, can be found on the IASB's website at
    www.iasb.org.uk.

    The Research Agenda
        In addition to the active agenda, there are 16 other issues that we
    refer to as our research agenda. Each is being worked on by one or more
    of our national standard setting partners. The IASB will be working
    with these partners, or at least monitoring their efforts, in order to
    ensure that any differences among national standard setters or with the
    IASB are identified and resolved as quickly as possible. We expect to
    move some of these issues to our active agenda as time and resources
    permit.
        The 16 issues on our research agenda are:

    Consolidations
        Of the 16 topics on our research agenda, one warrants special
    discussion today. For several years, there has been an international
    debate on the topic of consolidation policy. The failure to consolidate
    some entities has been identified as a significant issue in the
    restatement of Enron's financial statements.
        Accountants use the term consolidation policy as shorthand for the
    principles that govern the preparation of consolidated financial
    statements that include the assets and liabilities of a parent company
    and its subsidiaries. For an example of consolidation, consider the
    simple example known to every accounting student. Company A operates a
    branch office in Maryland. Company B also operates a branch office in
    Maryland, but organises the branch as a corporation owned by Company B.
    Every accounting student knows that the financial statements of each
    company should report all of the assets and liabilities of their
    respective Maryland operations, without regard to the legal form
    surrounding those operations.
        Of course, real life is seldom as straightforward as textbook
    examples. Companies often own less than 100 percent of a company that
    might be included in the consolidated group. Some special-purpose
    entities (SPE's) may not be organised in traditional corporate form.
    The challenge for accountants is to determine which entities should be
    included in consolidated financial statements.
        There is a broad consensus among accounting standard setters that
    the decision to consolidate should be based on whether one entity
    controls another. However, there is considerable disagreement over how
    control should be defined and translated into accounting guidance. U.S.
    accounting standards and practice seem to have gravitated toward a
    legal or ownership notion of control, usually based on direct or
    indirect ownership of over 50 percent of the outstanding voting shares.
        In contrast, the IFRS and the standards in some national
    jurisdictions are based on a broader notion of control that includes
    ownership, but extends to control over the financial and operating
    policies, power to appoint or remove a majority of the board of
    directors, and power to cast a majority of votes at meetings of the
    board of directors.
        A number of commentators, including many in the United States, have
    questioned whether the control principle described in IFRS is
    consistently applied. The IASB and its partner standard setters are
    committed to an ongoing review of the effectiveness of our standards.
    If they do not work as well as they should, we want to find out why and
    fix the problem. Last summer we asked the United Kingdom Accounting
    Standards Board to help us by researching the various national
    standards on consolidation and on identifying any inconsistencies or
    implementation problems. It has completed the first stage of that
    effort and is moving now to the more difficult questions.
        The particular consolidation problems posed by SPE's were addressed
    by the IASB's Standing Interpretations Committee in SIC-12. There are
    some kinds of SPE that pose particular problems for both an ownership
    approach and a control-based approaches to consolidations. It is not
    uncommon for SPE's to have minimal capital, held by a third party, that
    bears little if any of the risks and the rewards usually associated
    with share ownership. The activities of some SPE's are precisely
    prescribed in the documents that establish them, such that no active
    exercise of day-to-day control is needed or allowed. These kinds of
    SPE's are commonly referred to as running on ``auto-pilot.'' In these
    cases, control is exercised in a passive way. To discover who has
    control it is necessary to look at which party receives the benefits
    and risks of the SPE.
        SIC-12 sets out four particular circumstances that may indicate
    that an SPE should be consolidated:

     In substance, the activities of the SPE are being conducted on
        behalf of the enterprise according to its specific business needs
        so that the enterprise obtains benefits from the SPE's operation.
     In substance, the enterprise has the decisionmaking powers to
        obtain the majority of the benefits of the activities of the SPE
        or, by setting up an ``auto-pilot'' mechanism, the enterprise has
        delegated these decisionmaking powers.
     In substance, the enterprise has rights to obtain the majority
        of the benefits of the SPE and, therefore, may be exposed to risks
        incident to the activities of the SPE.
     In substance, the enterprise retains the majority of the
        residual or ownership risks related to the SPE or its assets in
        order to obtain benefits from its activities.

        The IASB recognises that we may be able to improve our approach to
    SPE's. With this in mind, we have already asked our interpretations
    committee if there are any ways in which the rules need to be
    strengthened or clarified.

    Current Criticisms and Concerns About Financial Reporting
        There are some common threads that pass through most of the topics
    on our active and research agendas. Each represents a broad topic that
    has occupied the best accounting minds for several years. It is time to
    come to closure on many of these issues.

    Off Balance Sheet Items
        When a manufacturer sells a car or a dishwasher, the inventory is
    removed from the balance sheet (a process that accountants refer to as
    derecognition) because the manufacturer no longer owns the item.
    Similarly, when a company repays a loan, it no longer reports that loan
    as a liability. However, the last 20 years have seen a number of
    attempts by companies to remove assets and liabilities from balance
    sheets through transactions that may obscure the economic substance of
    the company's financial position. There are four areas that warrant
    mention here, each of which has the potential to obscure the extent of
    a company's assets and liabilities.
    Leasing Transactions
        A company that owns an asset, say an aircraft, and finances that
    asset with debt reports an asset (the aircraft) and a liability (the
    debt). Under existing accounting standards in most jurisdictions
    (including FASB and IASB standards), a company that operates the same
    asset under a lease structured as an operating lease reports neither
    the asset nor the liability. It is possible to operate a company, say
    an airline, without reporting any of the company's principal assets
    (aircraft) on the balance sheet. A balance sheet that presents an
    airline without any aircraft is clearly not a faithful representation
    of economic reality.
        Our predecessor body, working in conjunction with our partners in
    Australia, Canada, New Zealand, the United Kingdom, and the United
    States, published a research paper that invited comments on accounting
    for leases. The United Kingdom Accounting Standards Board is continuing
    work on this topic and we are monitoring its work carefully. As noted
    above, we expect to move accounting for leases to our active agenda at
    some point in the future. There is a distinct possibility that such a
    project would lead us to propose that companies recognise assets and
    related lease obligations for all leases.

    Securitisation Transactions
        Under existing accounting standards in many jurisdictions, a
    company that transfers assets (like loans or credit card balances)
    through a securitisation transaction recognises the transaction as a
    sale and removes the amounts from its balance sheet. Some
    securitisations are appropriately accounted for as sales, but many
    continue to expose the transferor to many of the significant risks and
    rewards inherent in the transferred assets. In our project on
    improvements to IAS 39 (page 6), we plan to propose an approach that
    will clarify international standards governing a company's ability to
    derecognise assets in a securitisation. Our approach, which will not
    allow sale treatment when the ``seller'' has a continuing involvement
    with the assets, will be significantly different from the one found in
    U.S. GAAP.

    Creation of Unconsolidated Entities
        Under existing accounting standards in many jurisdictions, a
    company that transfers assets and liabilities to a subsidiary company
    must consolidate that subsidiary in the parent company's financial
    statements (refer to page 7). However, in some cases (often involving
    the use of an SPE), the transferor may be able (in some jurisdictions)
    to escape the requirement to consolidate. IFRS governing consolidation
    of SPE's are described earlier in my statement.

    Pension Obligations
        Under existing standards in many jurisdictions (including existing
    international standards) a company's obligation to a defined benefit
    pension plan is reported on the company's balance sheet. However, the
    amount reported is not the current obligation, based on current
    information and assumptions, but instead represents the result of a
    series of devices designed to spread changes over several years.

    Off Income Statement Items
        Under existing accounting standards in some jurisdictions, a
    company that pays for goods and services through the use of its own
    stock, options on its stock, or instruments tied to the value of its
    stock may not record any cost for those goods and services. The most
    common form of this share-based transaction is the employee stock
    option. In 1995, after what it called an ``extraordinarily
    controversial'' debate, the FASB issued a standard that, in most cases
    in the United States, requires disclosure of the effect of employee
    stock options but does not require recognition in the financial
    statements. In its Basis for Conclusions, the FASB observed:

              The Board chose a disclosure-based solution for stock-based
            employee compensation to bring closure to the divisive debate
            on this issue--not because it believes that solution is the
            best way to improve financial accounting and reporting.

        Most jurisdictions do not have any standard on accounting for
    share-based payments, and the use of this technique is growing outside
    of the United States. The IASB has yet to reach conclusions on this
    issue, but there is a clear need for international accounting guidance.

    Accounting Measurement
        Under existing accounting standards in most jurisdictions, assets
    and liabilities are reported at amounts based on a mixture of
    accounting measurements. Some of the measurements are based on
    historical transaction prices, perhaps adjusted for depreciation,
    amortisation, or impairment. Others are based on fair values, using
    either amounts observed in the marketplace or estimates of fair value.
    Accountants refer to this as the mixed-attribute model. It is
    increasingly clear that a mixed-attribute system creates complexity and
    opportunities for accounting arbitrage, especially for derivatives and
    financial instruments. Some have suggested that financial reporting
    should move to a system that measures all financial instruments at fair
    value.
        Our predecessor body participated with a group of 10 accounting
    standard setters (the Joint Working Group or JWG) to study the problem
    of accounting for financial instruments. The JWG proposal (which
    recommended a change to measuring all financial assets and liabilities
    at fair value) was published at the end of 2000. Last month, the
    Canadian Accounting Standards Board presented an analysis of comments
    on that proposal. The IASB has just begun to consider how this effort
    should move forward.

    Intangible Assets
        Under existing accounting standards in most jurisdictions, the cost
    of an intangible asset (a patent, a copyright, or the like) purchased
    from a third party is capitalised as an asset. This is the same as the
    accounting for acquired tangible assets (buildings and machines) and
    financial assets (loans and accounts receivable). Existing accounting
    standards extend this approach to self-constructed tangible assets, so
    a company that builds its own building capitalises the costs incurred
    and reports that as the cost of its self-constructed asset. However, a
    company that develops its own patent for a new drug or process is
    prohibited from capitalising much (sometimes all) of the costs of
    creating that intangible asset. Many have criticised this
    inconsistency, especially at a time when many consider intangible
    assets to be significant drivers of company performance.
        The accounting recognition and measurement of internally generated
    intangibles challenges many long-cherished accounting conventions.
    Applying the discipline of accounting concepts challenges many of the
    popular conceptions of intangible assets and ``intellectual capital.''
    We have this topic on our research agenda. We also note the significant
    work that the FASB has done on this topic and its recent decision to
    add a project to develop proposed disclosures about internally
    generated intangible assets. We plan to monitor those efforts closely.

    Conclusion
        As I said at the outset, the IASB's objective is to work toward a
    single set of high-quality international financial reporting standards,
    produced in the private sector under principles of transparency, open
    meetings, and full due process. The international financial markets
    clearly want a single set of accounting standards that apply worldwide.
    We have no intention to ``water down'' existing standards in any
    jurisdiction. Instead, we plan to build a set of financial reporting
    standards that are the ``gold standard.'' In pursuit of that goal, we
    plan to pick the best of available standards produced by national
    standard setters.
        No single group has a monopoly on the best in accounting, and we
    expect to learn from our colleagues. To the extent that the underlying
    rationale in U.S. GAAP is the best available and of high quality, we
    intend to incorporate that rationale into international standards. To
    the extent that another standard has a superior approach, we intend to
    adopt it. If no national standard adequately addresses the problem, as
    may be the case in accounting for leases or share-based payments, then
    we plan to work toward an international standard that does. We plan to
    develop standards based on clear principles, rather than rules that
    attempt to cover every eventuality. I hope that we can keep to that
    plan, but its success will depend on the professionalism and judgement
    of financial statement's preparers, auditors, and securities
    regulators.
        Our work will probably require tough decisions and unpopular
    standards. Assets and liabilities that companies have moved ``off
    balance sheet'' may move back ``on balance sheet.'' Expenses that today
    go unrecognised may be recognised in companies' income statements.
    Measurements may move from historical to more current information.
        The United States, indeed the whole world, has been shocked by the
    scale and speed of the Enron collapse. We who are on the outside learn
    a little more every day, but it still remains to be seen whether the
    financial reporting that preceded Enron's collapse was a result of
    flawed accounting standards, incorrect application of existing
    standards, auditing mistakes, or plain deceit. We owe an obligation to
    the investors, employees, and others who have suffered to ensure, to
    the best of our ability, that the lessons are learned. If there are
    weaknesses in accounting standards, we should acknowledge that fact and
    come forward with improvements.
        In partnership with the FASB and others, we intend to change
    financial reporting. In some cases, that change will be dramatic,
    especially for countries without the advanced standards and financial
    infrastructure found in the United States. Most of those changes will
    be controversial. You and your colleagues may be asked to stop their
    implementation in the United States. I hope that you resist those
    requests. Global accounting standards do not create a national
    disadvantage, and we have to work toward answers that investors can
    trust.

    Appendix One--Background Information on the IASB

    Introduction
        The International Accounting Standards Board (IASB), based in
    London, began operations in 2001. It is funded by contributions from
    the major accounting firms, private financial institutions, and
    industrial companies throughout the world, central and development
    banks, and other international and professional organisations. The 14
    Board members (12 of whom are full-time) reside in nine countries and
    have a variety of functional backgrounds. The Board is committed to
    developing, in the public interest, a single set of high-quality,
    global accounting standards that require transparent and comparable
    information in general purpose financial statements. In pursuit of this
    objective, the Board cooperates with national accounting standard
    setters to achieve convergence in accounting standards around the
    world.

    Trustees
        Board Members are appointed by the Trustees of the International
    Accounting Standards Committee Foundation (IASC Foundation). Under the
    IASC Foundation's Constitution, the Trustees also appoint the Standards
    Advisory Council and Standing Interpretations Committee. The Trustees
    also monitor IASB's effectiveness, raise funds for IASB, approve IASB's
    budget and have responsibility for constitutional changes. The Trustees
    are individuals of diverse geographic and functional backgrounds. Under
    the Constitution, the Trustees were appointed so that initially there
    were six from North America, six from Europe, four from Asia Pacific,
    and three others from any area, as long as geographic balance was
    maintained. Five of the nineteen Trustees represent the accounting
    profession, and international organisations of preparers, users, and
    academics are each represented by one Trustee. The remaining 11
    Trustees were ``at-large'' appointments, in that they were not selected
    through the constituency nomination process. The existing Trustees will
    follow similar procedures in selecting subsequent Trustees to fill
    vacancies.

    Board
        The Board consists of 14 individuals (12 full-time Members and two
    part-time Members) and has sole responsibility for setting accounting
    standards. The foremost qualification for Board membership is technical
    expertise and the Trustees exercised their best judgement to ensure
    that any particular constituency or regional interest does not dominate
    the Board. The Constitution requires that at least five Board Members
    have a background as practising auditors, at least three have a
    background in the preparation of financial statements, at least three
    have a background as users of financial statements, and at least one
    has an academic background. Seven of the 14 Board Members have direct
    responsibility for liaison with one or more national standard setters.
    The publication of a Standard, Exposure Draft, or final IFRIC
    Interpretation requires approval by eight of the Board's 14 Members. On
    January 1, 2002, the Board Members were: Sir David Tweedie, Chairman;
    Thomas E. Jones, Vice Chairman; Professor Mary E. Barth (part-time);
    Hans-Georg Bruns (Liaison with the German standard setter); Anthony T.
    Cope; Robert P. Garnett; Gilbert Gelard (Liaison with the French
    standard setter); Robert H. Herz (part-time); James J. Leisenring
    (Liaison with the United States standard setter); Warren McGregor
    (Liaison with the Australian and New Zealand standard setters);
    Patricia O'Malley (Liaison with the Canadian standard setter), Harry K.
    Schmid; Geoffrey Whittington (Liaison with the UK standard setter); and
    Tatsumi Yamada (Liaison with the Japanese standard setter).
        Upon its inception the IASB adopted the body of the International
    Accounting Standards (IAS's) issued by its predecessor, the
    International Accounting Standards Committee. The accounting standards
    developed by the Board will be styled International Financial Reporting
    Standards (IFRS).

    Standards Advisory Council
        The Standards Advisory Council (SAC) provides a formal vehicle for
    further groups and individuals having diverse geographic and functional
    backgrounds to give advice to the IASB and, at times, to advise the
    Trustees. The Trustees attach particular importance to the perspective
    that the Council can bring to the IASB's role and mandate. The Council
    comprises about 50 members, having diverse geographic and functional
    backgrounds and the expertise required to contribute to the formulation
    of accounting standards. It has the objective of (a) giving advice to
    the IASB on priorities in the IASB's work, (b) informing the IASB of
    the implications of proposed standards for users and preparers of
    financial statements, and (c) giving other advice to the IASB or the
    Trustees. The Council normally meets at least three times a year. It is
    to be consulted by the IASB on all major projects and its meetings are
    to be open to the public. The Trustees appointed the initial Members of
    the Council in June 2001.

    Standing Interpretations Committee
        The Standing Interpretations Committee (SIC) was formed in 1997 and
    was reconstituted in December 2001. The Trustees have proposed an
    amendment to the Constitution in order to change the name of the
    Committee to the International Financial Reporting Interpretations
    Committee and to give it the following mandate:

     Interpret the application of International Financial Reporting
        Standards and provide timely guidance on financial reporting issues
        not specifically addressed in IFRS, in the context of IASB's
        Framework, and undertake other tasks at the request of the Board.
     Publish Draft Interpretations for public comment and consider
        comments made within a reasonable period before finalising an
        Interpretation.
     Report to the Board and obtain Board approval for final
        Interpretations.

        The IFRIC consults similar national interpretative bodies around
    the world, in particular those in partner jurisdictions.
        The Committee has 12 voting members, appointed by the Trustees for
    a renewable term of 3 years. The International Organization of
    Securities Commissions (IOSCO) and the European Commission are
    nonvoting observers. In the changes to the Constitution, the Trustees
    have also proposed that a member of the IASB, the Director of Technical
    Activities or another senior member of the IASB staff, or another
    appropriately qualified individual be appointed to Chair the Committee.
    The Chair will have the right to speak to the technical issues being
    considered but not to vote.
        The IFRIC deals with issues of reasonably widespread importance:
    Not issues of concern to only a small number of enterprises. The
    interpretations cover both:

     Mature issues (areas where there is unsatisfactory practice
        within the scope of existing International Accounting Standards).
     Emerging issues (new topics relating to an existing
        International Accounting Standard but not considered when the
        Standard was developed).

        The IASB publishes a report on IFRIC decisions immediately after
    each IFRIC meeting. This report is made available (in electronic
    format) as soon as possible to subscribers and, subsequently, posted to
    the IASB website.

    IASB Staff
        A staff based in London, headed by the Chairman of the IASB,
    supports the Board. The technical staff and other project managers
    currently include people from Australia, Bermuda, Canada, France,
    Japan, New Zealand, the Russian Federation, Sweden, the United Kingdom,
    and the United States.

    Due Process
        The IASB published its proposed due process in an Exposure Draft of
    the Preface to International Financial Reporting Standards in November
    2001. The following is that proposed due process, and may be changed as
    a result of comments received on the Exposure Draft.
    IASB Due Process
        IFRS are developed through an international due process that
    involves accountants, financial analysts, and other users of financial
    statements, the business community, stock exchanges, regulatory and
    legal authorities, academics and other interested individuals and
    organisations from around the world. The Board consults with the SAC
    about the projects it should add to its agenda and discusses technical
    matters in meetings that are open to public observation. Due process
    for projects normally, but not necessarily, involves the following
    steps (the steps that are required under the terms of the Constitution
    are indicated by an asterisk*):

     Staff work to identify and review all the issues associated
        with the topic and to consider the application of the IASB's
        Framework to the issues.
     Study of national accounting requirements and practice and an
        exchange of views about the issues with national standard setters.
     Consultation with the SAC about the advisability of adding the
        topic to the Board's agenda.*
     Formation of an advisory group to give advice to the Board on
        the project.
     Publishing for public comment a discussion document.
     Publishing for public comment an Exposure Draft approved by at
        least eight votes of the Board, including any dissenting opinions
        held by Board Members and a basis for conclusions.*
     Consideration of all comments received on discussion documents
        and Exposure Drafts.*
     Consideration of the desirability of holding a public hearing
        and of the desirability of conducting field tests and, if
        considered desirable, holding such hearings and conducting such
        tests.
     Approval of a Standard by at least eight votes of the Board
        and inclusion in the published Standard of any dissenting opinions
        and a basis for conclusions, explaining, among other things, how
        the Board dealt with public comments on the Exposure Draft.*

    IFRIC Due Process
        Interpretations of IFRS are developed through an international due
    process that involves accountants, financial analysts and other users
    of financial statements, the business community, stock exchanges,
    regulatory and legal authorities, academics and other interested
    individuals and organisations from around the world. The IFRIC
    discusses technical matters in meetings that are open to public
    observation. The due process for each project normally, but not
    necessarily, involves the following steps (the steps that are required
    under the terms of the Constitution are indicated by an asterisk*):

     Staff work to identify and review all the issues associated
        with the topic and to consider the application of the IASB's
        Framework to the issues.
     Study of national accounting requirements and practice and an
        exchange of views about the issues with national standard setters,
        including national committees that have responsibility for
        interpretations of national standards.
     Publication of a Draft Interpretation for public comment if no
        more than three of the IFRIC's members have voted against the
        proposal.*
     Consideration of all comments received on a Draft
        Interpretation within a reasonable period of time.*
     Approval by the IFRIC of an Interpretation if no more than
        three of the IFRIC's members have voted against the Interpretation
        after considering public comments on the Draft Interpretation.*
     Approval of the Interpretation by at least eight votes of the
        Board.*

    Voting
        Each Board Member has one vote on technical and other matters. The
    publication of a Standard, Exposure Draft, or final IFRIC
    Interpretation requires approval by eight (8) of the Board's fourteen
    (14) Members. Other decisions, including the issuance of a Draft
    Statement of Principles or a Discussion Paper and agenda decisions,
    requires a simple majority of the Board Members present at a meeting
    attended by 50 percent or more of the Board Members. The Board has full
    control over its technical agenda.
        Each Member of the IFRIC has one vote on an Interpretation. Eight
    voting IFRIC Members represents a quorum. Approval of Interpretations
    requires no more than three IFRIC Members present at the meeting vote
    against the proposal.

    Openness of Meetings
     IASB and IFRIC meetings are open to public observation.
        However, certain discussions (primarily selection of items for the
        technical agenda and appointment and other personnel issues) are,
        at the Board's and the IFRIC's discretion, held in private.
        Portions of the Trustees' meetings are also open to the public, at
        the discretion of the Trustees.
     IASB continues to explore the use of recent technology (such
        as the Internet and electronic observation of meetings), to
        overcome geographical barriers and the logistical problems for
        members of the public in attending open meetings.
     IASB publishes in advance on its Internet site the agenda for
        each meeting of the Trustees, IASB, SAC, and the IFRIC and
        publishes promptly a summary of the technical decisions made at
        IASB and IFRIC meetings and, where appropriate, decisions of the
        Trustees.
     When IASB publishes a Standard, it publishes a Basis for
        Conclusions to explain publicly how it reached its conclusions and
        to give background information that may help users of IASB
        standards to apply them in practice. IASB also publishes dissenting
        opinions.

    Comment Periods
        The Board issues each Exposure Draft of a Standard and discussion
    documents for public comment, with a normal comment period of 120 days.
    In certain circumstances, the Board may expose proposals for a much
    shorter period. However, such limited periods would be used only in
    extreme circumstances. Draft IFRIC Interpretations are exposed for a 60
    day comment period.

    Coordination with National Due Process
        The Board meets with the Chairmen of its partner national standard
    setters at least three times a year. Close coordination between the
    IASB's due process and the due process of national standard setters is
    important to the success of the IASB. As far as possible, the IASB
    would integrate its due process with national due process. Such
    integration may grow as the relationship between the IASB and the
    national standard setters evolves. In addition, those Board Members
    having liaison responsibilities with a national standard setter provide
    a mechanism for more regular contact.

    Opportunities for Input
        The development of an International Accounting Standard involves an
    open, public process of debating technical issues and evaluating input
    sought through several mechanisms. Opportunities for interested parties
    to participate in the development of International Accounting Standards
    would include, depending on the nature of the project:

     Participation in the development of views as a member of the
        Standards Advisory Council.
     Participation in advisory groups.
     Submission of a comment letter in response to a discussion
        document.
     Submission of a comment letter in response to an Exposure
        Draft.
     Participation in public hearings.
     Participation in field visits and field tests.

        The IASB publishes an annual report on its activities during the
    past year and priorities for the next year. This report provides a
    basis and opportunity for comment by interested parties.
    Preface to Statements of International Accounting Standards
        The current Preface to Statements of International Accounting
    Standards was approved in November 1982 and published in January 1983.
        The Board issued a proposed Preface to International Financial
    Reporting Standards in November of 2001. The Board expects to complete
    its due process on the Preface in the second quarter 2002.
    IASB Framework
        The IASB Framework is a conceptual accounting framework (based on
    pioneering work by the FASB) that sets out the concepts that underlie
    the preparation and presentation of financial statements for external
    users. It was approved in 1989. The IASB Framework assists the IASB:

     In the development of future International Accounting
        Standards and in its review of existing International Accounting
        Standards.
     In promoting the harmonisation of regulations, accounting
        standards and procedures relating to the presentation of financial
        statements by providing a basis for reducing the number of
        alternative accounting treatments permitted by International
        Accounting Standards.

        In addition, the Framework may assist:

     Preparers of financial statements in applying International
        Accounting Standards and in dealing with topics that have yet to
        form the subject of an International Accounting Standard.
     Auditors in forming an opinion as to whether financial
        statements conform with International Accounting Standards.
     Users of financial statements in interpreting the information
        contained in financial statements prepared in conformity with
        International Accounting Standards.
     Those who are interested in the work of the IASB, providing
        them with information about its approach to the formulation of
        accounting standards.

        The Framework is not an International Accounting Standard and does
    not define standards for any particular measurement or disclosure
    issue.
        In a limited number of cases there may be a conflict between the
    Framework and a requirement within an International Accounting
    Standard. In those cases where there is a conflict, the requirements of
    the International Accounting Standard prevail over those of the
    Framework.
                                    *  *  *
        This project contemplates a review of differences between existing
    standards, rather than a comprehensive review of the topic.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                           TUESDAY, FEBRUARY 26, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:25 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, the Committee holds the third in a series of
    hearings on accounting standards and practices and investor
    protection. Our witnesses today have been asked to address the
    preparation and audit of the financial reports of public
    companies, auditor performance and independence, the
    formulation of auditing standards and accounting principles,
    and generally, the oversight of the accounting profession.
        It probably needs to be said at the outset that accounting
    abuses are not new under the securities law. The McKesson &
    Robbins investigation as long ago as 1940, the collapse of Penn
    Central and Equity Funding Corporation, the scandals leading to
    the Foreign Corrupt Practices Act, and, of course, the S&L
    crisis in the 1980's, all raised significant questions about
    auditing and accounting for public companies under the
    securities law.
        Today's difficulties, unfortunately, appear to be more
    widespread and the fears that they have generated are more
    widely shared since more and more people are investing in our
    stock market than ever before.
        What is at stake is the all-important trust of our
    citizens, and of the world's investors, in our capital markets.
    Yesterday's Wall Street Journal reports, for example, that the
    historical premium paid for U.S. stocks because of our:
    ``Supposedly stricter corporate governance standards'' and
    accounting rules may be disappearing. Less money in our capital
    markets directly reduces the ability of our economy to create
    jobs, prosperity, and a secure retirement for working men and
    women across America. This is an issue which must concern us
    all.
        The role of auditors in our free-market system was
    summarized by the unanimous Supreme Court 30 years ago:
        ``In certifying the public reports that collectively depict
    a corporation's financial status, the independent auditor
    assumes a public responsibility. That auditor owes ultimate
    allegiance to the corporation's creditors and stockholders, as
    well as to the investing public. This `public watchdog'
    function demands that the accountant maintain total
    independence from the client at all times and requires complete
    fidelity to the public trust.''
        Since the early days of the securities law, we have chosen
    to rely on private control of the audit process, private
    auditing and accounting standard setting, and for the most part
    private disciplinary measures, to maintain that public trust.
    But the growing number of serious failures--not only Enron--
    demands a response.
        I will say more on each witness as I turn to them, but let
    me say I feel that they are extremely well positioned to give
    this Committee assistance. Walter Schuetze, Michael Sutton, and
    Lynn Turner, in turn, occupied the position of SEC Chief
    Accountant during most of the 1990's, under Chairman Breeden
    and Chairman Levitt. And Mr. Schuetze returned to the SEC as
    Chief Accountant for the Division of Enforcement from 1997 to
    2001. Professor Beresford was Chairman of the Financial
    Accounting Standards Board for a decade, from 1987 to 1997.
        Before we turn to the witnesses, though, I want to note a
    matter which I think is of current and of extreme importance.
    And that is that the SEC be adequately funded and staffed to
    carry out its dual responsibilities of protecting investors and
    maintaining the integrity of the securities market. Especially
    in view of the mounting numbers of financial restatements and
    of the current apprehensions these have caused among investors,
    the SEC needs to be in a position to act prudently,
    efficiently, and decisively.
        In my view, and this is a view that I have held for quite a
    long period of time, it does not have the resources to do so.
    Its current Chairman actually has gone as far as to describe
    the situation as a staffing crisis.
        A GAO report dated September of last year found the
    following: More than 1,000, or about one third of the staff,
    left the Commission in the 3 year period from 1998 to 2000. Of
    those leaving, more than 500 were attorneys. SEC's turnover
    rates for attorneys, accountants, and examiners averaged 15
    percent in the year 2000. More than 280 positions, or nearly 10
    percent, of all Commission positions were unfilled at the end
    of 2001.
        There is nothing mysterious about this crisis. In terms of
    the compensation it can offer, the Commission is at a severe
    disadvantage. Compared to their counterparts at the other
    Federal financial regulatory agencies, SEC staff earn in the
    range of 24 percent to 39 percent less.
        Now, we worked hard in the last session to pass legislation
    authorizing pay parity for the SEC and also cutting a number of
    fees, because it was perceived that they were bringing in a lot
    more revenue than the rationale for establishing them to begin
    with, which was to be supportive of the SEC budget. The
    President signed that into law, but the Administration's budget
    request for the coming year does not make allowance for the
    staffing problems or measures. It does not provide for the pay
    parity, which I think we all assumed would be requested.
        It in effect continues a current level of funding, which I
    think is inadequate, and therefore, heightens the risk of
    losing staff competence and professionalism at the SEC.
        This is a matter that I think this Committee will return
    to.
        We are in the process now of trying to examine very
    carefully and comprehensively what systemic and structural
    changes need to be made and how the whole investor protection
    system and structure operates. We are obviously seeking the
    benefit of some very expert opinion in trying to arrive at our
    recommendations. But it seems to me that there is one thing
    that clearly could be done immediately that would help to
    address this problem, and that is to address this shortfall or
    shortage in the SEC budget.
        Now, I have written to both the President and the Chairman
    of the SEC, urging them to seek additional monies. We will try
    in the Congress as best we can to provide them, even if they do
    not seek them. It obviously would be helpful if the
    Administration were behind that push as well. Otherwise, we are
    going to continue to have this drain of the SEC staff because
    of the failure to reach pay parity, and we are going to
    continue to have the shortfall in terms of adequate staffing to
    really address the current situation.
        Senator Gramm.

                    STATEMENT OF SENATOR PHIL GRAMM

        Senator Gramm. Mr. Chairman, first of all, let me just
    begin by commenting on pay parity and fees.
        This has been a truly bipartisan effort. It started when I
    was Chairman, continued when you became Chairman. I think the
    bill we passed is a very important first step. I think the
    change in fees was needed. We provided pay parity. We can have
    endless debates about how big Government ought to be, but I do
    not think there is any debate about the fact that we want the
    best people that we can find in Government.
        I think it is foolish economics to hire people to do
    important jobs and then not pay them enough to recruit and to
    retain the best people.
        We have had a problem at the SEC. I think we have taken a
    major step in the direction of fixing the problem. I look
    forward to working with you on the SEC budget and trying to see
    that the fix is implemented.
        Let me also thank you, Mr. Chairman, for the forward-
    looking nature of these hearings. I do not know what the last
    count was--18 or 20 committees are holding hearings on related
    subjects. But the jurisdiction over the issue is this
    Committee's jurisdiction.
        So, in the end, it is not going to be enough for us to jump
    up and down and shout and point fingers at people. It is going
    to be our mission to figure out changes that need to be made.
        I think the first hearing you had was an excellent hearing.
    I look forward to hearing our witnesses today. I would say that
    one of the things that we have to make a fundamental decision
    on is who is going to set accounting standards?
        I would have to say that, all things considered, I still
    support an independent body setting accounting standards. It
    scares me to death having Government or politicians set
    accounting standards.
        As I once said to our previous Chairman of the SEC, that
    while I differed with him on breaking up accounting firms,
    there was no circumstance under which I at the time as Chairman
    was going to allow Congress to intervene, no matter what
    decision he made, that in the end, the only thing worse than
    the SEC setting standards is to have Congress get in the
    business of setting standards.
        I think, having said that, the question then becomes how do
    we fund FASB? How do we guarantee its independence, including
    independence from the Government, one of the most corrosive
    influences that I can imagine?
        So this is a tough assignment. It is one thing to talk
    about there is a need for change. But when you start talking
    about changing something as fundamental as accounting standards
    and accounting procedures, this is a very tough issue and it is
    one that we are going to have to be very deliberative about. It
    is one that we are going to have to be sure that we know what
    we are talking about.
        I think your hearings have thus far been excellent in terms
    of preparing us for that decision.
        Mr. Chairman, I look forward to working with you on this.
    This is something that can and should be done on a bipartisan
    basis. I think it is the only way it is going to be done right.
    This Committee has an opportunity to make a great contribution
    to the financial security of the country, to the well-being of
    workers and investors. We benefit every day by having the
    greatest capital market in the world. And we have it within our
    power to make it better, I believe.
        Chairman Sarbanes. Thank you very much.
        Senator Miller.

                    COMMENTS OF SENATOR ZELL MILLER

        Senator Miller. Thank you, Mr. Chairman.
        I do not have an opening statement, but I would like to
    echo the comments of Senator Gramm about the quality of these
    hearings. I would also like to thank all of our witnesses for
    being here, particularly Professor Beresford, who is at the
    University of Georgia, and we are so pleased that he is there.
        Thank you.
        Chairman Sarbanes. Senator Enzi.

                  STATEMENT OF SENATOR MICHAEL B. ENZI

        Senator Enzi. Thank you, Mr. Chairman.
        I want to thank you for your willingness to continue the
    dialogue on the accounting standards. This is a real red-letter
    day for me because we have had people who have been in here
    talking about a number of the problems that exist, some of
    which deal with accounting. And it is so exciting to finally
    have the accountants to be able to talk about accounting.
        [Laughter.]
        Chairman Sarbanes. Said in a heartfelt way by an
    accountant.
        Senator Enzi. Yes.
        [Laughter.]
        During the break, I traveled about 2,000 miles across
    Wyoming. And one of the exciting things was to find the renewed
    interest in accounting. Not in a negative way, but in a very
    positive way. There are people who just did not realize that
    this was such an exciting profession and that we controlled so
    much.
        [Laughter.]
        I know when I was going to college, I thought about the
    business courses or the more specified accounting courses. I
    picked accounting because it does not change as rapidly as some
    of the other
    principles and it is a way that you can find out how an entity
    is operating. Since I have gotten here, I have done some audits
    on agencies to see how what they say they are doing compares to
    what they really are doing. It is probably a good thing that a
    lot of our agencies aren't listed on the stock market.
        Today's witnesses will further educate us. After 2 weeks of
    hearings focused on protecting investors and our witnesses all
    have different ideas how best to combat these problems and it
    is important for us to learn from them before acting on
    legislation.
        I do appreciate the testimony they have provided. I know
    that it is longer than what they can present during the time
    that is allotted, but I do hope my colleagues will take a look
    at the extensive knowledge that they have shared with us in the
    testimony.
        The recent collapses of Enron and Global Crossing, and
    before that, Sunbeam, Waste Management, and MicroStrategy, as
    well as others, have affected the confidence of America's
    investors in our capital markets. While we in Washington
    encourage Americans to save and invest in the markets, we have
    not taken the needed time to ensure that the financial
    accounting system is providing the transparency needed for
    investors to invest their money wisely. However, I believe we
    should not rush to over-react.
        As we have seen, the marketplace has taken care of a lot of
    the problems created by Enron. Credit-rating agencies are
    examining the books more closely. Analysts are asking tougher
    and more pointed questions. These are very positive
    developments.
        Unfortunately, as new businesses have emerged, the
    accounting system has not kept pace. A simple example is Rule
    133, dealing with the financial derivatives. Eight hundred
    pages were required to outline and explain this rule. The
    accounting rules seem to be able to match the complexity of the
    Internal Revenue Code.
        When this many pages are required to explain a rule, it
    breeds an environment where loopholes are found to circumvent
    the rule instead of adhering to the spirit of the rule.
        Another example is FASB's consolidation policy. I look
    forward to hearing from our witnesses as to what they see are
    the hurdles to making substantial change. I also want to learn
    from them why we did not catch this type of problem sooner.
        It seems to me that any time you have a rule proposal that
    is not finalized for 15 years, a systemic problem exists,
    especially with the accounting industry where technology and
    standards are changing at an extremely rapid pace.
        Any action that is taken either through regulation or
    legislation must be sensitive to business size. And I say that
    because I know that a small business in Wyoming should not have
    the same restrictions or burdens placed on a large,
    multinational corporation.
        In many of the communities in Wyoming, we only have two or
    three accounting firms. If we fail to recognize the predicament
    of these small businesses, we will end up hurting more than
    helping.
        However, investors must also begin to scrutinize companies
    in which they invest more closely. A farmer wouldn't buy land
    without knowing what he could plant on the land or what kind of
    return it offers, whether it is close to a flood plain or what
    is grown on the land historically.
        In contrast, investors seem to be content to invest their
    money in the markets with little or no knowledge of what the
    company does, how it makes money, or with what it is affiliated
    or if it even has a product. This situation must change, and
    that is why I am glad that the Chairman has focused some of the
    Committee's attention on education, the financial education,
    the financial literacy.
        We had a great hearing on that here, and I do appreciate
    it. However, this is not meant to indicate that some form of
    legislation might not be needed. As we have seen, executive
    compensation needs to be reported more expeditiously and
    accurately. Off balance sheet debt must be accurately reflected
    in the balance sheets. And more oversight and accountability is
    needed by the boards of directors of these large corporations.
        Again, Mr. Chairman, I do appreciate your holding this
    hearing today. I look forward to working with you and Members
    of the Committee on this issue. I thank the witnesses and I
    look forward to hearing their testimony.
        Thank you.
        Chairman Sarbanes. Thank you very much, Senator Enzi.
        Senator Stabenow.

                  COMMENTS OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Well, thank you, Mr. Chairman. Thank you
    very much to the witnesses today. I also, Mr. Chairman, would
    echo what my colleagues have said about the thoughtfulness of
    the hearings and your willingness to be thorough.
        As we have listened to witnesses that have provided
    excellent information, I am sure the same will be true today.
    We have seen a number of common themes that I hope we will
    explore more today. One is the current process of establishing
    accounting standards and the problems, and I would welcome the
    comments from our witnesses today.
        I am certainly concerned about finding a better way to
    insulate the establishment of accounting standards from
    politics and pressures, both from the industry and, frankly,
    from Congress.
        We need to make sure that we are providing the right kind
    of standards in the right kind of way.
        I am also concerned that, as others have pointed out, we
    need to think about how the domestic as well as the
    International Accounting Standards Boards can create a system
    to finance themselves without relying on funding from
    corporations who would ultimately comply with the Board's
    standards. And whether there is wrong-doing or not, it
    certainly leaves an unfortunate impression.
        I would welcome thoughts from our panelists today as well.
    And certainly, I would also welcome comments regarding changes
    that need to occur, if any, at the SEC. I am continually
    concerned about our small investors, the employees that have
    been caught in systems where they are highly invested in their
    own companies, and I think they deserve a better system. And
    frankly, I do not think it is too much to ask for an accounting
    system that ensures that publicly released information is
    accurate, easily understandable, and comprehensive.
        I hope that as we proceed with the hearings, that we will
    be able to do everything within our power to ensure that
    investors can count on a system that has integrity, that is
    transparent, and ultimately, will allow them to protect their
    own interests.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Stabenow.
        Senator Allard.

                    COMMENTS OF SENATOR WAYNE ALLARD

        Senator Allard. Mr. Chairman, I would like to join my other
    colleagues on the Committee in thanking you for holding this
    hearing. You have moved forward quickly to examine recent
    corporate failures and I appreciate your swift action.
        I think that transparency needs to be resolved. I think it
    is key to bringing confidence to the stock market. We have all
    heard a great deal about the recent meltdowns at Enron and
    Global Crossing and other companies. A great deal of the
    controversy seems to center around the reliability of the
    financial statements from these companies.
        Our financial markets depend on timely, accurate, and
    reliable information. I believe that it is important to examine
    the public policy implications of these collapses so that we
    can help to restore investors' confidence.
        Particularly, I am concerned with the use of off balance
    sheet arrangements, which can be used to obscure the actual
    condition of a company. I am hopeful that the Financial
    Accounting Standards Board will ensure that such transactions
    are appropriately reflected in the financial statements and
    disclosures.
        I would like to take this opportunity, Mr. Chairman, to
    welcome one of my constituents, Lynn Turner, to the Banking
    Committee. Lynn was the Chief Accountant for the SEC from 1998
    to 2001, and he currently serves as the Director of the Center
    for Quality Financial Reporting at my alma mater, Colorado
    State University.
        I would also like to welcome our other witnesses and thank
    them for being here today. I understand that you are all very
    busy, but your expertise will be helpful as the Banking
    Committee grapples with the many accounting issues that have
    been brought to light during recent weeks. I again thank you
    for being here and I look forward to your testimony.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Shelby.

                 COMMENTS OF SENATOR RICHARD C. SHELBY

        Senator Shelby. Thank you, Mr. Chairman. I will try to be
    brief.
        Through the course of the hearings that the Committee has
    conducted in the last several weeks, we have heard a great deal
    about the importance of accurate information for properly
    functioning capital markets. One of the most essential tools
    for providing such information is the independent financial
    audit.
        Certified public accountants are supposed to provide
    objective analysis to ensure that the investing public is
    presented with an accurate picture of a company's financial
    condition. Unfortunately, recent events provide clear examples
    of where firms have acted more like lapdogs instead of
    watchdogs. We have seen that too often the ``public''
    responsibilities associated with the title ``certified public
    accountant,'' have been ignored.
        Mr. Chairman, the Enron case and many others like it
    requires that this Committee address a very basic question--can
    the accounting industry be relied upon to meets its
    responsibilities to the public? As I have noted in some of my
    previous remarks, addressing this question is extremely
    important. Fraud in the capital markets causes damage that go
    far beyond the losses of a particular group of investors. Fraud
    diminishes investor confidence and ultimately stifles economic
    growth.
        Because of the seriousness of the damage that it causes, I
    believe that we must not only severely punish fraud in our
    markets, we must also find ways to tear it in the first place.
        In the end, I do not think that we can legislate honesty or
    integrity in accounting or any profession. But I do believe
    that we must try to establish that those with responsibilities
    meet them or face consequences for their failure to do so.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Shelby.
        Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. Yes, Mr. Chairman. Thank you for holding
    this hearing. I will have a more complete statement that I
    would like to be put in the record. But I continue to say what
    was said at the previous hearings, that it is our
    responsibility to look at the underlying factors that I think
    have been highlighted by the Enron situation, but not unique
    with them with regard to financial disclosure, transparency of
    the financial information that companies present, particularly
    in the public forum. And that it is a broad-based issue that
    needs overall review.
        I would rather see us focused on the principles at play, as
    opposed to some of the more dramatic elements of it.
        I think this is truly one of the areas, the discussion
    today that the witnesses will bring to us, that can bring
    enhanced strength to our financial markets and security to
    investors. And I think as long as we keep it focused on that,
    we will do ourselves a big favor.
        Thank you very much for having these hearings and I
    appreciate the public service that the gentlemen at the table
    have provided to the Nation and I know that their testimony
    will be very helpful in addressing this issue.
        Thank you.
        Chairman Sarbanes. Thank you very much, Senator Corzine.
        Your full statement will be included in the record.
        We will now turn to our panel. I want to echo the
    appreciation which has been expressed by other Members of the
    Committee for your being willing to come today, and the time
    and effort that has obviously gone into the prepared
    statements, which will be included in full in the record, and
    given our time constraints, I know you understand the need to
    summarize.
        We will first hear from Walter Schuetze, who was the Chief
    Accountant at the SEC from January 1992 through March 1995, and
    actually came back to the SEC as Chief Accountant of the
    Commission's Division of Enforcement in November 1997 and
    served until February 2000.
        Mr. Schuetze was one of the initial members of FASB, from
    April 1973 through 1976. He was also a member of the Accounting
    Standards Executive Committee of the American Institute of
    Certified Public Accountants, a member of the Steering
    Committee of the International Accounting Standards Committee,
    and was a partner with the public accounting firm of KPMG from
    1965 to 1973 and from 1976 until 1992.
        Mr. Schuetze, we would be very happy to hear from you.

                    STATEMENT OF WALTER P. SCHUETZE

                            CHIEF ACCOUNTANT

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1992 TO 1995

        Mr. Schuetze. Thank you, Mr. Chairman, Senator Gramm, and
    Members of the Committee. My name is Walter Schuetze. My brief
    resume is attached.
        I need to mention that although I am retired, I am a
    consultant to the Securities and Exchange Commission and
    several other entities under consulting contracts. I will be
    pleased to discuss those privately with the Senators or their
    staff. In addition, I have one remaining tie with my former
    firm, KPMG, in that I am an insured under a group life
    insurance contract obtained and administered by that firm. I
    pay the premium attributable to me.
        You have my prepared remarks to which you may refer. In the
    interest of time, I will abbreviate those remarks.
        As has been noted by the Senators, the public's confidence
    in financial reports of and by Corporate America, and in the
    audit of those financial reports by the public accounting
    profession, has been shaken badly by the recent surprise
    collapse of Enron, by recent restatements of financial
    statements by the likes of Enron, Waste Management, Sunbeam,
    Cendant, Livent and MicroStrategy, and by the SEC's assertion
    of fraud by Arthur Andersen in connection with its audits of
    Waste Management's financial statements in the 1990's, which
    Andersen did not admit or deny in a settled SEC action last
    summer.
        As has been noted by the Senators, the financial statements
    and the financial reports are extremely important. I refer to
    them as the oxygen of our capital markets.
        You will hear or have heard many suggestions for
    improvement to our system of financial reporting and audits of
    those financial reports. Some will say that auditor
    independence rules need to be strengthened. That external
    auditors should not be allowed to do consulting work and other
    nonaudit work for their audit clients. That external audit
    firms should be rotated every 5 years or so. That oversight of
    auditors needs to be strengthened. That punishment of wayward
    auditors needs to be more certain and swift, and so on and on.
    In my opinion, those suggestions, even if legislated by
    Congress and signed by the President, will not fix the
    underlying problem.
        The underlying problem is a technical accounting problem.
    The problem is rooted in our rules for financial reporting.
    Those financial reporting rules need deep and fundamental
    reform. Unless we change those rules, nothing will change.
    Today's crisis as portrayed by the surprise collapse of Enron
    is the same kind of crisis that arose in the 1970's when Penn
    Central surprisingly collapsed and in the 1980's when hundreds
    of savings and loan associations collapsed, which precipitated
    the S&L bailout by the Federal Government. There will be more
    of these crisis unless the underlying rules are changed.
        Under our current financial reporting rules promulgated by
    the Financial Accounting Standards Board, management of the
    reporting corporation controls and determines the amounts
    reported in the financial statements for most assets.
        Except for inventories and marketable securities, none of
    these amounts in the financial statements is subjected to the
    test of what the cash market price of the asset is. Yet, we
    know that most individual investors, and, in my experience,
    even many sophisticated institutional investors, believe that
    the reported amounts in the financial statements, in the
    corporate balance sheet, represent the current market prices of
    those assets. Nothing could be further from the truth.
        And under the FASB's definition of an asset, corporations
    report as assets things that have no market price whatsoever.
    Examples are goodwill, direct response advertising costs,
    deferred income taxes, future tax benefits of operating loss
    carry forward, costs of raising debt capital, and interest
    costs for debt said to relate to the acquisition of fixed
    assets. I call these nonreal assets. Today's corporate balance
    sheets are laden with these nonreal assets. This is the kind of
    stuff that allows stock prices to soar when in fact the
    corporate balance sheet is bloated with hot air. When it comes
    time to pay bills or make contributions to employees' pension
    plans, this stuff is worthless.
        The same goes for liabilities. Corporate management
    determines the reported amount of liabilities for such things
    as warranties, guarantees, commitments, environmental
    remediations, and restructurings. Again, this is as per the
    FASB's accounting rules.
        The upshot is that earnings management abounds. Earnings
    management is like dirt--it is everywhere. SEC Commissioners
    have made speeches decrying earnings management. Business Week,
    Forbes, Barron's, The New York Times, The Wall Street Journal,
    and the Harvard Business Review carry hand-wringing articles
    about earnings management. Earnings management is talked about
    matter-of-factly on Wall Street Week and on Bloomberg TV, CNBC,
    CNNfn, and MSNBC. Earnings management is a scourge in this
    country. Earnings management is common in other countries as
    well because their accounting rules, and the accounting rules
    promulgated by the International Accounting Standards Board,
    are much the same as ours.
        We need to put a stop to earnings management. But until we
    take control of the reported numbers out of the hands of
    corporate management, we will not stop earnings management and
    there will be more Enrons, more Waste Managements, Livents,
    Cendants, MicroStrategys, and Sunbeams, to mention only a few.
        Now how do we take control of the reported numbers out of
    the hands of corporate management? We do it by requiring that
    the reported numbers for assets and liabilities, including
    guarantees and commitments, be based on estimated current
    market prices--current cash selling prices for assets and for
    current cash settlement prices for liabilities.
        Let me just give you an example of what I am talking about.
    Pre-September 11, 2001, the major airlines, to the extent that
    they own aircraft instead of leasing them, had on their balance
    sheets aircraft at the cost of acquiring those aircraft from
    Airbus and Boeing. Let's say that that cost was $100 million
    per aircraft. The prices of those aircraft fell into the
    basement post-September 11 to about $50 million per aircraft
    and they remain there today although prices have recovered
    somewhat. Yet under the FASB's rules, those airlines continue
    to report those aircraft on their balance sheets at $100
    million and are not even required to disclose that the aircraft
    are worth only $50 million. Under mark-to-market accounting,
    the aircraft would be reported at $50 million on the airlines'
    balance sheets, not $100 million.
        I could give you many more examples, but I will add just
    one more. In the late 1970's, this country was experiencing
    great inflation. The Federal Reserve Board raised short-term
    interest rates dramatically. Long-term rates shot up. As a
    consequence, the market value of previously acquired
    residential mortgage loans and Government bonds held by savings
    and loan associations declined drastically. But the regulations
    of the Federal Home Loan Bank Board and the FASB's accounting
    rules said that it was okay for the mortgage loans and bonds to
    be reported at their historical cost. Consequently, the S&L's
    appeared solvent but really were not. This mirage allowed the
    S&L's to keep their doors open and in so doing they incurred
    huge operating losses because their cost of funds far exceeded
    their interest income on loans and bonds in their portfolios.
    Some of the S&L's decided to double-down by investing in risky
    real estate projects, also accounted for at historical cost,
    and proceeded to lose still greater amounts, which losses were
    hidden on the balance sheet under the historical cost label.
        Of course, when the Federal Government had to bail out the
    insolvent S&L's in the 1980's, the Federal Government paid for
    the losses that were hidden in the balance sheet under the
    historical cost label and the operating losses that had been
    incurred while the S&L's kept their doors open because of
    faulty accounting. Had mark-to-market accounting been in place,
    and had the Federal Home Loan Bank Board computed regulatory
    capital based on the market value of the S&Ls' mortgage loans,
    Government bonds, and real estate projects, the S&L hole would
    not have gotten nearly as deep as it ultimately did.
        Various Members of Congress have said in recent hearings
    about Enron, and I think it was echoed here this morning, that
    a corporation's balance sheet must present the corporation's
    true economic financial condition. A corporation's true
    economic financial condition cannot be seen when assets are
    reported at historical cost amounts. The only objective way
    that the true economic financial condition of a corporation can
    be portrayed is to mark-to-market all of the corporation's
    assets and liabilities.
        Recall my earlier example about the cost of aircraft being
    $100 million and the current market value being $50 million.
    Mr. Chairman and Members of the Committee, is there any
    question that the $50 million presents the true economic
    financial condition and the $100 million does not? Moreover,
    following today's FASB's accounting rules produces financial
    statements that are understandable only to the very few
    accountants who have memorized the FASB's mountain of rules.
    Indecipherable is the word Chairman Pitt has used in recent
    speeches. On the other hand, marking to market will produce
    financial statements that investors, the Members of Congress,
    and my sister, who also happens to be an investor, can
    understand.
        The various proposals that have been made to cure Enronitis
    will not cure the problem. The only cure, in my opinion, is
    mark-to-market. Now, you may ask, how much will it cost to
    mark-to-market? Can we afford to mark-to-market?
        My response is that we cannot afford not to mark-to-market.
    How much of the cost of the S&L bailout was attributable to
    faulty accounting? The amount is unknowable, but undoubtedly,
    was huge. How much does an Enron or Cendant or Waste Management
    or MicroStrategy or Sunbeam cost? The answer for investors is
    billions, and that does not count the human anguish when
    working employees lose their jobs, their 401(k) assets, and
    their medical insurance, and retired employees lose their cash
    retirement benefits and medical insurance.
        By some estimates, Enron alone cost $60 to $70 billion in
    terms of market value that disappeared in just a few months.
    Waste Management, Sunbeam, and all of the others also cost
    billions in terms of market capitalization that disappeared
    when their earnings management games were exposed. And these
    costs do not include the immeasurable cost--which has been
    referred to here this morning--of lost confidence by investors
    in financial reports and the consequent negative effect on the
    cost of capital and market efficiency.
        By my estimate, annual external audit fees in the United
    States for our 16,000 public companies, 7,000 mutual funds,
    7,000 broker-dealers total about $12 billion. Let's say that of
    that $12 billion, $4 billion is attributable to mutual funds
    and broker-dealers. Incidentally, mutual funds and broker-
    dealers already mark-to-market their assets every day at the
    close of business, and we have very few problems with
    fraudulent financial statements being issued by those entities.
    Mark-to-market works and is effective. That leaves $8 billion
    attributable to the 16,000 public companies. Assume that the $8
    billion would be doubled or even tripled if the 16,000 public
    companies had to get competent, outside valuation experts to
    determine the estimated cash market prices of their assets and
    liabilities. We are then looking at an additional annual cost
    of $16 to $24 billion. If we prevented just one Enron per year
    by requiring mark-to-market accounting, we easily would pay for
    that additional cost. And when considered in relation to the
    total market capitalization of U.S. corporate stock and bond
    markets of more than $20 trillion, $16 to $24 billion is,
    indeed, a small price to pay.
        So the question arises--who should mandate mark-to-market
    accounting? I respectfully disagree with Senator Gramm. And I
    recommend that there be a sense of Congress resolution that
    corporate balance sheets must present the reporting
    corporation's true financial condition through mark-to-market
    accounting for the corporation's assets and liabilities. Then I
    recommend that Congress leave the implementation to the SEC,
    much the way it is done by the SEC today for broker-dealers and
    mutual funds. There will be many implementation issues, so the
    SEC will need more staff and more money.
        I will be pleased to answer the Committee's questions.
        Thank you very much.
        Chairman Sarbanes. Thank you, sir, for a very interesting
    statement. We very much appreciate it.
        We will next hear from Michael Sutton, who is currently an
    independent consultant on accounting and auditing regulations
    related to professional issues. Mr. Sutton was the Chief
    Accountant of the SEC from 1995 to 1998. He has also been a
    special consultant to FASB. From 1987 to 1995, he was a member
    of FASB's Emerging Issues Task Force, and from 1983 to 1986, he
    served on FASB's Financial Accounting Standards Advisory
    Council. Mr. Sutton was National Director of Accounting and
    Auditing Professional Practice of Deloitte & Touche and a
    Senior Partner in that firm, earlier in his professional life.
        Mr. Sutton, we are very pleased to have you here.

                     STATEMENT OF MICHAEL H. SUTTON

                            CHIEF ACCOUNTANT

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1995 TO 1998

        Mr. Sutton. Chairman Sarbanes, Senator Gramm, and Members
    of the Committee, thank you for inviting me to appear today.
        First, I will comment briefly on my background and
    experience. I was Chief Accountant of the Securities and
    Exchange Commission from June 1995 to January 1998. Prior to
    holding that office, I was a Senior Partner in the firm of
    Deloitte & Touche, responsible for developing and implementing
    firm policy relating to accounting and auditing and practice
    before the SEC. My career with Deloitte & Touche spanned from
    1963 to 1995. As a retired partner, I receive a fixed
    retirement benefit from that firm. Presently, I undertake from
    time to time independent consulting and other assignments in
    the field of accounting and auditing regulation and related
    professional issues and I would be pleased to discuss those
    with you or the Committee staff. Currently, I am serving on an
    arbitration panel of the American Arbitration Association
    hearing a dispute not involving a public company.
        As we gather today, we find ourselves at a crossroads. We
    are searching for a way forward that will restore badly shaken
    investor confidence. To help put that into perspective, I would
    like to offer some essential views that I think we all can
    agree on.
        I think we all will agree that our capital market system is
    a national treasure. It is vital to the success of the economy.
    Indeed, our exceptional standard of living depends on its
    vitality. Accordingly, we all share a compelling common
    interest in assuring the strength and liquidity of those
    markets. This compelling common interest must shape our policy
    goals and guide our thinking as we search for solutions.
    Finally, the most critical, yet intangible, ingredient of a
    successful capital market system is the confidence of investors
    that the markets are fair--confidence that the information they
    depend on is trustworthy, confidence that they can make
    informed decisions and will not be misled.
        In our search for solutions, I believe we need to consider
    a wide range of possible reforms. Every idea has to be put on
    the table and examined closely. I have offered a number of
    those thoughts in my written statement and I will comment
    briefly today on just some of the key points.
        For independent auditors, I believe that the future begins
    with full acknowledgement of the reality that seems so clear
    today. Failures in our financial reporting system are more than
    aberrations--they seriously undermine investor's confidence in
    the institutions they are supposed to protect. They ``poison
    the well.'' Pleas that the vast majority of financial reports
    are sound, that most audits are effective, and that failures
    are few, miss the point. In capital markets, a single financial
    reporting failure can be a disaster, in which losses can wipe
    out decades of hard work, planning, and saving. In that
    context, debates about how many failures can be tolerated are
    not only nonproductive, they are also nonsense. To restore and
    maintain confidence in the independent audit, I believe that
    the auditing profession will need to do three things.
        First, it will have to embrace a role that is fully
    consistent with high public expectations. In public capital
    markets, insiders have an advantage over public investors. And
    in that arena, independent auditors are expected to balance the
    scales by ensuring investors that the financial reporting gives
    them a fair presentation of the economic realities of the
    business.
        Second, the auditing profession will have to tackle
    fraudulent financial reporting as a distinct issue with a
    distinct goal--zero tolerance. We understand that, in life,
    ``zero defects'' are almost never realized. Nevertheless, the
    public expects that the profession will pursue that end.
        Third, it will have to accept and support necessary
    regulatory processes that give comfort to the public that the
    profession is doing all that it can do to prevent future
    episodes.
        Regulatory processes that will build confidence in the
    auditing profession will be truly independent; they will be
    open; they will actively engage, inform, and involve the
    public; they will be adequately resourced and empowered to
    accomplish their mission; and they will be adaptable to change.
    I believe that the critical ingredients of those processes
    include timely and thorough investigations of circumstances
    that may involve fraudulent financial reporting; objective and
    fair assessments of the role and performance of the independent
    auditor; timely and meaningful discipline of those who violate
    accepted norms of conduct; regular oversight and periodic
    examinations of the policies and performance of independent
    auditors; and, timely and responsive changes in professional
    standards and guidance when a need for improvement is
    identified.
        In my view, those goals can be best accomplished through an
    independent statutory regulatory organization operating in the
    private sector under the oversight of the Securities and
    Exchange Commission. That organization should be empowered to
    require registration of independent auditors of public
    companies, establish quality control, independence, and
    auditing standards applicable to registered independent
    auditors, conduct continuing investigations of the accounting
    and the auditing practices of registered firms, undertake
    investigations of possible financial reporting failures, and
    conduct proceedings to determine whether disciplinary or
    remedial actions are warranted.
        To carry out those responsibilities, the Statutory
    Regulatory Organization, SRO, will need appropriate subpoena
    and disciplinary powers. As a starting point, we might consider
    reconstituting the existing Public Oversight Board as an SRO,
    expanding its mandate and powers to include the elements that I
    have outlined.
        With respect to accounting standards, we simply cannot
    tolerate financial reporting that hides the ball, and we cannot
    tolerate processes that are not responsive to critical
    financial reporting needs. Current rules for accounting for
    SPE's, for example, are nonsensical. They can only be explained
    by accountants to accountants. We have a right to insist that
    accounting standards clearly reflect the underlying economics
    of transactions and events. And it is not acceptable to sit by
    while market innovations outstrip the development of needed
    guidance.
        Criticism of U.S. standards is beginning to focus on the
    fact that they have become increasingly detailed, and arguments
    have been made that they should be broader statements of
    principle, applied with good judgment and respect for economic
    substance. I have sympathy for the desire to break the cycle of
    the mind-numbingly complex accounting rules that have become
    the norm, but to do that I think we have to confront
    realistically the reasons why our standards have evolved the
    way they have. Here are some of the underlying pressures at
    work.
        Business managers want standards that provide the greatest
    flexibility and room for judgment. They want to be able to
    manage reported results, but yet be able to point to an
    accounting standard that assures the public that they are
    following the rules.
        Dealmakers and financial intermediaries want standards that
    permit structuring transactions to achieve desired accounting
    results--results that could obscure the underlying economics.
    In that world, creative transaction structures are a valuable
    commodity.
        Auditors are pressured to support standards that their
    clients will not take issue with, and they often are restrained
    in their expected support for reporting that is in the best
    interests of their investors and the public.
        Others, including some of the legislators, too often lose
    sight of the fundamental importance of an independent and
    neutral standard setting process. Without independence and
    neutrality, standards setters cannot effectively withstand the
    myriad of constituent pressures that it inevitably will face to
    make the tough decisions that it inevitably will need to make.
        And then, standards setters too often seem to pull their
    punches, perhaps because of a perceived threat to the viability
    of private-sector standards setting, perhaps because of the
    sometimes withering strain of managing controversial change,
    perhaps because of a loss of focus on mission and concepts that
    should guide their actions.
        As we reexamine our processes, the debate shouldn't be
    whether accounting standards should be broad or detailed.
    Rather, about what formulation of standards and standards
    setting processes best accomplish the goal of providing capital
    markets with reliable and decision useful financial
    information.
        We need to reenergize our standards setting processes and
    the commitment of capital market participants to support a
    fully effective independent standards setting.
        Of critical importance is the urgent need for those who
    have the greatest stake in transparent financial reporting,
    buy-side analysts, those who invest for retirees and manage
    their funds, and other institutional investors, to take a more
    active role in the processes.
        We should provide independent funding for the FASB, funding
    that does not depend on contributions from constituents that
    have a stake in the outcome of the process. We also need a more
    independent governance process to replace the current
    foundation board. The leadership for these changes should come
    from visionaries of unquestioned objectivity and demonstrated
    commitment to the goals of financial reporting and the public
    interest. Perhaps the needed change could be best considered
    and carried out under the auspices of an independent commission
    made up of leading lights within the corporate governance
    movement, heads of investment funds and retirement systems,
    academic leaders who are grounded in business and economics,
    and former leaders of institutions responsible for capital
    market regulation.
        In closing, I would suggest that some very practical and
    effective first steps in reforming the system could come from
    improvements in corporate governance. I understand that you
    will be conducting hearings on that subject later this week,
    and I have included some thoughts in my written statement that
    you may wish to consider at that time.
        Thank you again for inviting me. I would be pleased to
    respond to your questions.
        Chairman Sarbanes. Thank you very much, Mr. Sutton.
        We will now hear from Mr. Lynn Turner, who is currently, as
    Senator Allard indicated, the Director of the Center for
    Quality Financial Reporting at Colorado State University. Mr.
    Turner was Chief Accountant of the SEC from 1998 to 2001. In
    the early 1990's, he was a partner at Coopers & Lybrand, was
    designated as the SEC consulting partner. From 1989 to 1991, he
    was a professional accounting fellow at the SEC. And prior to
    that, he held various positions at Coopers & Lybrand.
        Mr. Turner, we are very pleased to have you here today.

                      STATEMENT OF LYNN E. TURNER

                            CHIEF ACCOUNTANT

                U.S. SECURITIES AND EXCHANGE COMMISSION

                              1998 TO 2001

        Mr. Turner. Thank you, Senator Sarbanes, Senator Gramm, and
    Members of the Committee.
        I had the good fortune of joining this proud profession
    straight out of the University of Nebraska and Colorado State
    University as well, in 1976, and I served until 1999 with
    Coopers & Lybrand, as you mentioned, as a partner and as leader
    of their National High Technology Practice and as an SEC
    consulting partner for them.
        Then in the summer of 1996, I joined the larger
    international semiconductor firm, Symbios, Inc., which is
    located in Colorado, and served as their Vice President and
    CFO. So, my remarks are made from both sides of the table in
    that regard.
        I would also note that Symbios had been one of my clients
    at Coopers & Lybrand. Then Chairman Levitt gave me a call and I
    did have the good fortune of serving as the Chief Accountant at
    the Securities and Exchange Commission from 1998 to 2001.
        Now, I have the privilege of shaping the minds of students
    who are the future of the accounting profession, as an
    accounting professor at Colorado State University. I also
    provide training and education to Bloomberg, and most recently
    served as an expert witness for one of the Big 5 accounting
    firms.
        I commend the Chairman and this Committee for scheduling a
    series of hearings on finding effective solutions to the issues
    that confront the capital markets today; that have caused
    investors to lose trust; that have unfortunately painted both
    the unscrupulous and the honest with the same brush. It is
    important that the current systemic failures be corrected.
        While I was at the Commission, we began work on a staff
    report that identified concerns and issues surrounding the
    financial reporting and accounting profession. Due only to time
    constraints, we were unable to complete the report.
        I know there have been some implications that perhaps
    Chairman Pitt had tried to stop that and that is absolutely
    incorrect. It was only the time constraints.
        Yet the recommendations for improving the deficiencies in
    the quality of our financial reporting system are even more
    relevant today than when I left the Commission. These
    recommendations essentially are about one vitally important
    principle--independence. Independent governance and oversight
    of the accounting profession, independence of the accounting
    and auditing standard setting process, independent auditors and
    audit committees, and independent analysts.
        My written testimony provides the Committee with an in-
    depth discussion of the specific recommendations we would have
    made in the report if we had had time to do so. Let me
    summarize some of my written comments for you today.
        Independent audits provide investors with confidence that
    the numbers are accurate and reliable. Yet, today, the
    multitude of organizations often referred to in the press as
    ``alphabet soup,'' do not yield an efficient or effective
    quality control process for the audits. I have prepared a
    diagram of the current confusing and ineffective structure. It
    probably best could be described--take the top one off--okay.
    That is fine. Thank you very much. It is almost like a
    spaghetti picture.
        In light of these recent events that have called into
    question the independence and integrity of the accounting
    profession, and as Chairman Pitt has stated, we need to
    establish an independent public accounting regulatory oversight
    body for the accounting profession under the supervision of the
    SEC.
        It is important that this body have these critical
    elements: That it be conducted by an adequately funded
    independent organization; that members are full-time and are
    drawn from the public rather than the profession; that it has
    timely and effective disciplinary actions against those who
    fail to follow the rules, regardless of whether they are small
    or large firms; that it has the authority to issue auditing and
    quality control standards that establish a benchmark for the
    performance of quality audits and its disciplinary process; and
    that it inspects the work of auditors on an ongoing basis.
        Audit quality will be enhanced through effective
    independent inspections by the oversight board. The current
    system of firm-on-firm reviews by the large firms reminds one
    of grade school where the rule was--``I won't tell on you so
    long as you do not tell on me.''
        As a result, further recommendations continue to need to be
    implemented to improve audit quality. They include: The 200
    plus recommendations the panel on audit effectiveness made to
    the profession and accounting standards setters in August 2000
    need to be adopted as proposed, without being watered down; and
    auditing standards need to be established by an independent
    standard setting body.
        Auditors' independence has long been a hotly contested
    issue to the profession and the SEC. But after cases such as
    Waste Management and Enron, no longer are people asking,
    ``where is the smoking gun.'' Disclosures of consulting fees
    that run into tens of millions of dollars and multiples of the
    audit fees are generating an outcry for action.
        Once and for all, we need to adopt rules that will truly
    protect the independence and the integrity of the audit, and
    gain the public's confidence that the auditors are working for
    them, not for management.
        To accomplish that we need to: Close the revolving door
    between audit firms, its partners and its employees, and the
    company being audited. Require that in order for the auditor to
    be considered independent, the firm must be hired, evaluated
    and, if necessary, fired by the audit committee. Adopt a rule
    that allows the auditors to provide only audit services to an
    audit client, unless the audit committee makes a determination
    and discloses that the services provided by the audit firm are,
    one, in the best interests of the shareholders and, two, will
    improve the quality of the company's financial reporting.
    Prohibit an independent auditor from assisting a company design
    and structure transactions, as we have seen on Enron, then
    provide their accounting or tax opinion on what the appropriate
    accounting is for the transaction, and then audit the
    accounting for that transaction. Finally, require mandatory
    rotation of the audit firm every 7 years.
        Remember that investors have suffered their largest losses
    on audits of companies that did not involve an initial audit,
    but rather an ongoing relationship. And I do understand that
    Senator Durbin from Illinois will be introducing legislation
    later on today that will incorporate many of these features.
        It was in 1940, after the discovery of a large fraud at
    McKesson & Robbins that the Commission first encouraged the
    establishment of independent audit committees.
        In light of Enron and questions surrounding the oversight
    of its audit committee, recommendations that can further
    enhance the vital role and quality of audit committees include:
    The audit committee should, as I mentioned previously, directly
    hire, evaluate and, if necessary, fire the auditor. The
    exceptions provided for in the rules of the stock exchanges,
    which still permit an audit committee member who is not
    independent, should be eliminated. The definition of an
    independent director should be modified to prohibit the company
    from engaging the director for any services other than those
    provided as a director, and ban financial payments on behalf of
    the director, such as contributions to charitable organizations
    or similar types of payments.
        The audit committee should require the CEO and CFO to
    provide to the audit committee and investors a report by
    management that clearly states management's responsibility for
    establishing, maintaining and ensuring an effective system of
    internal control actually exists and is operating. If the
    executives are nervous about signing such a report, I suggest
    investors should be nervous about the numbers. The CEO and CFO
    should be required to sign and certify to the audit committee
    and investors, as is done in some foreign jurisdictions, that
    the financial statements comply with the applicable rules and
    include disclosure of all material information. There should be
    civil penalties for negligence and criminal and civil penalties
    for intentional misrepresentations to the public or to the
    auditors.
        Let me shift gears to the topic of U.S. accounting
    standards that was mentioned earlier.
        I would like to thank the Chairman and his staff for their
    unyielding support of our efforts during recent years as the
    SEC tried to improve the quality of financial reporting
    standards with our initiatives on earnings management and
    auditor independence.
        Senator Sarbanes, some days you were like an old oak tree
    out there I could grab hold of, and I thank you for that.
        I would also say Senator Dodd and some of his staff were
    very helpful at times, too.
        But the job of improving accounting standards is not
    complete. Our rules and standard setting process here in the
    United States requires significant improvements to provide
    investors and regulators with greater transparency.
    Improvements that need to be made include:
        Revising the structure of the Board of Trustees of the FASB
    to bring it in line with the Trustees of the International
    Accounting Standards Board currently chaired by former Federal
    Reserve Chairman Paul Volcker.
        Create an independent, no strings attached, funding
    mechanism for the FASB.
        The FASB needs to develop accounting standards in a timely
    fashion that reflect the reality of the actual economics of the
    underlying transaction.
        As Senator Allard from my own State of Colorado mentioned,
    he has recently highlighted the need for timely issuance of
    such standards and I, as I am sure other investors do, commend
    you, Senator, for that position.
        The Emerging Issues Task Force at the FASB should be
    restructured to require public representation and should not be
    able to pass a new rule without the explicit approval of the
    FASB, as they do internationally.
        The SEC should require that companies disclose greater key
    performance indicators that give investors greater predictive
    capability with respect to trends in the business.
        The SEC proposed new rules to increase the transparency of
    reserves and large writedowns in the value of assets such as
    plant and equipment. As the Association for Investment
    Management and Research has recently requested, the SEC should
    quickly issue final rules similar to those proposed. And I
    could not agree more with Chairman Pitt on the issue of we do
    need to get the plain English financial statements through the
    SEC's review process.
        Touching on the SEC, let me talk about the resources.
    People down there have responsibility for about 12,000
    actively-traded public companies who file 12,000 annual
    reports, 36,000 quarterly financial statements, thousands of
    additional initial public offerings, registration statements,
    proxies, and tender offers. There is another 4,000 or 5,000 of
    inactive companies that they have to oversee.
        Senators, it is physically impossible within their current
    budgetary handcuffs for the SEC to carry out their mandate to
    ensure full disclosure and timely enforcement of the laws and
    regulations. The words pay parity in an unfunded bill is a
    broken promise to thousands of dedicated public servants at the
    Commission. The Panel on Audit Effectiveness recommended the
    SEC provide additional resources to combating financial fraud.
    I hope Congress will respond to the Panel report and provide
    the necessary funding for the SEC staff.
        The statutory authority of the SEC also needs to be
    examined and beefed up as it relates to Rule 102(e)
    proceedings. Gaining timely access to the work papers of
    auditors in foreign jurisdictions, modifying Section 10(a) of
    the Security Acts to more narrowly redefine how the auditors
    view their responsibility for reporting an illegal act. And I
    also believe that the SEC should make changes to its rules for
    Form 8-K disclosures whereby if there is a termination of a CFO
    who quite often these days will lose their job if there is a
    miss on earnings management numbers, if they do not manage the
    numbers. We need to get disclosure out there as to whether or
    not those CFO's will be terminated over a disagreement
    regarding a financial accounting or disclosure matter.
        Now, I have discussed recommendations for standards
    setters, regulators, and preparers. Let me shift the focus for
    just a moment to education.
        Great people who are talented, well educated, and motivated
    make for great organizations, while weak people are nothing
    less than, as the television show aptly calls it, the weakest
    link.
        To assure the public accounting profession is able to
    attract and retain the best and brightest minds, we need to
    correct the lack of investment that the public accounting firms
    have made when hiring new personnel. And educators need to take
    concrete steps to integrate into the classroom a broad-based
    business and accounting curriculum.
        Hopefully, the recommendations I have made today have given
    you an understanding of what the SEC staff was striving for in
    their report to the Commission. As you can see, it provides a
    benchmark for measuring the progress, or the lack thereof, by
    the profession in making substantive, meaningful change. As you
    can also see from the attached chart, these recommendations can
    no doubt create a new system of simpler, less complex
    regulation in a reliable and effective system.
        Thank you.
        Chairman Sarbanes. Thank you very much, Mr. Turner.
        Our concluding panelist this morning will be Dennis
    Beresford. Mr. Beresford was the former Chairman of the
    Financial Accounting Standards Board from 1987 to 1997, and he
    is now Professor of Accounting at the University of Georgia's
    Terry College of Business. Before becoming FASB's Chairman in
    1987, Mr. Beresford was National Director of Accounting
    Standards for Ernst & Young.
        We are very pleased to have you here, sir. We would be
    happy to hear from you.

                    STATEMENT OF DENNIS R. BERESFORD

                            FORMER CHAIRMAN

                  FINANCIAL ACCOUNTING STANDARDS BOARD

                              1987 TO 1997

        Mr. Beresford. Thank you very much.
        Good morning, Chairman Sarbanes, Senator Gramm, and other
    Committee Members. I am Denny Beresford, from the University of
    Georgia. Thanks to former Governor, now Senator, Zell Miller, I
    am proud to say that Georgia is one of the great public
    universities in this country.
        Senator Gramm is also a proud graduate, I understand.
        I am also a retired partner of Ernst & Young. I am
    presently a Board Member of National Service Industries, a New
    York Stock Exchange listed company, and Chairman of the Audit
    Committee.
        I have provided expert witness services to several
    corporations and accounting firms. And perhaps of relevance, I
    was a short-term investor in Enron from November 5 to November
    14, and lost $7,000, due to my own stupidity and no one else's
    fault.
        [Laughter.]
        Like former SEC Chairman Arthur Levitt and certain other
    recent testifiers, I believe that Congress should not get
    involved in specific technical accounting issues. A case from
    my personal experience where Congress allowed itself to do so
    was the debate over accounting for employee stock options.
        Certain Members of Congress were sufficiently influenced by
    the appeals from corporate executives that they were persuaded
    to introduce legislation to counter the FASB's proposal. Most
    importantly, the legislation would have required that the SEC
    repeat the FASB's process on any new accounting proposals, thus
    effectively eviscerating the FASB. Faced with the strong
    possibility that its purpose would have been eliminated by this
    legislation, the FASB made a strategic decision to require
    companies to disclose the effect of stock options in a footnote
    to the financial statements but not record the expense in the
    income statement. Thus, the FASB compromised only under
    Congressional pressure that would have effectively legislated
    it out of business.
        The FASB holds a public trust and Congress is entitled to
    examine how the Board is carrying out that duty, particularly
    in trying times like those at present. However, my view is that
    Congress' primary role in this area should be to see that the
    FASB is fulfilling its public obligations appropriately.
    Congress ought not to interfere with individual technical
    decisions.
        While the SEC has enforcement powers to correct reporting
    that is identified as being inappropriate, it does not have the
    resources to review all companies' reports and determine their
    propriety, as has been indicated already. It must rely on the
    private sector, including corporate executives and independent
    auditors, to do the right thing. There must be a high degree of
    trust among regulators, reporting companies, and auditors for
    the reporting system to work best. Therefore, I commend
    Chairman Pitt and Chief Accountant Herdman for their recent
    efforts to create a more positive environment in which all
    interested parties can work together to improve both individual
    companies' reporting and the overall system.
        At the same time, I am confident that the SEC will continue
    to act decisively when individual companies or their auditors
    have not performed in a satisfactory manner.
        Many of the commentators about the current state of
    financial reporting say that it takes way too long to develop
    accounting standards. I agree 100 percent. I believe that the
    FASB could reach earlier resolution on many projects by
    streamlining its internal processes in at least three ways.
        First would be to limit the content of FASB's standards to
    the most significant matters related to the issues in question.
    Dealing with great detail not only takes more time, it also
    leads to lengthy and complicated accounting standards that
    actually may result in less desirable outcomes.
        Second would be for the individual board members to not
    strive for what they personally believe are conceptually pure
    answers when doing so would significantly delay finalizing
    guidance for practitioners. A timely answer is better than an
    arguably more theoretically pure one delivered at a much later
    date.
        Third would be to increase the size of the FASB staff by 10
    to 15 people. This would almost certainly allow projects to be
    considered more rapidly. Additional funding and candidate
    identification are tough challenges, but the trustees of the
    Financial Accounting Foundation should consider these to be
    critical objectives in order to allow more timely attention to
    important accounting issues.
        Notwithstanding the complexities of today's business world,
    one of my major concerns is that accounting rules and
    regulations have become far too complicated. That has added to
    the burden of those who are reasonably informed and are
    reasonably diligent about studying corporate reports. It is
    time to step back to see if more general standards can work as
    well or better.
        Accounting standards are necessary in order to cause
    reports by various companies to be reasonably comparable.
    Similar to the rules of football, without some standardized
    approaches to accounting, sorting out the winners and losers in
    the business world would be much more difficult. However, like
    the compromise over Instant Replay for NFL games, often the
    parties involved in the process are willing to accept fewer or
    less specific rules so that the game flows more smoothly but
    still within some appropriate boundaries.
        The overemphasis on detail will not be reversed overnight.
    However, over time, this is something that I believe the FASB
    must strive for.
        In spite of the fact that the real issues in the Enron
    matter had to do with a lack of substance in certain
    transactions, attention has centered on the accounting for
    SPE's, largely because they were the vehicles used to obscure
    the transactions' substance. SPE's are included in the scope of
    a FASB project on consolidation. A few months ago, the Board
    agreed that it would concentrate its near-term efforts related
    to the consolidation project on SPE matters.
        I am sure all of you have wondered why it has taken so long
    to resolve the general consolidation matter.
        Control is a very hard notion to define in a way that can
    be applied consistently in practice. With each iteration of
    definition and supporting implementation guidance, the FASB has
    ultimately concluded that consistent application in practice
    was unlikely.
        Beyond these operational challenges, there is the matter of
    what reporting actually best serves users of financial
    statements in this area. For example, should a real estate
    operator have to consolidate all of the limited partnerships in
    which it serves as a general partner and arguably has control,
    even when its interest in each partnership is only 1 percent?
        Consolidation is only one matter relating to the overall
    topic of so-called off balance sheet financing that was
    mentioned earlier. At the extreme, this could include very
    simple executory contracts such as the University of Georgia's
    agreement to employ me for the next school year. Should Georgia
    record an asset for the value of my future services and a
    liability for the amount the University has agreed to pay me?
        I hope there is a match between those two things, by the
    way.
        [Laughter.]
        Most accountants probably would say, no, because this
    contract involves both future services and future payments. But
    that is also the case for most of the off balance sheet
    financing arrangements that have been criticized recently.
        A key reason why many of these arrangements are allowed to
    be kept out of balance sheets at present is that the company
    does not own the asset in question. A third party has legal
    title to the asset and often, but not always, has agreed to
    make it available over time to the company. If you have signed
    a lease for an apartment in Washington for the next year, do
    you consider that to be an asset? I suspect that most of you do
    not, and corporations often feel the same way about their
    future obligations.
        These have been tough accounting issues for some time. It
    is very appropriate for the FASB to seek quick improvements for
    SPE's, but broader topics like off balance sheet financing
    require careful study.
        As stated earlier, I am in favor of less complicated and
    less detailed accounting principles, which is the approach
    being pursued by the International Accounting Standards Board
    that you heard from 2 weeks ago.
        That said, it is important to note that, on balance, our
    U.S. financial reporting system remains the best in the world
    because of the combination of comprehensive accounting
    principles, required audits by independent accountants, and
    vigorous regulation and enforcement by the SEC.
        The IASB activity should be commended and supported by U.S.
    parties. However, no action should be taken in the near-term
    that would have the effect of watering down Generally Accepted
    Accounting Principles in our country simply for international
    convergence.
        My full statement also includes comments on funding of the
    FASB and composition of audit committees. However, in the
    interest of time, let me summarize by saying that this is a
    critical time for financial reporting and the auditing
    profession. It is important that the issues raised by the Enron
    matter and other recent business, accounting, and auditing
    failures be studied and be used to evaluate what changes can be
    made to improve the system.
        However, it is equally important that the baby not be
    thrown out with the bath water. The current system is not
    foolproof, but it works well in the vast majority of cases.
    Consideration of changes should call attention to and build on
    the strengths of the current system.
        Thank you.
        Chairman Sarbanes. Thank you, Mr. Beresford.
        I would like to ask the panelists if this is do-able, to
    outline very briefly what you think the structure should be in
    terms of how we monitor the accounting profession, both in
    terms of how the standards are set and how we survey or monitor
    the practice of the profession. What should the structure be,
    if you could just set that out for us briefly? I will just go
    right across the panel.
        Mr. Schuetze. Well, Mr. Chairman, we have had some 60 years
    of experience with private-sector standard setting in both
    accounting and auditing. When I look back over the some,
    approximately 40 years that I have been involved in the process
    since 1957, it is clear to me that private-sector standard
    setting has not worked. I am sorry to say that, but I think it
    has not worked.
        So as I recommended in my testimony, I think that there is
    a sense of the Congress to require mark-to-market accounting. I
    keep coming back to mark-to-market.
        Mark-to-market is extremely simple. Now it is not that easy
    to do in some cases, but it is extremely simple. And if we had
    a sense of the Congress that there should be mark-to-market in
    order to portray the true economic financial condition of
    corporations, and then leave the details and the implementation
    to the SEC, I think that solves a large part of the problem, 70
    to 75, 80 percent of the problem.
        Now, admittedly, there will be the continuing problems with
    the auditors, and I would recommend that that also be left to
    the SEC to deal with as the SEC sees fit, and then have the
    SEC, as it already does, report periodically to the Congress as
    to what----
        Chairman Sarbanes. I take it that your structure would in
    effect have a significant expansion within the SEC in terms of
    how it interacts with the profession. Is that correct?
        Mr. Schuetze. Well, mark-to-market is so simple. It is so
    simple, that you really do not need much more once you have
    that broad principle laid out. You do not need much
    implementation guidance. You do not need much regulation beyond
    that, I do not think.
        Now maybe in practical terms, the SEC would find that, day
    to day, there would need to be some guidance from the SEC. But
    I would leave it to the SEC to do.
        Chairman Sarbanes. Would your system have a FASB or a
    Public Oversight Board or anything like that?
        Mr. Schuetze. I don't think so.
        Chairman Sarbanes. Okay.
        Mr. Sutton.
        Mr. Sutton. With respect to the auditing profession, the
    profession has had decades--it has been on notice for decades--
    that its self-regulatory processes are not working and they
    have not improved, they have gotten worse.
        So my suggestion for the auditing profession is to
    establish an independent statutory regulatory organization--
    independent from the AICPA and the practicing profession and
    that has the requisite authority and powers to do that job
    effectively.
        With respect to the accounting standards, I said that what
    we need to do is reenergize and strengthen the process that we
    have by making it as independent as well as capable as it can
    be, in the process. And to foster that independence I suggested
    two things. One is funding, take control of the money away from
    those who want to manipulate the system. And two, have a truly
    independent governance process. If you do that, I think we
    would have a chance of getting better and more timely answers
    from the FASB.
        Chairman Sarbanes. Would the statutory board for the
    auditing standards also be the entity that monitored the
    application of those standards by the auditors?
        Mr. Sutton. I think that would be done indirectly through
    the oversight of the auditing profession. The auditing of the
    application of accounting standards, I think, would be as it is
    today--under the oversight of the SEC. So the registrants would
    be overseen by the SEC in their applications. But indirectly,
    through the oversight of the auditing profession, there would
    be some oversight there.
        Chairman Sarbanes. Mr. Turner.
        Mr. Turner. First, let me start off by saying that I harken
    back to some of the words that Senator Gramm said at the
    beginning of the hearing. He expressed the view that Congress
    should not be involved with accounting standard setting, and on
    that point, we could not agree more, Senator. I think Congress
    getting involved, explicitly or implicitly, is bad.
        I know at the Commission, even though we had an oversight
    responsibility, I remember a couple of times we were asked by
    the business community to overrule their standards explicitly.
    I think some of that was at your urging as well. We did not do
    that. I think keeping the politics out of the standard setting
    process is absolutely right. And you stood tall on that and
    certainly Chairman Levitt and I appreciated that.
        As far as the actual oversight body of the accounting
    profession, what I think I would do is take this spaghetti
    chart and if you create a single oversight board with auditing
    standards, quality control and the right to do inspection in
    it, then you can turn around and--if you would put up the next
    chart. You can take that spaghetti chart and turn it into
    something like this.
        I think there is just one question with respect to this
    chart, and that is, on the Financial Accounting Standards
    Board, do you leave it out still underneath an independent set
    of trustees?
        Right now, we really do not have an independent set of
    trustees like we have for Chairman Volcker in the International
    Accounting Standards Board, and I think we need to get that.
        So it is just a matter of do you use the Independent Public
    Oversight Board as independent trustees for the Financial
    Accounting Standards Board, or set up a separate set of
    trustees just to advise the current trustees and leave that
    structure in place?
        But aside from that, this is pretty much the structure that
    you would get, and it is much simpler, much more effective. I
    think it is going to be able to act much more timely and
    without a lot of the bureaucracy that we currently have.
        Chairman Sarbanes. So, you would establish that structure
    by statute?
        Mr. Turner. Yes.
        Chairman Sarbanes. And establish the funding of that
    structure by statute?
        Mr. Turner. Yes. Both of those would take statutory moves.
        Chairman Sarbanes. Mr. Beresford.
        Mr. Beresford. I will speak mainly in the accounting area.
    I feel obligated to offer a competing point of view from Walter
    Schuetze's, my good friend. Market value accounting is not
    simple.
        Chairman Sarbanes. That is why we have these panels.
        [Laughter.]
        Mr. Beresford. The FASB has been working on the definition
    of market value for 8 to 10 years. Now some could say that just
    shows that the FASB is too slow, but it is a very complicated
    issue and it works well when you can look it up in The Wall
    Street Journal. But beyond that, as Enron and some other
    situations have shown, it is much more problematic.
        I think that it is an overstatement to say that the
    International Accounting Standards Board has an independent set
    of trustees and that the FASB financial accounting foundation
    organization does not.
        Those things are always a question of degree. During my
    term at the FASB, through some pressures, frankly, that Arthur
    Levitt applied to the trustees, there was a reorganization. We
    appointed several new trustees that were more public in nature
    in that they did not represent a particular constituency like
    the auditing profession or reporting corporations and so forth.
        I think it is a fine group of individuals. I think there is
    a need to balance those who are interested and directly
    involved in the activity, as is the case in the international
    group right now, with those who are trying to serve the public
    interest and do not have quite as much of a vested interest in
    the outcome of the thing.
        So, I think that this is the kind of thing that I am
    reasonably happy with the way it is right now, as long as we do
    not digress or do not go back to a situation where there was
    too much special interest type representation on the FAF.
        I would be happy to talk more about funding, but I think
    that is a different subject that you might want to get to
    later.
        Chairman Sarbanes. Thank you very much. My time has run
    over, but the panel is being very helpful.
        Senator Gramm.
        Senator Gramm. Thank you, Mr. Chairman.
        Let me say, Mr. Beresford, that I agree with you that Zell
    Miller is the reason that Georgia now has two great public
    universities.
        All over America, States instituted lotteries and then took
    the money from the lottery and put it into the general budget
    where all money is fungible, and the money ended up being spent
    on everything except education. Only in Georgia did the money
    go to the student. As a result, my guess is that in the next
    rating, Georgia Tech will be one of the top 10 public
    universities in America, an extraordinary change.
        I wanted to concur with your assessment of Senator Zell
    Miller's leadership.
        Rules make a difference. They make a profound difference.
    Your example is one of them. What we are talking about here is
    another.
        Chairman Sarbanes. Actually, this is a classic example of
    how the elevation of an institution which Governor Miller
    helped to accomplish, accrues to the benefit of even the
    previous graduates of the institution.
        [Laughter.]
        Senator Gramm. That is right. You have two University of
    Georgia graduates on this Committee.
        [Laughter.]
        In fact, I took two courses in accounting. And other than
    lack of personality to be an accountant, the practice set in
    that second course convinced me that I did not want to do
    accounting.
        [Laughter.]
        But I benefited from those two courses.
        Mr. Beresford. That is why we have cut that requirement
    out.
        Senator Gramm. Oh, have you? Good.
        [Laughter.]
        I want to touch on a couple of things. Lynn, I want to
    thank you for your kind comment. I guess we are all affected by
    the lives we have lived.
        We have had several dozen bills introduced since I have
    been in the Senate that were aimed at mandating accounting
    standards and overriding FASB. I think that is potentially very
    dangerous. And in each and every case, as Chairman and as a
    Member of this Committee, while I, for example, never
    understood FASB's decision about stock options, I thought
    whatever they decided was far preferable to Congress voting on
    it.
        I would say that when we looked at the whole acquisition
    and mergers, that one of the things that we tried to do was to
    move toward mark-to-market. In terms of a general valuation of
    the assets required, I am not sure exactly how you would do
    that. But as a concept, I think it is a powerful concept.
        I want to ask my first question on the whole idea of
    funding. Let's just say for a second that we decided to have an
    independent board that set accounting standards that oversaw
    the implementation of those accounting standards, that had some
    real power in terms of power to subpoena. How would you fund
    it?
        I guess I would say in posing the question, that I am
    fearful about taxpayer funding because--you know, each of you
    felt the necessity to tell us where you were earning income. I
    would not want to hear from people who somebody was not paying
    them for their opinion.
        But Government funding carries its own problems in terms of
    political influence. And I would like to ask each of you, if
    you had made the decision, whether you are for it or not, to
    have the independent board, how would you fund it? Do you share
    concerns about public funding?
        Mr. Schuetze.
        Mr. Schuetze. Well, I wouldn't have this board.
        Senator Gramm. Okay. But if you had it, how would you fund
    it?
        Mr. Schuetze. I think you run into a Hobson's Choice there.
    You have the SEC. Commissioners are paid, what? $135,000.
    Senior staff are paid $130,000. If you are going to have this
    board, the current FASB is paid $430,000. How can you pay a
    board $400,000 when you have the SEC being paid $130,000? What
    kind of people are you going to get at the SEC?
        Senator Gramm. That is a question about funding at the SEC.
    I was the original----
        Mr. Schuetze. Well, wait a minute. If you limit the SEC
    salaries to the salaries that you personally get of--what is
    it, $145,000, $150,000, $175,000? And this board is being paid
    $400,000. What does that say about your salary?
        Senator Gramm. Look. I want good people on this board. In
    fact, $400,000 sounds perfectly reasonable to me. Maybe too
    little. I am in favor of giving the SEC more power to pay
    higher salaries. I think we get a very false economy by not
    hiring the best people.
        Mr. Schuetze. Then give the SEC pay parity, increase their
    budgets so that they can do more and better jobs. But do not
    create another body that is going to compete with them.
        Chairman Sarbanes. Do you regard this as a competition?
        Mr. Schuetze. I did not see that chart until just this
    morning. My eyesight is not good enough for me to see it.
        Chairman Sarbanes. Okay. You could have the SEC and then
    have beneath it these sort of----
        Mr. Schuetze. My experience tells me that private-sector
    standard setting doesn't work, and I recommend that you all not
    do it.
        Senator Gramm. Okay.
        Mr. Sutton.
        Mr. Sutton. With respect to the oversight of the auditing
    profession, let me separate them briefly. Whether they go under
    one organization or two organizations, I think is another
    discussion.
        But with respect to the oversight of the auditing
    profession, the auditing profession has been given a valuable
    franchise. I think it is reasonable to expect them to pay a fee
    to be a registered auditor of public companies. That would
    adequately fund that oversight.
        And with respect to the accounting standard setting
    process, the benefits are more broad than that. I would like to
    see some enlightened people figure out how to endow it--it is
    not that big of an expenditure on an annual basis when you
    compare it certainly to the damage that is done from bad
    accounting or other Government spending. But I would suggest
    that we look first at ways to endow it so that it doesn't have
    to have the fund-raising activity.
        Mr. Turner. Senator Gramm, I agree with you on the public
    funding issue. When you tie some of this into public funding,
    you again get Congress and politics involved, and that could
    have some very negative implications. So, I agree with you on
    the funding.
        On the oversight board itself, currently, the accounting
    profession funds that on their own. The accounting profession
    pays fees into the AICPA and it provides them to the various
    groups that is on the spaghetti chart and that funds it.
        I see no reason if you require the firms to register with
    this SRO, and part of the registration is that they have to by
    statute pay their fees. We just turn around and have those
    fees, instead of going to the AICPA, have those fees come into
    here.
        I think actually in a private-sector body, you will be able
    to attract some very good talent and I think that is very good.
        As a CFO, I found that the private-sector standard setters
    did a very good job and even as the CFO, wrote to my Members of
    Congress urging them to let it work.
        Nothing's perfect. As Denny said, we do have, though, the
    best system that there is in the world, bar none.
        I have seen both as a CFO and as an audit partner the
    quality of the systems in the other part of the world. I have
    gone through the Asian crisis up close and personal, very
    close, and I know we are much better. So, I would have to say
    that history has shown that we are much better, and I would do
    it.
        As far as funding the FASB and providing it the resources
    that it needs, I think you can tag on a fee that is either
    assessed to the members of the stock exchanges and/or issuers,
    and that would turn around and provide it the resources it
    needs, because one of the problems it has is they only have 40
    or so people up there.
        It is all resource-constrained. And in light of the crown
    jewel that our markets are to us today in providing capital and
    providing jobs and opportunities for people, I think that is a
    reasonable source of funding.
        Mr. Beresford. Again, speaking of the FASB specifically, we
    were not really resource-constrained in the sense we would have
    done X-more things if we had had Y-more dollars. That was not
    really an issue, although I think we could have moved some of
    the projects along more quickly, as I indicated, with more
    staff.
        The process right now involves about two-thirds of the
    funding being raised by selling our own publications, largely
    to accounting firms, but to corporations and libraries and
    other people like that. So it is a commercial operation of
    sorts. And about one-third from voluntary contributions. Those
    are spread over about a thousand public corporations and
    hundreds of accounting firms and practitioners and so forth.
        Frankly, that seems to me to be kind of a nice balance
    because it provides some amount of independence in the sense
    that the Board has a commercial operation, but it also provides
    a bit of a market test that if the Board was getting so far out
    of touch with its constituents--the business community, the
    accounting firms, the users of financial statements and so
    forth, that people were simply unwilling to provide any
    financing in the future, then I think that would be a strong
    signal.
        I think that it is important that the Board be reasonably
    independent and also be subject to oversight by the SEC, which
    has always been excellent as far as I was concerned. But also
    participate in the process and such in a way that can be open-
    minded and not arrogant, not be so isolated that the rulings
    come down from on high and are not received with some degree of
    acceptability by the business community.
        We have a term called Generally Accepted Accounting
    Principles, which really means, generally required accounting
    principles. Companies have to follow them. They have no real
    choice in the matter. But by calling them generally accepted,
    that indicates at least some degree of participation, which
    there is plenty of, but also at least some degree if they
    really agree with the final outcome.
        Senator Gramm. Thank you.
        Mr. Chairman, my time is up.
        Chairman Sarbanes. Thank you.
        Senator Miller.
        Let me just say, since we have had this extensive promotion
    here for the University of Georgia, that the University of
    Maryland is also a very fine academic institution.
        [Laughter.]
        Senator Miller. Thank you, Mr. Chairman, and I thank
    Senator Gramm for his very generous remarks.
        I guess I will have to wait until later in the day to see
    how I pay for that.
        [Laughter.]
        But I appreciate it very much. I appreciate all of your
    testimony. It has been very, very informative.
        Mr. Schuetze, I want to explore this a little bit more
    because I am intrigued, but I am not yet convinced. Tell me
    how, in your opinion, if we had had mark-to-market accounting,
    if we had had that in effect, how would that have affected the
    Enron situation? In particular, the SPE's?
        Mr. Schuetze. I have not looked at Enron, so I cannot
    comment on that. But let me just deal with the SPE situation
    conceptually.
        The Financial Accounting Standards Board a couple of weeks
    ago tentatively decided that it is going to change the 3
    percent minimum investment to 10 percent. And if that 10
    percent minimum investment is not met by an outside party, then
    the assets and the debt have to be consolidated. I will tell
    you what that is going to do. It is going to corrupt and
    contaminate the asset side of the balance sheet by putting on
    there an asset that the enterprise doesn't own and cannot sell.
        Now why would you want to do that?
        Well, the FASB is going to do it because everybody up here
    is saying that we have to get the debt on the balance sheet.
    That is not correct. You cannot put on the balance sheet an
    asset that you do not own and cannot sell. That corrupts and
    contaminates the assets of the corporation.
        The trick, under mark-to-market accounting, is to find the
    market price of the guarantees that the enterprise has made to
    pay the debt of the SPE. What would Goldman Sachs charge to
    stand in the shoes of the enterprise to pay off that guarantee?
        That is where mark-to-market accounting is so simple and it
    works. You do not put on the balance sheet an asset you do not
    own and cannot sell. You put on the balance sheet the market
    value of your guarantee. That is what SPE's are all about. That
    is how it works. It is deceptively simple and it is so
    effective. And it works. I hope that answers your question.
        Senator Miller. Does any panelist have any comment on that?
        Mr. Schuetze. What the FASB is going to do is corrupt the
    balance sheet by putting on assets that you do not own and
    cannot sell. You cannot do that.
        Senator Miller. Mr. Turner, and then I want to hear from
    Mr. Beresford.
        Mr. Turner. After I got my accounting class out of the way,
    I went and took some series of six economic classes. I did not
    stop at two, but made it all the way through six. And one thing
    that you learned is that relevant information for people is
    what is the current value of something today.
        If I had something that I paid $1,000 for 5 years ago and
    it is worth $5,000 today, people are probably going to want to
    know what it is worth today and what I can realize out of it.
    And so, the concept of fair value accounting and the concept of
    putting these things on your financial statements at fair value
    I think is very good and I do not think that I would have had
    any problem with that as a CFO. I think it probably would have
    put better information out there for me to manage my business
    with, which is what is most important. That is what you get out
    of that.
        But I do know, on the other hand, that trying to come up
    with the values for some of the derivatives that we would enter
    into and trade in, and some of the other financial instruments
    that are dealt with in the market today, if they are publicly-
    traded, it is very easy to get those market values. If they are
    not the type of derivatives that you see traded on Wall Street,
    there is a portion of those that are not. Those are not simple
    to value. It is not real easy and it is not real easy, quite
    frankly, for the auditors to verify that.
        So one, I think moving in that direction is very positive.
    It is really good. It really reflects economics in underlying
    transactions and I think that is what we ought to get to.
        On the other hand, until we get some real good guidance on
    how we are going to mark some of these to model and make sure
    that those are reliable numbers, if we can get that, then I
    would agree with Walter, let's go. But we need to make sure
    that we have good, reliable numbers before we go.
        Mr. Schuetze. But you go ask Senator Corzine the amount of
    money that he would pay for it when he was Co-Chair of Goldman
    Sachs, he can give you the number.
        Senator Gramm. Well, unfortunately, he left.
        [Laughter.]
        Mr. Schuetze. Senator Corzine dealt in over-the-counter
    instruments every day, hour-by-hour. He knows how to price
    those instruments.
        Mr. Sutton. What is being manifested here right now is the
    fact that there are different notions of what assets and
    liabilities are.
        Now, my response to your question would be, we need
    accounting that can be understood, not just by accountants, but
    by economists and business people and investors. And I cannot
    explain to anyone except an accountant why the debt of an SPE
    is not on the balance sheet. I think that is the bottom line.
        Senator Miller. Mr. Beresford.
        Mr. Beresford. Senator Miller, I think your question was,
    would mark-to-market accounting have somehow disclosed Enron's
    problems sooner? My answer is no.
        Senator Miller. My time is up. Mr. Chairman, thank you.
        Chairman Sarbanes. Thank you, Senator Miller.
        Senator Enzi.
        Senator Enzi. Thank you, Mr. Chairman.
        While we are getting in plugs for universities, I have to
    mention George Washington University, which is where I went to
    college. My advisor was a Professor E.J.B. Lewis, who was the
    Editor for the Governmental Accountant magazine.
        I thought that I received too much governmental accounting
    because I was going into business and would never need that
    sort of thing. Then I came here and found out that that was
    mostly what I needed. It is kind of good to be getting back to
    some business accounting again.
        When I came today, I expected to have a delicious, four-
    course dinner of accounting information. And it exceeded my
    expectations. It turned out to be four delicious desserts.
        [Laughter.]
        It was a bit of an overload, though. I do appreciate you
    having written testimony in the longer, more extensive form.
        Mr. Schuetze, I appreciate the two additional, very learned
    documents that you included. We do not get to talk about
    something that sounds as simple as what are assets and
    liabilities. And I am sure that today, we have given some
    people some insight into how complicated all of these things
    are, even though they sound very simple at first.
        A difference that I noticed with this panel today from any
    other that I have heard since I came to Washington, is all of
    you gave some disclosures before you started testifying.
        [Laughter.]
        I do not know if that is just an accounting thing or what.
        [Laughter.]
        I do appreciate that. Mr. Beresford, your example of an SPE
    using your teaching contract, extremely helpful, showing the
    future value offset by the amount that the university has to
    pay you. And just from what I have read from your testimony and
    heard today, I expect that the university comes out very well
    on that.
        Mr. Beresford. Thank you.
        Senator Enzi. I would love to take a course from you
    sometime.
        With your involvement in FASB, though, can you give me some
    insight into why it has taken so long to finalize the FASB
    consolidation policy?
        Mr. Beresford. I tried to mention that briefly. It was a
    combination of disagreement over what represents control.
        I think in my longer statement I mentioned that we met with
    David Ruder, who was then Chairman of the SEC, early in the
    project. And he said, good luck. The SEC has been working on
    that definition since 1932 or so, and still has not come up
    with something completely satisfactory.
        And then, second, what information was of most usefulness
    to users of financial statements?
        You have already heard within our panel disagreements on
    whether more or less consolidation of some of these entities
    would provide more useful information. Beyond that, frankly,
    the process is one where the board members listen very
    carefully to a wide range of views from preparers, auditors,
    users of financial statements, regulators and so forth, and
    develop their own personal views. We simply had an impasse on
    the question of what represented control for a long period of
    time.
        During the time that I was Chairman, the voting
    requirements were changed by the trustees of the Financial
    Accounting Foundation. There are those who feel that that
    wasn't necessarily a change for the better.
        We previously had a requirement that only four out of seven
    board members had to approve something and it was changed to
    five out of seven, a super-majority requirement. That certainly
    slowed things down on some of the projects. I am not saying
    that it was the thing that finally caused us not to resolve
    that more timely, but we simply could never get five board
    members who agreed that we had a sufficiently operational
    answer with respect to what does control represent and whether
    the resulting information would really be an improvement versus
    a bright line test that we have right now that you have to have
    more than 51 percent ownership.
        I recall having a brief conversation with Lynn Turner on
    this and his sharing with me at the time that the SEC was very
    concerned about lots and lots and lots of disagreements with
    auditors and corporations if the board had gone with at least
    one of the various iterations in that project.
        So notwithstanding all of what I have said, I tend to be a
    pragmatist and I think the Board needs to figure out a way to
    resolve issues and come up with the best possible answer, even
    if it is not going to satisfy everyone on a more timely basis.
        Senator Enzi. A major point that other panels we have had
    on FASB has been changing so that it stated a principle and
    then gave examples and guidelines. As a final part of the
    process of auditing, the audit report would include a statement
    that the principles were met, not all of the detailed rules--
    getting way from the 830 page rule and getting to a goal that
    would be attested to by the accountant. I would be interested,
    since the nonaccountants all suggested that, in what the
    accountants would say about it. I appreciate all your help.
        Chairman Sarbanes. Thank you very much, Senator Enzi.
        Actually, it would be extremely helpful to the Committee if
    the panelists could make themselves available to us for a
    further interchange. We have to obviously digest these
    statements very carefully. But there is a tremendous amount of
    knowledge and wisdom at the table, and we would hope to be able
    to draw on it.
        We appreciate that very much.
        Senator Stabenow.
        Senator Stabenow. Thank you, Mr. Chairman.
        I too have numerous questions and will just speak to a
    couple of them at this point.
        Clearly, we are all very interested in looking for the best
    way to make sure that there is integrity in the system. There
    is transparency, there is confidence in the system for
    investors, for employees. And all of the pieces that you have
    talked about today raise important issues regarding the best
    way to make that happen.
        When we look at an independent oversight board, I wonder if
    each of you could speak to the question of who should sit on
    that board? Some people have said that there should not be any
    members of the accounting profession on the board. Others have
    said there should be.
        I noticed, Mr. Turner, you embraced the British model that
    has no members of the accounting profession on the board.
        I wondered if others on the panel would like to
    specifically address whether or not you believe that an
    independent oversight board should include members of the
    accounting profession.
        Mr. Schuetze. Well, as I said, I wouldn't support such a
    board. But if we had to have one, I would opt for having a
    preponderance of public members as opposed to professional
    accountants on it.
        Senator Stabenow. Yes.
        Mr. Sutton. The model I would support would have these
    board members separating their ties to their former positions,
    whatever they might be. In other words, truly, someone who
    comes out of the private sector business and goes into the
    private sector regulatory process and is compensated for doing
    that.
        Having done that, which is the model for the SEC, I would
    say that we need to get the best people for those positions
    that you can find. Background might be important to consider.
    And like Mr. Schuetze, I would be a little uncomfortable if the
    preponderance of the members came from the accounting
    profession. But assuming that the board is established as an
    independent board, separated from the profession, then I would
    say get the best people you can.
        Senator Stabenow. Mr. Turner, would you want to respond any
    more to the British model that you spoke of ?
        Mr. Turner. In the British model, which was set up as a
    result of some business accounting audit issues over their
    failures, the accounting profession actually took the lead over
    there and come up with the model that they took to the
    government.
        Their oversight board--it is called the foundation--is
    entirely members from the public, very prestigious some of
    those members from the public are. The notion is you really
    want public oversight because that is who the ultimate client
    is here, the public.
        I think that is a very good approach. I think it is very
    similar to what the Congress established with the SEC. You make
    them all full time.
        This is a big job to do, all the discipline, auditing
    standard setting, the inspections. This is not a part-time job.
    So, I think that is important. I do agree with Mike that it
    needs to have the very best people that you can get.
        I would provide for some nonpracticing accountants that
    have severed their ties for some period of time from the
    accounting profession. We have some wonderful people out there
    that meet that criteria--Chuck Bowsher, former Comptroller of
    the GAO in the United States, the gentlemen here at this table
    before me. These are all wonderful people. And as long as they
    have cut that tie and there has not been a conflict there for
    some period of time, 2, 3, 4, whatever number of years, then I
    think you can bring some accounting experience to the board as
    well. But I would not bring practicing accountants.
        We had a mixed board at the Independent Standards Board
    which had practicing accountants on it, and members of the
    public. It was a 50/50 board. And that experience tells me that
    that does not work.
        Senator Stabenow. Thank you.
        Mr. Beresford.
        Mr. Beresford. It really depends on what the particulars
    are going to be, I suppose. It is hard for me to right now
    envision what a group like this would do on a full-time basis.
        Now having said that, obviously, the FASB did work on this
    on a full-time basis. But thinking about what the Public
    Oversight Board has done up until recently, maybe they did too
    little. But it was very definitely a part-time type of
    organization.
        It is a little hard to answer the question until I hear
    more about what the structure might be.
        I do think, though, that it is very important to have a
    mixture between the two. I think that having had some people,
    as Lynn said, there are plenty of excellent people that have
    done good things in the profession and have finished their
    career or moved into a different area and might be excellent
    candidates for something like this.
        I think it would be a mistake to have a group that is
    totally devoid of any knowledge and experience with the area in
    question.
        It is just a question of the right balance.
        Senator Stabenow. If I might ask one other question, Mr.
    Chairman, regarding separating consulting and accounting
    services.
        In light of Enron, we have heard a lot of discussion, the
    industry seems to be moving away from allowing both of those to
    happen with the same accounting firm.
        My concern is, once the fervor dies down, whether or not
    the separation will remain. Mr. Turner, it appears that you
    would support a clear separation between those two functions.
    And I am wondering if other members on the panel would also
    support a clear separation and possibly a legal ban on mixing
    those consulting services and auditing services.
        Mr. Schuetze. I did not deal with this in my testimony, but
    I would support a complete separation and allow the audit firm
    to provide only audit services to the audit client. No other
    services whatsoever, and that includes tax. No tax work.
        Senator Stabenow. Okay. Thank you.
        Mr. Sutton. I would support a complete separation, with two
    provisos. One is that this new board that might be set up would
    have the authority to examine whether or not, for some specific
    service, the auditor should be permitted to do that. But absent
    some affirmative undertaking by that board, have a complete
    separation. Whatever nonaudit services might be permitted, I
    think they should be permitted only with the approval of the
    audit committee board of directors.
        Mr. Turner. In my written statement, I did say that I think
    there should be a ban on anything other than auditing services
    being provided to the audit client.
        I do not think we can possibly foresee when we might see
    something where there is a service that actually will enhance
    the quality of the audit. Or you might run into situations
    where you have a small accountant in Gillette or Sheridan,
    Wyoming. You have to give this some flexibility where there
    might be some situation where, because of that, especially with
    some of the small towns and small firms, you may want to allow
    some flexibility.
        So, I would build into it, as Mike said, this override
    protection on behalf of the audit committee.
        If the audit committee can conclude that, in fact, it will
    enhance the quality of the auditor, it will turn around and
    improve the quality of financial reporting, the audit committee
    should be the ones closest to it and have that ability to deal
    with that issue and give that by-pass, provided they disclose
    it to investors.
        I think that is also one of the ways to deal with some of
    the issues that might come up on a small business perspective,
    which you have to be cognizant of.
        The one thing to keep in mind is this does not require
    separation of the audit and accounting practice. It just means
    they can still do consulting if they want. They cannot do that
    consulting for that audit client, which is what I think the
    real concern is on behalf of the investors.
        Mr. Beresford. This is a tough issue and I chose not to
    discuss it in my comments because I do not feel that I am as
    expert as the gentlemen to my right who had to deal with these
    kinds of things in their work at the SEC. Nevertheless, I have
    a personal view.
        It is a tough call. I think it is hard to determine what is
    a consulting service, for one thing. Certainly, the auditing
    profession now refers to attestation, which involves a lot of
    things besides just the basic auditing.
        Lynn mentioned whether a service enhances the quality of
    the audit. It is hard for me to know that there would be too
    many things that would do that.
        Perhaps the other question is, does it detract from the
    quality of the audit? And there are many things that probably
    would meet, if that is considered to be a lesser test.
        I think that this is definitely the type of issue that
    should be considered by a group like the Independent Public
    Oversight Board. The Independence Standards Board was dealing
    with this before it went out of business, and I guess to a
    certain extent, the POB in its prior life was doing it as well.
        I think that those are issues that should be left to very
    careful consideration by groups like that. And if they are
    properly constituted and sufficiently independent, I would
    trust their judgment.
        Senator Stabenow. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Stabenow.
        Senator Allard.
        Senator Allard. I will have to admit, Mr. Turner, that your
    chart seems to streamline a process that looks kind of tortuous
    to somebody that is not an accountant. And from a management
    standpoint, it looks like it has had some advantages. I also
    notice that the auditing standards board that you had on the
    chart had oversight from the Securities and Exchange Commission
    and then from the accounting standards executive committee. And
    when I look at your chart, there is nothing there about the
    auditing board.
        Don't the problems that we are having today concern audits
    and how you handle debt in a financial statement? I would like
    to have you share with me how it is you are treating the
    auditing function in your chart?
        Mr. Turner. That is a very good question, Senator.
        The auditing standards board who sets the standards that
    govern what steps we have to do during the course of an audit
    today, is comprised of about 16 members of the American
    Institute of CPA's. Most of those I think actually are
    accountants and probably 13, 14 of those are actually
    practicing accountants with an accounting firm. They actually
    draft the standards.
        One of the problems with that part of the system today is,
    when they go through that drafting process, since it is all
    being done by the firms themselves, in fact, their legal
    counsels get involved in editing those very standards
    themselves, those standards tend to be written to protect the
    accounting firms in case they get in trouble on an audit,
    sometimes probably which is deserved and, quite frankly,
    sometimes which is not deserved. But they write it to protect
    themselves and you cannot fault them for that. If I was
    drafting, I would probably be doing the same thing.
        It is not drafted with the public interest in mind. And
    back in 1978, probably the greatest predecessor to the three of
    us is Chief Accountant Sandy Burton, who testified before
    Congress and said, ``As long as you leave that standard setting
    process in the hands of the firms and the firm's legal counsel,
    you are going to get standards written to protect them in
    court, as opposed to standards written to ensure that they do
    audits that will protect the public.''
        As a result, what you see in the revised chart is that the
    auditing standards board goes away. We create an independent
    board with adequate staff, knowledgeable staff, who then will
    start drafting and issuing auditing standards that will be
    driven by the public interest.
        Let me give you a good example.
        Recently, the board adopted a standard on documentation,
    what has to be documented and included in the work papers on
    the work that they have performed. We tried to push that
    auditing standards board to say, you have to document enough
    and leave enough in the work papers so that if someone else
    from the outside comes in and looks at it, they can determine
    that you have really done a good audit. Yet, in the final
    conclusion, when they finally issued that standard last month,
    they chose to leave that requirement out of it. So even today,
    the auditors could do an audit and if you want a third party,
    the SEC or someone to come in and overlook and see if it was
    done, you cannot tell.
        It may help them in court, but it certainly is not going to
    protect the public. And I think that is a good example of what
    is going on and why we need to pull it out of the profession.
        As Sandy Burton said 20, 25 years ago, put it in the hands
    of the public, or at least have the public oversee it.
        Senator Allard. I am not a serious investor in the stock
    market, but I look at the financial statement. The financial
    statement includes debt, or should. At least when I took one to
    the banker when I was trying to get a loan, he did not want me
    to leave out debt. Would you explain to me a little bit, Mr.
    Schuetze, how you leave debt out of here? You have lost me on
    your comment there.
        Mr. Schuetze. Well, I wouldn't leave the debt out. There
    would be disclosure of the amount of debt of the special
    purpose entity that had been guaranteed by the reporting
    enterprise.
        Let's say that that total debt was $100. But the fair value
    of the guarantee--and there are companies that write guarantees
    every day. Chase Bank, CitiBank. Everybody in the financial
    world is writing guarantees every day for money. Guarantees are
    being priced in the marketplace.
        So what you need to do is get on the balance sheet of the
    reporting entity the market price of the guarantee that it has
    written. It is a put. It is a written put. And then there needs
    to be disclosure of the $100.
        Let's say the guarantee is worth $16. You put the $16 on
    the balance sheet as a liability. That is the fair value of the
    written put.
        Now this is technical, but if you guarantee my debt, how
    much would you charge to guarantee my debt of $100? In the
    scenario that I just posed, you would charge $16. Well, that is
    the fair value of the guaranteed liability. That is what needs
    to go on the balance sheet. But do not put on the balance sheet
    all of the assets that are not owned and cannot be sold.
        Senator Allard. Now let me just bring in an everyday
    situation that myself would look at as a small businessman.
        If you signed a lease, a 10 year lease, that you are going
    to pay so much per month for 10 years. And if you do not meet
    that, that is an obligation that you still owe because you
    signed the lease. You have an obligation for 10 years out. So
    isn't that in a way a debt to you as a businessman because you
    signed the lease? But whoever owns the building, is that
    carried out as an asset, then, on his side?
        Mr. Schuetze. Generally speaking, in leases that are
    written in the United States, and there are many types of
    leases, but leases what I call a drop-dead liability. Instead
    of the total rents for the next 10 years, if I, the lessee, can
    get out of the lease by paying the exit price. Let's assume
    that the annual lease payments are $100, $100, $100, for the
    next 10 years. That is $1,000.
        Senator Allard. Yes.
        Mr. Schuetze. But most leases are written such that the
    lessee can exit the lease for a payment of, let's say, $250.
    The $250 is the drop-dead liability. Not the $1,000. The $250
    is the drop-dead termination liability. That is what needs to
    go on the balance sheet.
        Senator Allard. And do accountants generally agree with
    what you are saying?
        Mr. Schuetze. Lease accounting is a veritable hash. It is
    hash with ketchup on it.
        [Laughter.]
        It is a book this thick. You cannot make heads or tails of
    it.
        Senator Allard. So there is a lot of individual
    interpretation from the accountant or the auditor as you move
    forward. Doesn't that speak to why we need to have more
    transparency in these statements?
        Mr. Schuetze. That speaks to why we need mark-to-market
    accounting, because mark-to-market accounting is simple and it
    is by its nature transparent.
        Mr. Turner. Senator, I could not agree with you more about
    the lease. That is a prime example of why we need to have more
    transparency in the financial statements.
        Back in 1964, the standards setter then turned around and
    wrote a general standard that says that these are installment
    purchase of an asset. You ought to have them on your balance
    sheet and you ought to have them in our liability.
        Unfortunately, we as a profession did not do a very good
    job of following that. And if we had, we probably wouldn't have
    had some of these problems we have today. But that is a prime
    example of the need for greater transparency.
        Senator Allard. I see that my time is expired, Mr.
    Chairman.
        Chairman Sarbanes. Thank you very much, Senator Allard.
        Senator Schumer.

                STATEMENT OF SENATOR CHARLES E. SCHUMER

        Senator Schumer. Mr. Chairman, thank you for holding
    today's hearing.
        I want to thank all four of our witnesses for a great deal
    of erudition and lots of different ideas. We are hearing a
    whole lot of them.
        I would like ask every one of the panelists three ideas and
    their opinion of them. All of them relate to the fundamental
    problem I think we have here--I do not know the history, you
    know it better than me--but you are basically paying your own
    watchdog. The company pays their accountant and they are paying
    their own watchdog. And that is the fundamental issue here.
        Mr. Turner, for instance, proposed a solution of forced
    rotation of accountants which gets at that to some extent. I
    would be very interested in the other three people's view of
    that issue.
        Now, I have heard the other side. The other side is that
    the first few years that the new accountant comes on board,
    they do not know the company well and if you have a company
    that is out to fool the accountant, then it is much easier to
    do without that knowledge.
        So for the three of you, what do you think of the forced
    rotation? And for Mr. Turner, what is the answer to that
    problem? It is an idea that intrigues me. I ask all three and
    then ask the panel to respond seriatim.
        I have been very intrigued by the idea of what we call here
    an uber-auditor, that in troubled companies or potential
    troubled companies, that the SEC has the ability itself to do
    an audit. Obviously, they could not do this for very many
    companies. But when they begin to smell a rat, that they might
    be able to go in and do an audit themselves. The idea is that
    the companies should have the same reaction to an SEC audit
    being possibly done as a taxpayer would have to an IRS audit
    being done.
        It also, again, gets to the fundamental problem that at
    least you wouldn't be paying your SEC auditor and could relate
    to some independence.
        Now, you would all know much better than I how difficult
    that would be to do, how cumbersome it would be to do, how
    expensive it would be to do. But it is an idea that intrigues
    me because I think you would get some bang for the buck. Just
    the idea that it would be out there would be somewhat
    prophylactic.
        Then, I had breakfast with one of our leading economic
    thinkers in the Government. I won't say who because I am not
    sure it was public. And I asked that person, what is the number
    one thing you would do to prevent all the problems we have been
    seeing? He answered unequivocally. He said, expense stock
    options. He said the idea that stock options are given so much
    out there and willy-nilly, has fundamentally created a problem
    where, not just the CEO, but the leadership of the company all
    having these options puts an undue emphasis on the stock price.
    The stock price drifts away from the real value of the
    company--what they are producing, what their earnings are, et
    cetera. And everyone's just focused on making the price as high
    as possible.
        Again that seems to make some sense and deals not only with
    the recent problems--we have had Enron, Global Crossing, Tyco--
    but also with the whole idea that the dot coms, which did a lot
    of these stock options. And that is how they paid a lot of
    their employees--ended up having stock values that seemed
    totally remote from the actual sales, revenues, or anything
    else.
        So those are the three issues that I would ask each of you
    to comment on--forced rotation of auditors, 5 to 7 years,
    something like that. This uber-auditor idea that the SEC could
    come in and occasionally do its own audit. And the expensing of
    stock options, which does seem to have some merit as the root
    cause of everything we are talking about, because you are going
    to find six different ways that each problem comes about. That
    is because of all of the complexity that you gentlemen have
    been expostulating on, far more knowledge than I have. But the
    fundamental thrust--let's get that stock price up as quickly as
    possible.
        Mr. Schuetze, let me start with you and just work my way to
    the other side of the panel.
        Mr. Schuetze. On the first question that you posed, paying
    your own watchdog, Congress considered that when the 1933 and
    the 1934 Acts were enacted and recognized the problem that
    exists when the client pays the auditor, that there is the
    problem of, at least the appearance of lack of independence, if
    nothing else. But nonetheless, decided back in 1933, 1934 to
    leave that be.
        I think it would be a good idea to have forced rotation of
    auditors every 5 years or so. Then at least the retiring
    auditor would take his or her Brillo pad and scrub the balance
    sheet in the third or fourth year and hand over a balance sheet
    that looked like a new copper penny to the new auditor. And I
    think that would be a very good idea.
        Senator Schumer. Do you want to comment on the other two,
    uber-auditor and stock options?
        Mr. Schuetze. The uber-auditor? As a practical matter, I do
    not think that would work.
        You mentioned IRS examinations. Those are done in
    retrospect. They aren't done beforehand. It would be very
    difficult for the SEC to, ``smell something or to see something
    rotten in Denmark'' and do something before something happens.
        The enforcement division right now does that on a
    retroactive basis. When something breaks down, the enforcement
    division looks back to see what happened. I think it would be
    very difficult to do looking forward.
        The expensing stock options, I know that that has a great
    currency. I personally disagree with it for very, very
    technical reasons. I will spend just a couple of minutes
    describing those technical reasons. Expensing stock options
    implies that the stock of the corporation is an asset of the
    corporation. The stock of the corporation is not an asset of
    the corporation.
        Enron used its own stock to backstop its SPE's. I think
    that clearly implied that the stock of Enron was an asset of
    the corporation. That is wrong.
        Stock options to me are divisions of the ownership interest
    between owners and they represent a division of ownership
    interest--they do not affect the corporation. The corporation
    does not get any assets as a result of stock options except the
    exercise price. The corporation does not pay out any assets.
    The total market capitalization of the corporation does not
    decrease as a result of issuance of stock options.
        I think all of the proposals that have been made regarding
    accounting for stock options as an expense of the corporation
    amount of proforma, as-if accounting. And I do not agree with
    it, but it is extremely technical.
        Now if the Congress wants to do it and if the accounting
    profession wants to expense stock options, I think that is
    probably okay because it is proforma, as-if, and it does not
    affect the assets of the corporation. But I personally think it
    is wrong because I think the underlying thesis for it is wrong
    because stock is not an asset of the corporation and you cannot
    use stock to create an expense.
        Now it is highly, highly technical and I will send you an
    article that I have written about it. But I would not do it,
    personally.
        Senator Schumer. My guess is I wouldn't understand----
        Mr. Schuetze. Yes, you will. It is written in English.
        [Laughter.]
        Senator Schumer. Thank you.
        Mr. Schuetze. It is written in English.
        [Laughter.]
        Senator Schumer. Well, I have some rudimentary knowledge of
    English of the Brooklynese variety, so----
        [Laughter.]
        Mr. Sutton.
        Mr. Schuetze. South Texas and Brooklyn are compatible.
        [Laughter.]
        Mr. Sutton. With respect to the rotation watchdog issue, I
    agree with Walter's recollection of 1933, 1934. But my
    recollection also is that Congress arrived at that decision
    because of the reality that there was not a workforce in place
    that could do the work that needed to be done. And the auditing
    profession stepped forward and volunteered to do that, and
    Congress agreed with that.
        With respect to rotation, I would say rotation is one of
    the issues that I would present more generally. And that is,
    how do you break the bond between management and auditors?
        I would support the rotation of auditors. It would mean
    that the profession, the practicing accountants would have to
    change their business model. But I am convinced that they could
    adapt to that and rotation could be an effective way of
    breaking the bond.
        Uber-auditor--I think I agree with Walter that my sense of
    the SEC mandate is that that would be difficult to do. In my
    view, the issue that you are talking about there would be, we
    would get at that through this new independent oversight board.
    It would be that body that would be looking over the auditor's
    shoulder, if you would.
        Expensing stock options, I could not disagree with Walter
    more. Again, I accept his explanation that it is a very
    technical issue. He has a model of accounting and a definition
    of assets and liabilities that I respect. But they are his and
    not mine and probably not the rest of the profession.
        Of course, stock options are an expense, is my answer to
    that. The FASB concluded that and was prepared to issue a
    statement to that effect. But I will leave it to Mr. Beresford
    to explain further why that did not happen.
        Senator Schumer. Do you think it is important to do? I
    mean, is it as high up as this gentleman mentioned to me?
        Mr. Sutton. I do. I think Lou Lowenstein wrote a brilliant
    article and the theme of it was, you manage what you measure.
    And if you do not measure real economic things----
        Senator Schumer. You do not manage them.
        Mr. Sutton. --you do not manage them.
        Senator Schumer. Okay.
        Mr. Turner.
        Mr. Turner. Senator Schumer, let me start with the last one
    first, the stock options.
        I love going to New York and I would love it a lot more if
    you could figure out how to get those stock options expensed.
        I think the real economics are that there is tremendous
    value in there. In fact, I will tell you as a CFO of a major
    high-tech company, we go through valuation. We had independent
    outside valuation, very good experts come in and just tell us
    how much value there really was there. There was phenomenal
    value.
        In fact, I participated in a survey periodically with many
    of the best-known companies out of the Silicon Valley. We all
    did compensation surveys of what one another was paying.
        There are three pieces to those charts every time--cash
    compensation, perks, including 401(k)-type benefits, and then
    the third chart, every single time, was how much value we were
    giving our stockholders in terms of compensation in stock
    options.
        There is unequivocally a piece when you manage a business
    that you have to look at as far as what is the cost to the
    stockholders of those stock options. And to play Grimm's Fairy
    Tales that these things have no value is crazy.
        We need transparency, as Senator Allard mentioned.
    Transparency means, as Senator Gramm said, getting the real
    economics of the transactions in the financial statements. And
    in this case, it has been too long and it is well past due to
    start recording those stock options as expense.
        Senator Schumer. Do you agree with the fundamental analysis
    that it separates the value of the company from the value--or
    puts a premium on the leadership of the company trying to get
    the value of the stock up, whether the value of the company is
    increased or not. The actual things we know companies are
    supposed to do, which is make profits.
        Mr. Turner. There is no question, having sat in that seat,
    that those stock options have an impact on the management, have
    an impact on the employees, absolutely.
        Senator Schumer. Uber-auditor?
        Mr. Turner. On the uber-auditor, I think just personal
    behavior would be that if you know you have an IRS auditor
    coming in, you are going to act differently.
        A couple of comments on it. Obviously, the SEC does not
    have the resources or the talent right now to do it.
        Senator Schumer. We would have to give them the resources.
        Mr. Turner. Right. You would have to give them the
    resources. But more importantly, American investors over the
    last half-dozen years, give or take a number, have seen about
    $200 billion in value come out of the markets when these
    balloons have been burst on these companies that have had
    problems.
        My concern with the uber-auditor thing is we need to make
    sure that the problems get fixed before a bad event happens.
        Chairman Pitt, and I very much commend him for this, has
    said, we have too many problems popping up and we are dealing
    with them through enforcement afterwards.
        I hope our system, with what changes we make to it, will
    prevent that type of damage to American lives and their savings
    rather than dealing with a situation like Enron where, even
    though you go in there afterwards, it won't matter. There is
    not enough money to recoup the $60, $70, $80 billion that these
    people have lost. They are not going to see it again.
        So even in an Enron case, a uber-auditor does not do us any
    good. It does not help those tens of thousands of American
    lives that, quite frankly, have been destroyed.
        And I hope we turn from being reactive to being proactive.
        Senator Schumer. The uber-auditor could go in at any time.
    It would not have to wait until the bubble bursts.
        Chairman Sarbanes. Chuck, we are 10 minutes over and
    Senator Shelby is waiting.
        Mr. Turner. Actually, that is exactly what the Public
    Oversight Board, if you look at it, that is exactly what it
    does. It turns it into an uber-auditor.
        Senator Schumer. I would just ask Mr. Beresford to submit
    the answers in writing.
        Chairman Sarbanes. No, go ahead, Mr. Beresford. We will
    give you a minute or two here.
        Mr. Beresford. I will talk about stock options because that
    is where I might have a comparative advantage, I guess you
    might say, with the others.
        Clearly, the FASB would have adopted a final rule on
    accounting for stock options, except that Congress threatened
    to put us out of business. We were convinced that was a real
    threat. It would happen. The SEC said they would not support us
    on the issue because it was not important enough for them--or
    for us, frankly, to lose the franchise.
        The question I think you started with, though, was is this
    the most important issue of the day? I am not convinced it is,
    frankly, but it is one that is such a sensitive issue to both
    corporations and fortunately now, to investors, that it might
    be a symbol, if the FASB and/or the international groups were
    able to deal with this issue right now.
        There are great difficulties in determining what the value
    of options would be. There are complex accounting questions
    about whether you determine the value at grant date or vesting
    date or exercise date, things like that, that those can be
    dealt with. And even if it is a minimum measure of the
    compensation amount, it ought to be recorded in financial
    statements. How much that would actually change behavior, is
    really almost impossible for me to predict. But it is a pretty
    glaring omission from the accounting model today.
        Senator Schumer. Thank you, Mr. Chairman. I thank the
    panel.
        Chairman Sarbanes. Senator Shelby.
        Senator Shelby. Thank you, Mr. Chairman.
        If the basic purpose of an audit, as I understand it, that
    is, is to provide information to the marketplace, or to meet
    legal requirements by providing technical or financial
    information, how would you rate the quality of the information
    that is available in the average financial statement of the
    average publicly-traded company?
        Mr. Schuetze.
        Mr. Schuetze. The financial statements today are
    impenetrable.
        Senator Shelby. That is right.
        Mr. Schuetze. They are indecipherable, to use Chairman
    Pitt's words. If you go to the Internet and pull down the
    financial statements of relatively simple companies, the
    management discussion and analysis, the financial statements
    and the notes to the financial statements run 40, 50, 60, 70
    pages of simple companies, never mind complex companies. So, I
    think the usefulness of the information is pretty close to a D.
    It has to be C-minus.
        Senator Shelby. Mr. Sutton.
        Mr. Sutton. I might give it a slightly higher grade, but I
    would agree that the financial reporting has become
    increasingly impenetrable, to use Walter's word. And it is time
    that we reexamine----
        Senator Shelby. Past time, isn't it?
        Mr. Sutton. Past time--how we go about establishing
    standards and what those standards should present and what
    financial reporting should present.
        Senator Shelby. Mr. Turner, how would you rate it?
        Mr. Turner. Actually, I think there is a lot of good people
    out in America preparing these financial statements that do a
    good job.
        Senator Shelby. We know that. There are a few bad ones,
    too.
        Mr. Turner. Yes, there are. If you look at the surveys,
    there are probably about 10 percent of them, 15 percent, that
    clearly, unequivocally, have gone over the cliff and are off
    the map, so to speak. I would guess that you probably have an
    equal amount that are doing an outstanding job and I would give
    them an A for their transparency.
        Senator Shelby. What do you do with these people? In the
    legal profession, which some of us are familiar with, you get
    suspended, you get disbarred, you do all these things. But the
    CPA's, what happens to these guys that continue to do bad work
    or continue to be compromised, continue to have to restate
    their audits, so to speak?
        Mr. Turner. Very good question, Senator Shelby.
        There are in the existing disciplinary system, the
    profession itself essentially does not do any real discipline.
    We actually saw some cases at the Commission where we had even
    censured the professionals. And the profession itself actually
    voted not even to investigate the matter. It would have been
    one thing if they investigated and had taken action. But they
    actually voted not even to investigate the matter where the SEC
    itself had chosen to censure these people.
        Senator Shelby. That is a sad state of affairs.
        Mr. Turner. It is a very sad state of affairs. The State
    boards are so resource-constrained, that the State boards
    themselves basically can very seldom take action. They are very
    difficult. And the State boards, keep in mind, basically are
    representatives. They are people out of accounting firms, a
    growing percentage of them coming from the Big 5 accounting
    firms.
        So the State boards themselves have inherent conflicts. I
    do not know that you can always look to the States. Some do a
    very good job and try, but they are very budget-constrained.
        The SEC--this is back where we get into the discussion of
    pay parity and resources. They have 20 to 25 accountants in the
    Division of Enforcement in Washington, DC, down the street from
    here. Two hundred to 250 cases. Maybe 30 to 40 accounts around
    the rest of the country.
        I have been an expert witness, as I admitted. Three to four
    of us would have to work on every single case to get it ready.
    And on an Enron case, maybe you would need 10 accountants. If
    you think that they have 20 to 25 accountants, 200 to 250
    cases--there is not a prayer. Many of those cases will go
    unprosecuted, not because the dedicated staff do not want to go
    after them, but because the staff just do not have the bodies,
    do not have the resources and, quite frankly, are getting paid
    cents on the dollar compared to what they can do if they go
    elsewhere.
        Senator Shelby. I do not know what the term would be. Since
    you are not admitted to the bar, you are admitted to the
    accounting profession. Do they disbar, using the term loosely,
    accountants? In other words, do you have just hundreds of them
    kicked out of the profession each year?
        Mr. Turner. No, you do not. In fact, the State boards----
        Senator Shelby. Why not? For the reasons you told me?
        Mr. Turner. For the reasons I told you. They do not have
    the resources. The States grant the license. The States take
    away the license. They do not have the ability to prosecute.
        Probably, quite frankly, one of our faults at the SEC was
    we did not interact enough with the States on that. We were
    trying to do that and met with the States a number of times, as
    Chairman Levitt and I were in the latter years. But it is a
    system that needs to be fixed. The discipline does not exist.
        Senator Shelby. Mr. Beresford.
        Mr. Beresford. Senator Shelby, as you know, those of us in
    the university community have been accused of grade inflation.
        Nevertheless, I think that financial reporting deserves a
    much higher grade than my fellow panelists do. However, I would
    also say that it requires, as the FASB concepts state, that you
    have to be reasonably educated in accounting-type issues and
    you have to be reasonably diligent in being able to look
    through reports.
        There have been lots of reports that Enron's financial
    statements, were basically incomprehensible, at least the
    footnotes and so forth. I have tried hard to look through them.
    And I find them challenging, to say the least. But that does
    not mean that every other corporation in America is beyond
    comprehension.
        The average person, the average man or woman on the street
    is not going to be able to look at a complete set of financial
    statements of the typical publicly-held company and have much
    hope of understanding exactly what is going on.
        Now, we do have lots of financial intermediaries, as I
    would call them in our system, financial analysts, lending
    officers, other people who make decisions based on the
    financial information.
        I absolutely agree with the statements that have been made
    otherwise that our financial reporting system is the best in
    the world. Can it be better? Absolutely, yes. Can it be simple?
    No.
        Senator Shelby. What are your views as to the causes behind
    the increases in the number of restatements and audit failures?
    In other words, why? They do a financial statement for various
    companies. We showed how many in the chart here a week or so
    ago that the Chairman had a hearing on. It has just moved up so
    fast.
        Obviously, you look back and you say, gosh, we were wrong.
    And these are accountants doing this. Why can't they get it
    right the first time? Because, to me, it goes to the very truth
    of a situation. What is the true state of this company's
    financial condition at this given time? And it is either false
    or it is not, or it is misleading or it is not.
        Mr. Schuetze. Well, when I was Chief Accountant of the
    Division of Enforcement at the SEC, we prosecuted a number of
    cases where the auditors had seen the problems. It was
    documented in the auditor's working papers that they had seen
    the problem, knew what it was, and they decided, simply decided
    to sign unqualified opinions, notwithstanding that they had
    seen it.
        Now, I cannot explain to you why that is happening. I just
    know that it is. The number of restatements that we are seeing
    has grown immensely. And in the number of cases in which I was
    involved when I was in the Division of Enforcement, we saw that
    the auditors saw the problems.
        Senator Shelby. But they did not solve the problems, did
    they?
        Mr. Schuetze. They did not solve the problems. They did not
    go to their clients and say, Mr. or Mrs. Client, you need to
    adjust these financial statements. They simply did not do it.
        Senator Shelby. This was mentioned earlier. And Mr.
    Chairman, you have been lenient with me on the time. But if you
    do audits and if you have to do them, the big accounting firms
    have to do them, in the future, why can't you rotate these
    firms? In other words, one cannot do the audit next year and
    the management cannot choose. They can maybe choose from
    somebody else, or the SEC sends the dogs in to look at the
    situation. Dogs meaning the accountants.
        Mr. Schuetze. Well, as I stated previously, I think that
    auditor rotation is a good idea.
        Senator Shelby. Mr. Sutton, what do you think?
        Mr. Sutton. It is one of the ways where you can go about
    getting at a broader issue, and that is, breaking the bond
    between management and the auditor. And as you look at
    corporate governance, there would be some other ideas there
    like wresting control from management and putting more control
    in the audit committee and some other ideas. But rotation would
    work.
        Senator Shelby. Mr. Turner.
        Mr. Turner. I agree totally with you, Senator Shelby. I
    would rotate just as was mentioned. And probably when the new
    auditor came in, have some type of public reporting of any
    problems that they saw as they came in because, as Walter
    mentioned, during my term, we also saw a number of instances
    where the auditors actually identified the problem,
    notwithstanding that, in fact, meetings where there were many
    auditors in the room and they documented the fact that they
    found the problem, but then still let the report go out. It is
    not just the auditors. It is also the management team.
        Keep in mind that the primary responsibility for these
    financials are the management team. We have to get to where not
    only do we have good discipline and timely, effective
    discipline as the auditors as you proposed, and I commend you
    for that, but we also have to get timely and effective
    discipline of the people who cook the books and are in the
    kitchen stirring the kettle. And that is the CEO and the CFO.
        Senator Shelby. Maybe we do not have enough criminal
    statutes out there to prosecute these guys yet.
        Mr. Turner. I think we need to get some things to put the
    heat under their feet because as long as they are cooking the
    books, you are having situations where people, quite frankly,
    are also probably lying to the auditors as well as the
    investors, and that is a serious concern.
        Senator Shelby. You steal something at the grocery store
    and you are caught, you should be prosecuted. No telling what.
    Or you steal a car and you are prosecuted, and you should be.
    But people in corporate America, a lot of them have stolen and
    cheated people out of millions, hundreds of millions, if not
    billions of dollars.
        Look at the enormous difference there. Not that there is
    any difference in--if you break the law, you ought to be
    punished. But these people, for the most part, are getting by
    with that.
        I think it is sad and I think the American people, the
    average person, investor or noninvestor, they realize that
    there is a deep problem in the capital markets. And the people
    aren't going to trust the accounting profession. They are not
    going to trust these statements. That is not good for America.
        Mr. Turner. No, it is not. You are right. We do need to
    step up the enforcement. And if there is one criticism I would
    probably have of us, even while we were at the SEC, we probably
    needed to take stiffer actions as well. When you turn around
    and slap someone on the hands, it sends a message after a while
    that that is all that is going to happen.
        The greatest fine we ever fined an accounting firm was
    while we were there and we fined them only $7 million, where
    the investors lost billions. We probably have an obligation
    that the Commission get tougher.
        Senator Shelby. But if we do not go back to what is true
    value, as Mr. Schuetze said earlier, if we do not get back to
    what is really valued in a company's financial statement, it is
    a fraud in a way. And if you cannot sell something--I know you
    can trade options. We understand all that. Some things might be
    valuable from an accounting standpoint, but it has no value in
    the marketplace. That is a problem. It looks to me like it
    makes the statements more bloated to fool the investor in the
    long run.
        Mr. Turner. I agree. After those six economic classes, I
    tell you, our financial statements have to reflect the actual
    underlying economics and not sham transactions like we have
    seen with the SPE's or without real good values being reported
    in the financials, as Walter has mentioned. And until we get
    there, we have still a lot of work to do and we are not being
    honest with the public and with investors.
        Senator Shelby. Mr. Beresford.
        Mr. Beresford. Just one comment. You started with the
    question of why have there been so many restatements in recent
    years?
        Senator Shelby. Absolutely.
        Mr. Beresford. Why has there been such an increase? A big
    reason for that is that the accounting rules were changed after
    the fact in many situations. These are complicated areas that
    companies dealt with. Whether they were dealing with the best
    professional advice or judgment in all cases, that is
    questionable.
        But, to be clear, there were a number of situations with
    respect to revenue recognition and some other specialized
    situations where they were told after they had reported
    something, that there was a new rule that had to be applied and
    they had to go back and correct earlier financial statements.
        Senator Shelby. A lot of these rules are going to have to
    be revisited, aren't they? Accounting rules that brought about
    the situation that we are in today. Not just Enron. Perhaps not
    just Global Crossing. But no telling what else is out there.
        Mr. Turner. I would actually disagree with Denny on his
    remarks. I think in most of the cases, the people actually just
    flat out cooked the books. There is a study that has been done
    by the financial executives that found that in 85 percent of
    the cases, there were errors that were found after the fact by
    either the auditors or the companies themselves, companies like
    Sunbeam, that have found it out after the company went under.
    About 15 percent of the cases were actually found by the SEC
    where they went in and looked at it.
        So, I think, quite frankly, most of the restatements have
    come out when there has been a problem develop at the business,
    and unfortunately, the problem was not reported in a timely
    fashion to investors. Like cases like Sunbeam and W.R. Grace.
    And then, eventually, as the business got into trouble and it
    came to light, yes, they did have to restate.
        Senator Shelby. Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you very much, Senator Shelby.
        This has been an enormously helpful panel. I just want to
    ask a couple of questions in closing.
        If the standard being set by the institutions established
    to set accounting standards are wrong or inadequate, in the
    judgment of the SEC, with respect to public companies
    currently, does the SEC have the authority to set a different
    standard?
        Mr. Schuetze. Yes.
        Mr. Sutton. Yes.
        Chairman Sarbanes. Does the SEC currently have the
    authority to discipline the auditors or accountants that it
    thinks are not measuring up to required performance, again with
    respect to public companies?
        Mr. Schuetze. The SEC has a rule called Rule 102(e), which
    is in the rules of practice before the Commission. The SEC sued
    two auditors back about 20 years ago under a predecessor to the
    rule that is now in place. The name of that case is Checcosky
    and Aldridge. It took that case about 15 years to work its way
    through the courts. And after that case worked its way through
    the courts, the SEC changed its Rule 102(e) to where now it
    does not require recklessness in order to charge auditors with
    malfeasance.
        It requires heightened concern in certain areas. But even
    that standard I think is very, very difficult to police. I
    would go back to a standard that is based upon negligence
    alone. I think we ought to have a standard for corporate
    officers based on negligence alone, not recklessness or gross
    negligence. I would move the standard over to negligence for
    both auditors and corporate officers and the directors.
        Chairman Sarbanes. Yes?
        Mr. Beresford. The answer to your question is yes.
        Chairman Sarbanes. What?
        Mr. Beresford. The answer to your question is yes, clearly.
        Chairman Sarbanes. Obviously, I understand the pressures
    that the SEC was placed under in a governmental context. But it
    goes to the question of what structure we are going to
    establish to monitor the situation, and what resources you give
    to the SEC and so forth. We are thinking about all these
    different boards and everything. But a very enforcement-
    oriented SEC could make a really big difference.
        Now the question is, well, that is true in today's
    environment since everyone's running around now concerned about
    Enron and all the rest of it. Some people have completely
    flipped positions and so forth. But the fact remains what
    structure do you get that gives us the greatest assurance that
    these things can be policed and prevented from happening?
        That is one of the things that we need to search through in
    order to figure out in terms of what needs to be put in place.
    So any further thoughts you have on that, we very much
    appreciate it. Did you want to add anything?
        Mr. Sutton. I was just going to say that one thing to keep
    in mind is that if we wanted to do the disciplinary part of
    this through the SEC, I suspect the SEC would still need more
    than just resources. It probably would need some more finely
    tuned enforcement tools.
        Today, the SEC is principally a law enforcement agency. The
    club it carries is a real big one. And so, if we are going to
    try to do discipline through the SEC, I think you ought to
    consider--and I am not a lawyer--what additional tools you
    might need for the SEC to do that, not just resources.
        Senator Shelby. Chairman Sarbanes, can I ask a question?
        Chairman Sarbanes. Sure.
        Senator Shelby. Does the SEC currently have the power, if
    you saw fit, to suspend from practicing in the United States an
    accounting firm that consistently made gross mistakes or was
    complicit in something that was deemed fraud or close to it?
        Mr. Schuetze. Maybe not a firm, but individual auditors,
    yes.
        Senator Shelby. Why not the firm? I have seen accounting
    firms that have paid out hundreds of millions of dollars, in
    the billions, probably. I am going to have a chart on it, Mr.
    Chairman, when we have another hearing sometime.
        It looks to me like it is so rampant. In other words,
    nobody has been disciplined, as we talked about earlier. There
    is a fear factor. Fear is a heck of a thing, positive and
    negative.
        But in this case, if you are going to oversee accounting
    firms--and FASB obviously is not going to oversee them. They
    just haven't done it. And I do not think they are capable of
    doing it in the way that they are set up today.
        If you suspended one of these firms, I think the message
    would go out, oh, there would be political fallout, but it
    wouldn't last long because the American people would be behind
    you.
        Mr. Schuetze. If you go back to 1975, and the settlement
    reached between Peat Marwick Mitchell & Coe and the SEC in the
    Penn Central matter, the Penn Central matter and National
    Student Marketing and some others that existed at that time,
    the SEC and Peat Marwick did agree that Peat Marwick would not
    take on a new publicly-held client for 6 months. And that put a
    significant crimp in Peat Marwick's practice.
        Now that is the most severe penalty that I am aware of in
    terms of a suspension of practice. In the Arthur Andersen
    matter that was settled last summer between the SEC and Arthur
    Andersen, Arthur Andersen did agree to an injunction.
        So starting in the summer of 2001, there was an injunction
    in place against the firm and the individuals within Arthur
    Andersen regarding further fraudulent activity by that firm and
    its partners and staff.
        I am not a lawyer. I would need help from a lawyer to
    explain the significance of that. But as I understand it from
    the lawyers at the SEC, that was a powerful settlement that the
    SEC extracted from Arthur Andersen. It has been given very
    little note. Everyone in the press has focused on the $7
    million fine that was assessed against Arthur Andersen, but has
    not focused on the fact that the SEC has an injunction that
    prohibits further fraudulent activity by the firm.
        Senator Shelby. So, Mr. Chairman, maybe this is not the
    same analogy, but it is an analogy of sorts.
        You say a college football team or a university
    participates in the NCAA athletic program. They could be
    suspended. They could be punished in various ways for violating
    the rules. Or their program could be terminated. It was. I
    think it was SMU, a great school in the southwest a number of
    years ago.
        But that puts the fear factor out there that accountants
    would know, we are not only going to be suspended, but also we
    might lose this client. We are going to lose our whole
    livelihood.
        Mr. Schuetze. That is an idea worthy of consideration.
        Senator Shelby. I did not say do it. I am saying it would
    work.
        Mr. Schuetze. It would work. But you then have to consider
    the impact of that. Each of the Big 5 firms has approximately
    2,000 publicly-held clients. And if you say to one of the Big 5
    firms that as of, let's say, March 31, you are precluded from
    practicing before the SEC, the firm, then you have 2,000
    companies who cannot get an audit report. That may effectively
    preclude them going to market until they are able to get
    replacement auditors. That is a huge economic burden that is
    placed now on 2,000 registrants and all of their shareholders.
        Senator Shelby. I understand that. But the other is worse,
    not to do anything. In other words, to let the situation fester
    as it is today, where more and more people in America have
    little, if any, confidence in the financial statements in our
    capital markets, in the accounting profession, and so forth.
        Mr. Schuetze. I was simply pointing out the ramifications.
        Senator Shelby. Yes, sir, I understand. But, still,
    somebody would supply that. It might take a little while.
        Mr. Schuetze. Oh, sure.
        Senator Shelby. Yes, sir, Mr. Sutton.
        Mr. Sutton. Senator Shelby, I think that hits on my comment
    that if we pursue more disciplinary activities through the SEC,
    it may be necessary to more fine-tune the tools so that this
    does not happen.
        Senator Shelby. Yes, sir.
        Mr. Turner. I would agree with that, Senator Shelby. I do
    think that the SEC does need to fine-tune some additional tools
    and fine-tune some of the rules that are there. You need to
    give that to them if you are going to look for more.
        Mr. Schuetze. I would encourage you all to move the
    standard from recklessness over to negligence. If you do that,
    you will get fine-tuned audits.
        Senator Shelby. You will get better audits, won't you?
        Mr. Schuetze. You will get fine-tuned audits.
        Senator Shelby. You will get more independent accountants
    and you will have more honesty in the financial statement,
    would you not, Mr. Turner?
        Mr. Turner. You would have created that uber-auditor in the
    back of their mind, anyway, if you bring it down to negligence.
        I would agree with you, Senator.
        Senator Shelby. Mr. Chairman, I hope you will consider
    that. You are our leader.
        Chairman Sarbanes. We are going to consider a range of
    things. I am pondering how we alter the structure of the
    balance so that the auditors and the accountants have a more
    independent position to resist the pressures that are put on
    them by the companies.
        Senator Shelby. That is right.
        Chairman Sarbanes. The companies, after all, are the ones
    who are paying them. The companies want to achieve a certain
    result. My perception is they push the auditors to approve
    those results.
        Now, I guess a very upright auditor resists all of that,
    but a lot of them fall prey to it. And the people who are
    pushing them to do it, in effect, can presumably fire them.
        We are going to do corporate governance tomorrow, so we
    will examine the role of the audit committee and how that
    relates to management and the directors and so forth.
        But the whole thing is structured now, it seems to me, in a
    way that constantly has the pressure working to go to the
    lowest common denominator rather than the highest common
    denominator. Part of that is, of course, you have a stick or
    enforcement. Volcker talked about this at some length when he
    was here. How do you change this frame of mind, this attitude?
        Actually, it is very interesting. I read a little bit about
    Arthur Andersen himself, the individual who founded this firm
    and who came with a highly responsible set of values to the
    role of the accountants. But, obviously, we have not always
    been able to carry through on that.
        Senator Shelby. Mr. Chairman, one last comment, if I could.
    I know we are missing our conferences, but this is more
    important, is it not.
        Our banking system--and this is the Banking Committee--we
    have auditors from the Federal Deposit Insurance Corporation,
    the Comptroller of the Currency, the Federal Reserve, different
    ones. They go into X-bank, not as a friendly auditor,
    necessarily. Perhaps maybe not as an adversary. They are not
    owned by anybody. They are not influenced by anybody. And I
    think that is healthy.
        I am not proposing that the SEC set up something to audit
    everybody yet. The Chairman sort of alluded to it. Maybe not
    the same thing that I am getting ready to say. There is some
    fear there with the auditor, that when the FDIC auditor comes
    into the bank, they had better have those things in order.
        I am not sure there is any fear in corporate America to
    speak of when the auditors come in and they are so close to
    them, they are sweethearts, as opposed to off-hands auditor,
    maybe not adversary.
        There is a difference there. How do we stop that? I think
    that will go to the independence of the auditor and the
    independence of the people preparing the tax return, without
    being compromised by who is paying them.
        It is difficult, but it is not impossible to handle. I
    think what is at stake is something much bigger, the integrity
    and the perception of integrity in our capital markets. Isn't
    this true?
        Chairman Sarbanes. Does anyone on the panel have any
    closing remarks?
        Mr. Turner. I would agree with you, Senator.
        Senator Shelby. Do you disagree with that?
        Mr. Turner. No, I agree with you, wholeheartedly.
        Senator Shelby. Thank you, Mr. Chairman.
        Chairman Sarbanes. Gentlemen, thank you very much. You have
    been an extremely helpful panel and we appreciate it.
        This hearing is adjourned.
        [Whereupon, at 1:25 p.m., the hearing was adjourned.]
        [Prepared statements, response to written questions, and
    additional material supplied for the record follow:]
                   PREPARED STATEMENT OF SENATOR WAYNE ALLARD
        I would like to thank the Chairman for holding this hearing. He has
    moved forward quickly to examine recent corporate failures, and I
    appreciate his swift action.
        We have all heard a great deal about the recent meltdowns at Enron,
    Global Crossing, and other companies. A great deal of the controversy
    seems to center around the reliability of the financial statements from
    these companies. Our financial markets depend on timely, accurate,
    reliable information. I believe that it is important to examine the
    public policy implications of these collapses so that we can help
    restore investors' confidence.
        In particular, I am concerned with the use of off balance sheet
    arrangements, which can be used to obscure the actual condition of a
    company. I am hopeful that the Financial Accounting Standards Board
    will ensure that such transactions are appropriately reflected in the
    financial statements and disclosures.
        I would like to take this opportunity to welcome one of my
    constituents, Lynn Turner, to the Banking Committee. Lynn was the Chief
    Accountant of the SEC from 1998 to 2001, and he currently serves as the
    Director of the Center for Quality Financial Reporting at my alma
    mater, Colorado State University.
        I would also like to welcome our other witnesses and thank them for
    being here today. I understand that you are all very busy. Your
    expertise will be helpful as the Banking Committee grapples with the
    many accounting issues that have been brought to light during recent
    weeks.
        Again, thank you for being here. I look forward to your testimony.

                                   ----------

                PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY

        Through the course of these hearings that the Committee has
    conducted, we have heard a great deal about the importance of accurate
    information for properly functioning capital markets. One of the most
    essential tools for providing such information is the independent
    financial audit.
        Certified public accountants are supposed to provide objective
    analysis to ensure that the investing public is presented with an
    accurate picture of a company's financial condition. Unfortunately,
    recent events provide clear examples of where firms have acted like
    lapdogs instead of watchdogs. We have seen that too often the
    ``public'' responsibilities associated with the title ``certified
    public accountant'' have been ignored.
        The Enron case and the many others like it requires that this
    Committee address a very basic question: Can the accounting industry be
    relied upon to meet its responsibilities to the public? As I have noted
    in some of my previous remarks, addressing this question is extremely
    important. Fraud in the capital markets causes damage that goes far
    beyond the losses of a particular group of investors. Fraud diminishes
    investor confidence and ultimately stifles economic growth.
        Because of the seriousness of the damage that it causes, I believe
    we must not only severely punish fraud in our markets, we must also
    find ways to deter it in the first place.
        In the end, I do not think that we can legislate honesty or
    integrity in accounting or any profession. But I do believe that we
    must try to establish that those with responsibilities meet them or
    face consequences for their failure to do so.

                                   ----------

                  PREPARED STATEMENT OF SENATOR JON S. CORZINE

        Mr. Chairman, thank you for holding these important hearings, and
    for your thoughtful approach to analyzing the many factors that affect
    investor confidence in our financial markets.
        In the wake of what we have witnessed at Enron, Tyco, and Global
    Crossing, there is little doubt in my mind of the need for Congress to
    take a close look at corporate governance and public company
    accounting. These scandals have led to a crisis of confidence in our
    markets and fed public cynicism about the integrity of our markets as
    well.
        These scandals did not occur in a vacuum. What we have witnessed is
    the result of the obsessive zeal with which corporate financial
    officers--due to greed and pressure from corporate management--felt
    compelled to show increased earnings and growth, often at any cost.
        This hearing, featuring the former chief accountants of the SEC, is
    an important one in that it will give us a historical perspective of
    the evolution of our financial reporting system and provide us with
    insights as to how to best fashion a response aimed at restoring
    investor trust in the numbers presented by our public companies.
        If investors are to remain confident in our markets, America's
    publicly-traded companies must embrace a culture of financial reporting
    that is based on accurate, transparent disclosure. And if these
    attempts at cultural reform are to succeed, the SEC must be a willing
    partner.
        I want to thank all of our witnesses for taking the time to join us
    today. I look forward to their testimony.

                                   ----------
                    PREPARED STATEMENT OF WALTER P. SCHUETZE

           Chief Accountant, U.S. Securities and Exchange Commission
                                  1992 to 1995
                               February 26, 2002

        Thank you, Mr. Chairman, Senator Gramm, and Members of the
    Committee. My name is Walter P. Schuetze. My brief resume is attached
    hereto.
        Just a few comments about my experience and background. I was on
    the staff and a partner with the public accounting firm KPMG and its
    predecessor firms for more than 30 years. I was one of the Charter
    Members of the Financial Accounting Standards Board from April 1973
    through June 1976. I was a Member and Chair of the Accounting Standards
    Executive Committee of the American Institute of Certified Public
    Accountants in the 1980's. I was Chief Accountant to the Securities and
    Exchange Commission from January 1992 through March 1995 and Chief
    Accountant of the SEC's Division of Enforcement from November 1997
    through mid-February 2000.
        I need to mention that although I am retired, I am a consultant to
    the Securities and Exchange Commission and several other entities under
    consulting contracts. In addition, I have one remaining tie with my
    former firm, KPMG, in that I am an insured under a group life insurance
    contract obtained and administered by that firm; I pay the premium
    attributable to me. The views I express here today are my personal
    views.
        I appreciate very much the opportunity to testify here today. Your
    letter of January 16, 2002 inviting me to testify at this hearing says,
    ``A number of high-profile business failures in recent years,
    including, most recently, the collapse of Enron Corp., have involved
    significant accounting irregularities, and the February 26 hearing will
    examine the issues raised by those failures for financial reporting by
    public companies, accounting standards, and oversight of the accounting
    profession. You should feel free to address those issues as you see
    fit. The Committee would also appreciate any recommendations you may
    have about ways to deal with the issues you discuss.'' I, indeed, have
    a major recommendation, which I will get to at the conclusion of my
    remarks.
        The public's confidence in financial reports of and by Corporate
    America, and in the audits of those financial reports by the public
    accounting profession, has been shaken badly by the recent surprise
    collapse of Enron, by recent restatements of financial statements by
    the likes of Enron, Waste Management, Sunbeam, Cendant, Livent, and
    MicroStrategy, and by the SEC's assertion of fraud by Arthur Andersen
    in connection with its audits of Waste Management's financial
    statements in the 1990's, which Andersen did not admit or deny in a
    settled SEC action last summer. The public's confidence needs to be
    regained and restored. If that confidence is not regained and restored,
    the result will be that investors will bid down the price of stocks and
    bonds issued by both the United States and foreign corporations; we
    have seen evidence of that phenomenon in recent weeks. That is an
    investor's natural response to increased risk or the perception of
    increased risk. This will reduce the market capitalization of
    corporations, which in turn will negatively affect capital formation,
    job creation and job maintenance, and ultimately our standard of
    living. So, we are concerned today with a very important matter.
        You will hear or have heard many suggestions for improvement to our
    system of financial reporting and audits of those financial reports.
    Some will say that auditor independence rules need to be strengthened.
    That external auditors should not be allowed to do consulting work and
    other nonaudit work for their audit clients. That external audit firms
    should be rotated every 5 years or so. That external auditors should be
    prohibited from taking executive positions with their corporate clients
    for a number of years after they have been associated with the audit
    firm doing the audit unless the firm resigns as auditor. That peer
    reviews of auditors' work need to be improved and done more frequently
    if not continuously. That auditors should be engaged by the stock
    exchanges and paid from fees paid to the exchanges by listed companies.
    That the oversight of auditors needs to be strengthened. That
    punishment of wayward auditors needs to be more certain and swift. In
    that regard, Chairman Pitt of the SEC has proposed that there be a new
    Public Accountability Board overseeing the external audit function;
    this Board would, as I understand it, have investigative and
    disciplinary powers. And so on and on. In my opinion, those
    suggestions, even if legislated by Congress and signed by the
    President, will not fix the underlying problem.
        The underlying problem is a technical accounting problem. The
    problem is rooted in our rules for financial reporting. Those financial
    reporting rules need deep and fundamental reform. Unless we change
    those rules, nothing will change. The problems will persist. Today's
    crisis as portrayed by the surprise collapse of Enron is the same kind
    of crisis that arose in the 1970's when Penn Central surprisingly
    collapsed and in the 1980's when hundreds of savings and loan
    associations collapsed, which precipitated the S&L bailout by the
    Federal Government. Similar crises have arisen in Australia, Canada,
    Great Britain, and South Africa. There will be more of these crises
    unless the underlying rules are changed.
        Under our current financial reporting rules promulgated by the
    Financial Accounting Standards Board, management of the reporting
    corporation controls and determines the amounts reported in the
    financial statements for most assets. For example, if management
    concludes, based on its own subjective estimates, that the cost of an
    asset--say equipment--will be recovered from future cash flows from
    operations without regard to the time value of money or risk, no write
    down is required even when it is known that the current market price of
    the asset is less than the cost of the asset. The external auditor
    cannot require that the reported amount of an asset be written down to
    its estimated selling price; the external auditor cannot even require
    the corporation to determine the estimated selling price of the asset
    and disclose that price in its financial statements. So when it comes
    time to sell assets to pay debts, there often are surprise losses that
    investors then see for the first time. Management also makes similar
    assessments in determining the amount of inventory obsolescence, the
    allowance for bad debts, and whether declines in the values of
    investments below cost are ``other than temporary.''
        Under our current accounting rules, corporate management often
    records sales and trade receivables at 100 cents on the dollar even
    though a bank or a factor would pay only pennies on the dollar for
    those trade receivables. We saw that phenomenon in the past few years
    in the telecom rage where sales and receivables were recorded followed
    several months later by write offs of the receivables. On another
    front, we currently are seeing swaps of assets and the recognition of
    gains in what is effectively a barter transaction, even though the fair
    value of what was exchanged is apparently negligible.
        Except for inventories and marketable securities, none of these
    asset amounts in the financial statements--trade receivables,
    commercial and consumer loans receivable, real estate loans, oil and
    gas reserves, mineral deposits, pipelines, plant, equipment,
    investments--is subjected to the test of what the cash market price of
    the asset is. Yet, we know that most individual investors, and, in my
    experience, even many sophisticated institutional investors, believe
    that the reported amounts of assets in corporate balance sheets
    represent the current market prices of those assets; nothing could be
    farther from the truth.
        Under the FASB's definition of an asset, corporations report as
    assets things that have no market price whatsoever; examples are
    goodwill, direct response advertising costs, deferred income taxes,
    future tax benefits of operating loss carry forwards, costs of raising
    debt capital, and interest costs for debt said to relate to the
    acquisition of fixed assets. I call these nonreal assets. Today's
    corporate balance sheets are laden with these nonreal assets; this is
    the kind of stuff that allows stock prices to soar when in fact the
    corporate balance sheet is bloated with hot air. Of course, when it
    comes time to pay bills or make contributions to employees' pension
    plans, this stuff is worthless.
        The same goes for liabilities. Corporate management determines the
    reported amount of the liabilities for such things as warranties,
    guarantees, commitments, environmental remediation, and restructurings.
    Again, this is as per the FASB's accounting rules.
        The upshot is that earnings management abounds. Earnings management
    is like dirt; it is everywhere. SEC Commissioners have made speeches
    decrying earnings management. Business Week, Forbes, Barron's, The New
    York Times, The Wall Street Journal, and the Harvard Business Review
    carry hand-wringing articles about earnings management. Earnings
    management is talked about matter-of-factly on Wall Street Week and on
    Bloomberg TV, CNBC, CNNfn, and MSNBC. Earnings management is a scourge
    in this country. Earnings management is common in other countries as
    well because their accounting rules, and the accounting rules
    promulgated by the International Accounting Standards Board, are much
    the same as ours.
        We need to put a stop to earnings management. But until we take
    control of the reported numbers out of the hands of corporate
    management, we will not stop earnings management and there will be more
    Enrons, Waste Managements, Livents, Cendants, MicroStrategys, and
    Sunbeams. How do we take control of the reported numbers out of the
    hands of corporate management? We do it by requiring that the reported
    numbers for assets and liabilities, including guarantees and
    commitments, be based on estimated current market prices--current cash
    selling prices for assets and current cash settlement prices for
    liabilities. And by requiring that those prices come from, or be
    corroborated by, competent, qualified, expert persons or entities that
    are not affiliated with, and do not have economic ties to, the
    reporting corporate entity. And by requiring that the names of the
    persons or entities furnishing those prices, and the consents to use
    their names, be included in the annual reports and quarterly reports of
    the reporting corporate entity so that investors can see who furnished
    the prices.
        Let me give you an example of what I am talking about. Pre-
    September 11, 2001, the major airlines, to the extent that they own
    aircraft instead of leasing them, had on their balance sheets aircraft
    at the cost of acquiring those aircraft from Airbus and Boeing. Let's
    say that cost was $100 million per aircraft. The market prices of those
    aircraft fell into the basement post-September 11 to about $50 million
    per aircraft and remain there today although prices have recovered
    somewhat. Yet under the FASB's rules, those airlines continue to report
    those aircraft on their balance sheets at $100 million and are not even
    required to disclose that the aircraft are worth only $50 million.
    Under mark-to-market accounting, the aircraft would be reported at $50
    million on the airlines' balance sheets, not $100 million.
        I could give you many more examples, but I will add just one more.
    In the late 1970's, this country was experiencing great inflation. The
    Federal Reserve Board raised short-term interest rates dramatically.
    Long-term rates shot up. As a consequence, the market value of
    previously acquired residential mortgage loans and Government bonds
    held by savings and loan associations declined drastically. But the
    regulations of the Federal Home Loan Bank Board and the FASB's
    accounting rules said that it was okay for the mortgage loans and bonds
    to be reported at their historical cost. Consequently, the S&L's
    appeared solvent but really were not. This mirage allowed the S&L's to
    keep their doors open and in so doing they incurred huge operating
    losses because their cost of funds far exceeded their interest income
    on loans and bonds in their portfolios. Some of the S&L's decided to
    double-down by investing in risky real estate projects, also accounted
    for at historical cost, and proceeded to lose still greater amounts,
    which losses were also hidden on the balance sheet under the historical
    cost label. (The Federal Home Loan Bank Board even went so far as to
    allow S&L's to capitalize and report as assets losses on sales of
    assets, but the FASB said no to that procedure.) Of course, when the
    Federal Government had to bail out the insolvent S&L's in the 1980's,
    the Federal Government paid for the losses that were hidden in the
    balance sheet under the historical cost label and the operating losses
    that had been incurred while the S&L's kept their doors open because of
    faulty accounting. Had mark-to-market accounting been in place and had
    the Federal Home Loan Bank Board computed regulatory capital based on
    the market value of the S&Ls' mortgage loans, Government bonds, and
    real estate projects, the S&L hole would not have gotten nearly as deep
    as it ultimately did.
        Various Members of Congress have said in recent hearings about
    Enron that a corporation's balance sheet must present the corporation's
    true economic financial condition. A corporation's true economic
    financial condition cannot be seen when assets are reported at their
    historical cost amounts. The only objective way that the true economic
    financial condition of a corporation can be portrayed is to mark-to-
    market all of the corporation's assets and liabilities. Recall my
    earlier example about the cost of aircraft being $100 million and the
    current market value being $50 million. Mr. Chairman and Members of the
    Committee: Is there any question that the $50 million presents the true
    economic financial condition and the $100 million does not? Moreover,
    following today's FASB's accounting rules produces financial statements
    that are understandable only to the very few accountants who have
    memorized the FASB's mountain of rules. Indecipherable is the word
    Chairman Pitt has used in recent speeches. On the other hand, marking
    to market will produce financial statements that investors, Members of
    Congress, and my sister, who also happens to be an investor, can
    understand.
        The various proposals that have been made to cure Enronitis will
    not cure the problem. I liken our current accounting system to bridges
    built from timber, which bridges keep collapsing under the weight of
    eighteen-wheelers. The public demands that expert consulting engineers
    be called in to oversee the building of replacement bridges. But the
    replacement timber bridges keep collapsing under the weight of
    eighteen-wheelers. More expert consulting engineers will not make the
    timber bridges any stronger. What needs to be done to fix the problem
    is build bridges with concrete and steel. The same goes with
    accounting. In the 1970's, after the surprise collapse of Penn Central,
    the auditing profession instituted peer reviews--where one auditing
    firm reviews the work and quality controls of another auditing firm. In
    the 1970's, auditing firms also instituted concurring partner reviews
    where a second audit partner within the public accounting firm looks
    over the shoulder of the engagement audit partner responsible for the
    audit. These procedures have been ineffectual as shown by the dozens of
    Enrons, Waste Managements, Sunbeams, MicroStrategys, Cendants, and
    Livents that have occurred since then. Coincidentally, the Financial
    Accounting Standards Board also came on the scene in 1970's; it was
    going to write accounting standards that would bring forth financial
    statements based on concepts. What happened was that the FASB wrote a
    mountain of rules that produce financial statements that nobody
    understands and that can be and are gamed by corporate management. What
    all of that amounted to was continuing to build timber bridges that
    keep collapsing under the weight of eighteen-wheelers. We need to stop
    building timber bridges. We need to build concrete and steel bridges.
    We need to mark-to-market all assets and liabilities.
        Now, you may ask--how much will concrete and steel bridges cost?
    Can we afford to build concrete and steel bridges? My response is that
    we cannot afford not to build concrete and steel bridges. How much of
    the cost of the S&L bailout was attributable to faulty accounting; the
    amount is unknowable but no doubt was huge. How much does an Enron or
    Cendant or Waste Management or MicroStrategy or Sunbeam cost? The
    answer for investors is billions, and that does not count the human
    anguish when working employees lose their jobs, their 401(k) assets,
    and their medical insurance, and retired employees lose their cash
    retirement benefits and medical insurance. By some estimates, Enron
    alone cost $60-$70 billion in terms of market capitalization that
    disappeared in just a few months. Waste Management, Sunbeam, Cendant,
    Livent, MicroStrategy, and all of the others also cost billions in
    terms of market capitalization that disappeared when their earnings
    management games were exposed. And these costs do not include the
    immeasurable cost of lost confidence by investors in financial reports
    and the consequent negative effect on the cost of capital and market
    efficiency.
        By my estimate, annual external audit fees in the United States for
    our 16,000 public companies, 7,000 mutual funds, and 7,000 broker-
    dealers total about $12 billion. Let's say that $4 billion is
    attributable to mutual funds and broker-dealers. (Incidentally, mutual
    funds and broker-dealers already mark-to-market their assets every day
    at the close of business, and we have very few problems with fraudulent
    financial statements being issued by those entities. Mark-to-market
    works and is effective.) That leaves $8 billion attributable to the
    16,000 public companies. Assume that the $8 billion would be doubled or
    even tripled if the 16,000 public companies had to get competent,
    outside valuation experts (and not the public accountants because they
    are not competent valuation experts) to determine the estimated cash
    market prices of their assets and liabilities. We are then looking at
    an additional annual cost of $16-$24 billion. If we prevented just one
    Enron per year by requiring mark-to-market accounting, we easily would
    pay for that additional cost. And when considered in relation to the
    total market capitalization of the U.S. corporate stock and bond
    markets of more than $20 trillion, $16-$24 billion is, indeed, a small
    price to pay.
        So the question arises: Who should mandate mark-to-market
    accounting? I recommend that there be a sense of the Congress
    resolution that corporate balance sheets must present the reporting
    corporation's true economic financial condition through mark-to-market
    accounting for the corporation's assets and liabilities. Then I
    recommend that Congress leave implementation to the SEC, much the way
    it is done today by the SEC for broker-dealers and mutual funds. There
    will be many implementation issues, so the SEC will need more staff and
    money.
        My testimony today is a summary of a lengthy article that I wrote
    about the definition of assets and liabilities, earnings management,
    and mark-to-market accounting that was published last year in Abacus, a
    University of Sydney publication, and which was the basis for the RJ
    Chambers Research Lecture that I presented last year at the University
    of Sydney. That article and lecture are being submitted for the record.
        I will be pleased to answer the Committee's questions.

                    PREPARED STATEMENT OF MICHAEL H. SUTTON

           Chief Accountant, U.S. Securities and Exchange Commission
                                  1995 to 1998
                               February 26, 2002

        Chairman Sarbanes, Senator Gramm, and Members of the Committee.
    Thank you for inviting me to share my thoughts on the issues raised by
    recent high-profile business failures, in particular the issues of
    financial reporting by public companies, the efficacy of accounting
    standards, and oversight of the accounting profession.
        Let me begin with a few brief comments about my background and
    experience. I was Chief Accountant of the Securities and Exchange
    Commission from June 1995 to January 1998. Prior to holding that
    office, I was a Senior Partner in the firm of Deloitte & Touche,
    responsible for developing and implementing firm policy on technical
    and professional matters relating to accounting, auditing, and practice
    before the SEC. My career with Deloitte & Touche spanned from 1963 to
    1995. As a retired partner, I receive a fixed retirement benefit from
    that firm. Presently, I undertake from time to time independent
    consulting and other assignments in the field of accounting and
    auditing regulation and related professional issues. The comments I
    offer today are my personal views.
        As we gather today, the institutions responsible for financial
    reporting in our capital markets are reeling from the fall-out of a
    financial reporting scandal of colossal proportions. Reports on the
    collapse of Enron to date have exposed massive manipulations of
    financial reporting by management, inexplicable breakdowns in the
    independent audit process, astonishing revelations of holes in our
    financial reporting standards and practices, and stunning lapses of
    corporate governance. The Enron debacle has become a poster child for a
    system that seems to be out of control.
        We have witnessed high profile failures of our financial reporting
    system in the past and have encountered similar questions about the
    performance of the key players in our financial reporting system.
    Clearly, however, Enron is a cataclysmic event that has changed the
    world's view of a system that we have often touted as ``the best in the
    world.'' This time, the damage to the reputation of our financial
    reporting system and its critical guardians is so severe that the
    investing public can be expected, rightly so, to demand answers and
    meaningful reforms.
        So, we are now once again at a crossroad. As we reexamine the
    partnership between the public and private sectors that has been the
    basis for oversight of our capital markets, we must confront candidly
    and honestly some challenging questions. Can we any longer believe in
    and rely on the independent audit? Can we any longer believe that our
    accounting and disclosure standards provide the transparency that is
    essential to investors and the public? Can we rely on self-regulatory
    systems to ensure audit quality and to root out and to discipline
    substandard performance? Can we rely on corporate governance
    processes--oversight by boards of directors and audit committees--to
    ride herd on management and to see to it that auditors do their job?
    Enron has changed, perhaps for decades to come, how we look at and
    think about those questions.
        The road ahead seems awesomely challenging. Where do we begin to
    reform a system that suddenly seems very fragile, and perhaps seriously
    flawed? What are the essential changes that we need to make? Today, I
    would like to offer some perspectives and insights drawn from my nearly
    40 years in accounting practice and public service. I also will share
    some thoughts on needed reforms.
        I begin with some essential views that I think all who have
    important roles in and benefit from a vibrant capital market system can
    agree on--business, government, auditors, standards setters, investment
    bankers, analysts, and the investing public. We all share a common,
    linked starting point:

     Our capital market system is a national treasure that is vital
        to the success of the economy. Indeed, our exceptional standard of
        living depends on the success of that system.
     Accordingly, we share a compelling common interest in assuring
        the strength and liquidity of our capital markets. We all benefit
        in the result.
     This compelling common interest should shape our policy goals
        and guide our thinking as we explore reforms. Other goals and
        interests must not obstruct our vision.
     The most critical, yet intangible, ingredient of a successful
        capital market system is the confidence of investors and the public
        that the markets are fair--confidence that the information flowing
        into the markets is trustworthy and that investors can make
        informed decisions and will not be misled.\1\
    ---------------------------------------------------------------------------
        \1\ Indeed, the focus of the securities laws is rooted in this view
    of our capital markets. Historian David M. Kennedy described the events
    that surrounded the enactment of the securities laws in his Pulitzer
    Prize winning book, Freedom From Fear. In describing the formulation of
    the securities laws, he wrote, ``For all the complexity of its enabling
    legislation, the power of the SEC resided principally in just two
    provisions, both of them ingeniously simple. The first mandated
    disclosure of detailed information, such as balance sheets, profit and
    loss statements, and the names and compensation of corporate officers,
    about firms whose securities were publicly traded. The second required
    verification of that information by independent auditors using
    standardized accounting procedures. At a stroke, those measures ended
    the monopoly . . . on investment information.'' He went on to observe,
    ``The SEC's regulations unarguably imposed new reporting requirements
    on businesses. . . . But they hardly constituted a wholesale assault on
    the theory or practice of free market capitalism. All to the contrary,
    the SEC's regulations dramatically improved the economic efficiency of
    decisions. . . . This was less the reform than it was the
    rationalization of capitalism, along the lines of capitalism's own
    claims about how free markets were supposed to work.''

        As we look at the issues today, it should be abundantly clear that
    there is no higher goal for financial reporting than providing useful
    and reliable information that promotes informed investment decisions
    and confidence in the system. Sometimes, however, we hear arguments
    that financial reporting should take into account other policy goals in
    the name promoting various economic benefits or market efficiency. That
    view of the world is based on a curious, upside down logic. The truth
    is, without investor confidence, arguments about how financial
    reporting does or does not contribute to economic goals or market
    efficiency simply are moot--they are a waste of time. If investors do
    not have confidence or lose confidence in the integrity of the
    information they receive, they will flee the markets, and we all will
    pay a devastating price.

    Independent Audits
        In the past, the auditing profession has responded to challenges to
    its performance with arguments that, on the whole, audits are effective
    and that public expectations of the independent audit are unrealistic.
    As the dialogue continues, attention turns to the standards that govern
    financial reporting and auditor performance. After extended debate,
    changes are proposed, and some are adopted. Opinion about whether the
    changes will improve auditor performance or enhance investor
    confidence, however, is mixed, and the ensuing periods of peace and
    adjustment are uneasy. Investors and the public, who understand little
    about how audits and auditors work, are left to wonder what the future
    holds.
        Today, in the light of all that has happened, we must find more
    substantive and lasting remedies. Now is the time to design and
    implement essential reforms, both through regulatory processes and by
    reexamining and, if necessary, redefining relationships and reporting
    responsibilities.
        I believe that the road to a more lasting resolution begins with
    full acknowledgement by the auditing profession of the reality that
    seems so clear today. Failures in our financial reporting system are
    more than aberrations. They seriously undermine the confidence of
    investors and the public in the institutions that are supposed to
    protect them. They ``poison the well.'' Pleas that the vast majority of
    financial reports are of high quality, that most audits are effective,
    and that financial reporting failures are few, miss the point. In
    capital markets, a single catastrophic reporting failure is a disaster
    in which losses to investors and the public can be, and often are,
    overwhelming, wiping out decades of hard work, planning, and saving.
    Debates about how many failures are tolerable are not only not
    productive, they are also nonsense.
        The urgent challenge is to find ways to restore and maintain
    confidence in the independent audit. To achieve that goal, I believe
    that the auditing profession will need to do three things:

     First, it will have to embrace a role that is fully consistent
        with high public expectations. Those expectations contain the seeds
        of a fundamental conflict that we must deal with. And that
        fundamental conflict is that, in public capital markets, insiders
        have an advantage over public investors. In that arena, independent
        auditors are expected to balance the scales by assuring that
        financial reporting provides useful and reliable information to
        investors and gives them a fair presentation of the economic
        realities of the business. And they are expected to uncover and
        report to the public financial improprieties of the kind that
        existed at Enron.
     Second, the auditing profession will have to tackle financial
        reporting failures as a distinct issue with a distinct goal--zero
        tolerance. We understand that, in life, ``zero defects'' are almost
        never realized. Nevertheless, the public expects that the
        profession will pursue that end--and with greater energy than in
        the past--and with more success.
     Third, it will have to accept and support necessary regulatory
        processes that give comfort to investors and the public that the
        profession is doing all that it can do to prevent future episodes
        of failed financial reporting.

        Regulatory processes that will build confidence in the auditing
    profession will be truly independent; they will be open; they will
    actively engage, inform, and involve the public; they will be
    adequately resourced and empowered to accomplish their mission; and
    they will be amenable to change as events dictate. I believe that the
    critical ingredients of an effective regulatory process that can
    restore and maintain public trust include:

     Timely and thorough investigations of circumstances that may
        involve fraudulent financial reporting.

     Objective and fair assessments of the role and performance of
        the auditor.

     Timely and meaningful discipline of auditors and firms that
        violate acceptable norms of conduct.

     Regular oversight and periodic examinations of the policies
        and performance of independent auditors.

     Timely and responsive changes in professional standards and
        guidance when a need for improvements is identified.

        Specifically, I believe that those goals can best be accomplished
    through an independent statutory regulatory organization operating
    under the oversight of the Securities and Exchange Commission. That
    organization should be empowered to require registration of independent
    auditors of public companies, establish quality control, independence,
    and auditing standards applicable to registered independent auditors,
    conduct continuing inspections of the accounting and auditing practices
    of registered firms, undertake investigations of possible financial
    reporting failures, and conduct proceedings to determine whether
    disciplinary or remedial actions, including fines, are warranted. To
    carry out these responsibilities the statutory regulatory organization
    will need appropriate subpoena and disciplinary powers. As a starting
    point to implementation, we might consider reconstituting the existing
    Public Oversight Board as a statutory regulatory organization and
    expanding its mandate and powers to include the elements I have
    outlined.

    Accounting Standards
        Strengthening the independent audit, though vital, is only part of
    the needed reform of our financial reporting system. We also need to
    examine critically and take action to strengthen the processes by which
    our accounting standards are developed. As we have seen in the Enron
    case, poor accounting standards and guidelines can exact their own
    toll. They can be extremely costly to investors and the public. We
    simply cannot tolerate financial reporting standards that enable those
    who come to the markets seeking investor capital to ``hide the ball.''
        Further, we cannot tolerate processes that fail to produce
    accounting standards that are responsive to critical financial
    reporting issues as they arise in the marketplace--and that fail to do
    so on a timely basis. Current rules for accounting for SPE's, for
    example, are nonsensical--they can only be explained by accountants to
    accountants--or more disturbingly, perhaps, by accountants to deal
    makers. Yet, the Financial Accounting Standards Board has studied
    consolidation issues for years, and has done little more than tinker
    around the edges. We have a right to insist that accounting rules be
    clearly responsive to the underlying economics of transactions and
    events. And it is not acceptable to sit by while financial market
    innovations outstrip the development of needed guidance.
        There seems to be a great deal of finger-pointing today about what
    is wrong with U.S. accounting standards. Some have placed the blame for
    Enron-like financial reporting failures on an accounting model that is
    out of date. The popular rhetoric asserts that the essential problem is
    that we are trying to apply an industrial age accounting model to an
    information age economy. The solutions offered include such things as
    more timely reporting, reporting that seeks to avoid impenetrable
    complexity by requiring more understandable disclosures, and a greater
    recognition in the financial statements of intangible assets. While
    there are very real problems with our accounting model, and while the
    ideas that have been offered may be well intended, they would do little
    to remedy the challenges presented by an Enron.
        Additional criticism is beginning to focus on the fact that U.S.
    standards have become increasingly detailed, and suggestions have been
    made that they should be broader statements of principle, applied with
    good judgment and respect for the substance of underlying transactions
    and events. I have sympathy for the desire to break the cycle of the
    mind-numbingly complex accounting rules that have become the norm, but
    to do that I think we have to confront realistically the reasons why
    our standards have evolved the way they have, and what will be required
    to avoid the same pitfalls in the future.
        What the capital markets need and demand is accounting and
    disclosure that provides a clear picture of the underlying economics
    and furnishes information that is comparable among companies and
    consistently presented over time. The issue and debate should not be
    about whether accounting standards should be detailed or broad, but
    rather about what formulation of standards and standards setting
    approaches best accomplish the goals to which financial reporting
    should aspire.
        To fully appreciate the challenges of improving financial
    reporting, it is useful to look for a moment at the forces at work in
    shaping our accounting standards, and to reflect on the obstacles they
    present. Here are some of the underlying pressures:

     Business managers urge standards that provide the greatest
        flexibility and room for judgment. They want to be able to manage
        reported results, but yet be able to point to an accounting
        standard that assures the public that they are following the rules.

     Dealmakers and financial intermediaries want standards that
        permit structuring transactions to achieve desired accounting
        results--results that could obscure the underlying economics. In
        that world, creative transaction structures are valuable
        commodities.

     Auditors are pressured to support standards that their clients
        will not take issue with, and they often are restrained, perhaps by
        commercial concerns, in their expected support for reporting that
        is in the best interests of their investors and the public.

     Legislators too often lose sight of the fundamental importance
        of an independent standards setting process and neutral accounting
        rules. Without that independence and neutrality, standards setters
        cannot effectively perform their essential service to the investing
        public.

     The standards setters too often pull their punches, backing
        down from solutions they believe are best--perhaps because of a
        perceived threat to the viability of private sector standards
        setting--perhaps because of the sometimes withering strains of
        managing controversial, but needed change--perhaps because of a
        loss of focus on mission and concepts that are supposed to guide
        their actions.

        Effectively meeting the expectations of investors and the public in
    that environment requires a standards setting process that has the
    independence to withstand the myriad of constituent pressures that it
    inevitably will face and to make the tough decisions that inevitably
    are required.
        Now is the time for a critical reexamination of our standards
    setting processes, and the willingness and commitment of capital market
    participants to support a fully effective, independent standards
    setter. If the public-private sector partnership for improving
    financial reporting is to continue, we need to reenergize our
    commitment to the needs of investors. Of critical importance is the
    urgent need for those who have the greatest stake in transparent
    financial reporting--buy side analysts, those who invest for retirees
    and manage their funds, and other institutional investors--to take a
    more active role in the standards setting and rulemaking processes.
        To restore confidence in our standards setters, we should take
    immediate steps to secure independent funding for the FASB--funding
    that does not depend on contributions from constituents that have a
    stake in the outcome of the process. We also should take immediate
    steps to establish an independent governance process to replace the
    current constituent-based foundation board. The leadership for
    implementing these changes should come from leaders of unquestioned
    objectivity and demonstrated commitment to the goals of high quality
    financial reporting and the public interest. Perhaps the needed reforms
    could be best developed and implemented under the auspices of an
    independent commission made up of leading lights within the corporate
    governance movement, heads of investment funds and retirement systems
    responsible for managing and for investing the Nation's savings and
    pension assets, academic leaders who are grounded in business and
    economics, and former leaders of institutions responsible for capital
    market regulation.

    Corporate Governance
        Perhaps one of the most practical and effective first steps in
    reforming the financial reporting system would be to immediately
    revisit and rewrite our corporate governance policies and guidelines to
    clearly break the bonds between management and the independent auditor,
    and to unmistakably spell out the responsibilities of boards of
    directors and audit committees to shareholders and the investing
    public. Management should be the subject of, not the manager of, the
    independent audit relationship and process. The ultimate responsibility
    for full and fair disclosure to shareholders, and the direct
    responsibility for the independent audit relationship and the quality
    of the audit process, should be clearly fixed with the board of
    directors and its audit committee. The audit committee should be made
    up entirely of independent directors.
        Ensuring a relationship with the independent auditor that best
    protects audit quality may require further measures such as periodic
    rotation of auditing firms, limitations on hiring personnel from the
    independent auditing firm, and further restrictions on nonauditing
    services that an independent auditor may provide to audit clients. As
    we confront those issues, it is important to keep in mind that investor
    confidence is influenced by both the fact and the appearance of the
    independence of the auditor. At the end of the day, governance of the
    financial reporting process should provide comfort to the investing
    public that the financial statements they receive have been subjected
    to an effective and truly independent audit.

    Conclusion
        So yes, we are once again at a crossroad. As we reexamine the
    partnership between the public and private sectors that has been the
    basis for oversight of our capital markets in the past, we must
    confront candidly and honestly some challenging questions. Are we
    willing to fulfill, with commitment and enthusiasm, our clear
    responsibilities to serve investors and the public? Are we willing to
    exercise discipline to assure that we faithfully fulfill that
    commitment? Are we willing to be spirited participants in regulatory
    and governance processes that are essential to provide comfort to
    investors that our capital markets can be trusted? Only clear
    affirmative answers to these questions will assure that the partnership
    can continue and flourish.
        At the outset, I suggested that the common interest in preserving
    and maintaining healthy capital markets far outweighs the concerns or
    goals of any particular group or special interest. We have to keep
    focusing on that fundamental tenet and on the goal of assuring that
    confidence in our capital markets is preserved and that confidence in
    our financial reporting and disclosure system is restored. Only a
    continuing commitment to that goal will guarantee that we continue to
    enjoy the best capital markets in the world.

                                   ----------

                      PREPARED STATEMENT OF LYNN E. TURNER

           Chief Accountant, U.S. Securities and Exchange Commission
                                  1998 to 2001
                               February 26, 2002

        Chairman Sarbanes, Senator Gramm, Members of the Committee. Thank
    you for asking me to share my thoughts regarding an issue of vital
    importance to our Nation's capital markets. I had the good fortune of
    serving as the Chief Accountant of the U.S. Securities and Exchange
    Commission (SEC) from July 1998 to August 2001. Now, I have the
    privilege of shaping the minds of students who are the future of the
    accounting profession, as a professor in the College of Business at
    Colorado State University (CSU).
        Prior to joining the Commission, I was the Chief Financial Officer
    (CFO) and the Vice President of Symbios, Inc., an international
    manufacturer of semiconductors and storage solution products. I was a
    member of the executive management team and had responsibility for our
    financial reporting and disclosures, as well as our audits. I also
    regularly interacted with our Board of Directors including the audit
    committee. After graduation from CSU and the University of Nebraska, I
    joined the widely respected international accounting firm of Coopers &
    Lybrand, now PricewaterhouseCoopers. I rose through the ranks to became
    a partner, after spending a 2 year fellowship with the SEC. As a
    partner with the firm, I was the leader of the national high technology
    industry audit practice, served as an SEC specialist, and also had
    partner responsibility for a number of our audit clients. In addition
    to teaching today, I also do limited consulting in the accounting
    industry and business.

    Why Reliable Numbers are Critical to the Success of the
    U.S. Capital Markets
        In business, we use numbers to report to investors, lenders,
    regulators and other users of the financial statements, the economic
    performance of a company. The numbers in the financial statements, just
    like a score on a college student's test, tell investors how a company
    has performed in comparison to expectations of management, the markets
    and competitors. Without these historical numbers, it is difficult, if
    not impossible, to gauge the future prospects of a company. Without
    accurate numbers, investors are likely to be misled into making make
    wrong decisions. In essence, those who prepare or aid in the
    preparation of false and misleading financial statements take away from
    investors their ability to make their own informed choice as to whether
    they would invest in a company. When this occurs with increasing
    frequency, as we have seen in recent weeks and years, investors
    question whether they can invest with confidence without losing their
    money.

    Moving Toward a Solution
        I commend the Chairman and this Committee for scheduling a series
    of hearings on finding effective solutions to the issues that confront
    the capital markets today; that have caused investors to lose trust;
    that have unfortunately painted both the unscrupulous and the honest
    with the same brush. There is no question in my mind that the SEC and
    Justice Department, left unfettered and given sufficient resources,
    will thoroughly investigate and bring to justice those who are found
    culpable of the damage and destruction to the lives of thousands of
    Americans who invested in or worked at Enron. But once their job is
    done, it will be equally, if not more important, that the current
    systematic failures are corrected. And those corrections will need to
    be more than just a Band-Aid.
        While I was at the Commission, we began work on a staff report that
    identified concerns and issues surrounding the quality of financial
    reporting and the accounting profession. The report was designed to
    discuss not only the issues the staff had identified, but also the
    progress that had been made by the profession on the issues and
    recommendations for continuous improvement in the quality of audits and
    financial reporting. We wanted to be sure a report card was created
    against which future progress could be measured, similar to what the
    General Accounting Office (GAO) had done with their report on the
    profession in 1996. In that way, the investing public could be provided
    an ongoing report card, hopefully prepared by the Public Oversight
    Board (POB) on the progress being made toward ensuring investor
    protection through higher quality financial reporting. While due to
    time constraints, we were unable to complete the report, the SEC staff
    did provide some, but not all, of our materials to the GAO. Perhaps
    some of that may be used in their forthcoming report on the accounting
    profession.
        The Commission asked the POB to provide an annual report card to
    the public on the implementation of the many recommendations of the
    Panel on Audit Effectiveness. This Panel had been formed at the urging
    of the SEC, to formulate recommendations on how audits could be made
    more effective. Its members included the former Chief Executive Officer
    (CEO) of PriceWaterhouse, two former SEC Commissioners, two former
    CEO's of the American Stock Exchange, two former CEO's of public
    companies and an academic.
        The POB was also to issue two reports on the progress large
    accounting firms had made in the implementation and operation of
    quality controls ensuring their compliance with the auditor
    independence rules. This project was undertaken due to serious concerns
    by the SEC with respect to the lack of compliance with applicable rules
    by these firms. Unfortunately, now with the decision of the POB to
    disband, a situation in which they were probably left no choice, there
    is no one left to fill out the report card.
        Enron has brought to light many of the shortcomings the SEC staff
    had identified with various facets of the accounting profession such as
    peer review, the lack of an effective and timely self-disciplinary
    process, the need for more effective auditing standards and concerns
    about financial conflicts that impaired the independence of auditors.
    As a result, the need for the full report has been somewhat mitigated.
        Yet the recommendations for improving the deficiencies in the
    quality of our financial reporting system are even more relevant today
    than when I left the Commission. And it is that portion of what would
    have been in the staff report to the Commission, if we had time to
    complete it, I would like to share with you today. I will point out
    that many of the recommendations the SEC staff were anticipating making
    were already set forth in a series of speeches last spring and summer
    that were titled ``The State of Financial Reporting Today; An
    Unfinished Chapter I, II, and III,'' as well a speech entitled, ``An
    Investor's Bill of Rights.'' Some of these recommendations come from
    reports that are not new. They are recommendations that continue to
    gather dust on a bookshelf as they continue to fail to be implemented.
        The specific areas that the recommendations in the report would
    have addressed include:

     The self-governance of the profession.
     The quality of audits including the standard setting process.
     Auditor's independence.
     Audit committees.
     The quality of financial reporting including the standard
        setting process.

        These recommendations essentially are about one vitally important
    principle, INDEPENDENCE. Independent oversight of the accounting
    profession, independence of the accounting and auditing standard
    setting process, independent auditors and audit committees and
    independent analysts. Independence is a word that has served this
    country well for the past 225 years and it will also serve to protect
    the interests of the investing public. It is a concept that will
    overcome the fears of investors arising from the arrogance, ignorance,
    and influence they have listening to with respect to Enron and other
    financial failures.

    Independent Governance of the Profession
        The quality and reliability of financial statements and disclosures
    provided to investors are ultimately determined by whether there is
    compliance with the applicable accounting rules. You can write all the
    accounting rules you want to; you can require sufficient disclosures to
    fill up a phone book; but unless someone assures investors the
    established rules are being followed, they are meaningless. That is why
    we have independent audits. Independent audits provide investors with
    confidence that the numbers are accurate and reliable.
        Since the financial frauds and failures arising from the 1972-1973
    bear market, including cases such as Penn Central and Equity Funding,
    the profession has attempted to ensure audit quality through a self-
    governance process. While some argue that 99.9 percent of the audits
    each year are okay, remember that Enron was once one of those 99.9
    percent. The fact is we really do not know how many more audits are
    like the iceberg below the water level, unseen until it is too late.
        What we do know today, is that the increasing number of earnings
    restatements, the number of massive financial frauds, the tens and
    hundreds in billions of losses to investors and now Enron, accompanied
    by the almost daily parade of financial reporting issues, highlight a
    serious question in the minds of investors with respect to the quality
    of audits. They also strike at the very heart of the credibility of my
    once esteemed and proud profession. Yet the multitude of organizations
    often referred to in the press these days as ``alphabet soup'' do not
    yield an efficient or effective quality control process. A diagram of
    this confusing and ineffective structure is attached hereto as
    appendix.
        It is well past time to establish an SEC supervised public
    accounting oversight board in light of:

     The American Institute of Certified Public Accountants (AICPA)
        and profession having cut-off the funding for the POB in spring of
        2000 when it attempted to fulfill its mandate to the public and
        carry out an investigation of the lack of compliance with
        independence rules.
     The AICPA having a weak, if not totally ineffective self-
        disciplinary group called the Professional Ethics Executive
        Committee or PEEC. A group that conducts its meetings behind closed
        doors, that often defers taking action on cases for years at a
        time, that has no subpoena powers, and that has failed to take
        action in a number of instances after the SEC has. The AICPA and
        firms had stated to the SEC and public in press releases toward the
        end of 2000 that they would work toward increasing the public
        membership of this organization from the current three out of
        twenty members. Andersen publicly said it would support an increase
        in public membership to half of the Committee's total membership.
        Unfortunately, this has become a broken promise.
     The AICPA creating a for-profit portal and web of business
        relationships called CPA2Biz, and along with a failed attempt at
        establishing a business consulting credential. It is difficult to
        understand how a not-for-profit organization can enter into this
        web of for-profit relationships and not create conflicts with the
        notion of being a public interest self-regulatory organization.
     The POB itself has no disciplinary powers.
     The POB has limited capabilities to ensure auditing standards
        are written based on meeting the needs of the public for effective
        audits, as opposed to being written by, and for, the general legal
        counsels of the firms.
     The Quality Control Inquiry Committee or QCIC that is often
        trumpeted as investigating alleged audit failures in fact has no
        subpoena powers. It only has
        members from the profession, often retired partners from the Big 5
        ``club,'' lacks members from the public and only looks at documents
        that are already publicly available. It has recommended cases to
        the PEEC or Auditing Standards Board (ASB) for further action.
        Action that too often fails to materialize.
     We may now be faced with an unfortunate outcome of Enron, one
        I truly hope does not become reality, of having four major
        accounting firms. As I have previously expressed to the POB, this
        in and of itself will result in the need for major revisions to the
        existing system as the concentration of the public audit function
        becomes extremely concentrated in just four global and large firms.
        From small firms with a few offices at the time the Securities Acts
        were passed, these businesses have grown to global organizations
        that employ in some cases in excess of 100,000 on a global scale.

        In light of these and other recent events, today we need to
    establish an independent public accounting regulatory oversight body
    for the accounting profession under the supervision of the SEC. That
    body needs to have these critical elements:

     It is conducted by an adequately funded independent
        organization.
     Its members are drawn from the public rather than the
        profession.
     Timely and effective disciplinary actions against those who
        fail to follow the rules, regardless of whether they are small or
        large firms.
     It has the authority to issue auditing and quality control
        standards that establish a benchmark for the performance of quality
        audits and its disciplinary process, thereby serving and protecting
        the investors as opposed to the interests of the profession.
     It inspects the work of auditors on an ongoing basis to ensure
        they have made the investing public, not the amount of consulting
        fees they can generate, their number one priority.

        I have heard some say that unless practicing accountants serve on
    the board it will not have the necessary expertise. Yet in the United
    Kingdom the accounting profession itself recommended a new framework
    for the independent regulation of the profession that has an
    independent oversight board, called the ``Foundation,'' without any
    practicing accountants among its members. I believe you can get many
    well-qualified public servants who understand audits and will protect
    investors by drawing from the ranks of former auditors such as Charles
    Bowsher, the former Comptroller General of the United States or some of
    these distinguished gentlemen who sit next to me today.
        I have also heard some say we should consider using one of the
    existing self-regulatory structures that exist today. However, these
    may well involve organizations where the members themselves have a
    vested interest in the outcome of accounting and auditing standards.
    For example, members of a stock exchange have a vested interest in the
    numbers they must report, the disclosures they must make, and the
    outcome of their audits. This creates a conflict that will not ease
    investor's fears about the current lack of independence.
        One reason for creating a private oversight board is the need for
    an active inspection program that can discipline auditors when
    substandard work is identified. An inspection requires very experienced
    personnel who are typically partners and managers and who have
    significant practical experience. These people would be no lower than a
    GM-15 or Senior Executive Service in the Government personnel scale.
    For a typical accounting firm office, it may take on average of ten
    reviewers working 7 to 10 days to perform an inspection. Large offices
    like those located in major metropolitan areas will take significantly
    more staff. Given the large accounting firms today have a hundred
    offices in just the United States, one can quickly see where it will
    take significant manpower to perform timely and effective inspections.
    Being able to attract, competitively compensation and retain such staff
    will be a challenge for the oversight board. However given today's
    budgetary pressures, this is probably easier accomplished in the
    private board as opposed to the SEC.

    Improving Audit Quality
        Audit quality will be enhanced through effective independent
    inspections by the oversight board I just described. Performance of
    annual on-going independent inspections of the large accounting firms,
    with perhaps no less than tri-annual inspections of smaller firms who
    tend to audit fewer public issuers, should overcome the current system
    of ``backslapping'' peer reviews. It is interesting to note that today
    it is perhaps the smaller firms that face the most rigorous reviews.
    This system of firm-on-firm reviews by the large firms reminds one of
    grade school where the rule was ``I won't tell on you so long as you do
    not tell on me.'' A system that time and time again I questioned the
    credibility of the reviews being performed. A process that did not
    examine audits such as Enron or Global Crossings where investors had
    alleged a failure occurred, and did not mandate that all audits in
    which a restatement had occurred to be inspected.
        And when the SEC staff raised questions with the peer reviewers,
    meaningful and satisfactory responses were generally not forthcoming.
    The responses we did receive continually sounded like a rationalization
    of whatever had been done. Yet the public continued to be provided with
    the blue ribbon seal of approval by the very profession under scrutiny.
    Eventually this led to the SEC removing the ``endorsement'' of the peer
    review process from its Annual Report to Congress in 1999.
        Further recommendations continue to need to be implemented to
    improve audit quality. They include:

     The 200 plus recommendations the Panel on Audit Effectiveness
        made to the profession and accounting standard setters in August
        2000 need to be adopted as proposed, without being watered down.
        This includes a substantial rewrite of many of the auditing
        standards to require certain forensic audit procedures be
        incorporated into each audit, and to put sufficient detail into the
        standards to ensure they can be enforced. The POB was charged with
        overseeing the implementation of the Panel's recommendations. I
        would encourage the GAO or an independent oversight board to
        undertake that charge, as the POB will soon cease to exist.

     Auditing standards need to be established by an independent
        standard setting body.

        No doubt some will argue that you need to have a knowledgeable body
    of auditors to set auditing standards if you are going to be effective.
    But keep in mind that for the past 20 plus years, the ASB has been
    drawn almost exclusively from ``knowledgeable'' auditors with the major
    accounting firms. And yet the Board's Statements on Auditing Standards:

     Result in an audit report to investors that fails to provide
        an adequate explanation of an audit, such as the fact the auditor
        may not even have tested internal accounting controls, or while
        generally accounting rules are followed, aggressive accounting
        practices have been employed by the company to meet the earnings
        expectations.

     Today still do not require auditors to look at large unusual
        adjusting journal entries that are a common characteristic of many
        financial frauds.

     Do not provide guidance to auditors on factors an auditor
        would need to consider in assessing materiality until after the SEC
        staff issued guidance on this subject in August 1999.

     Still have not provided an auditing standard with
        authoritative guidance on auditing ``cookie jar'' reserves despite
        the request of the SEC staff over 2 years ago to provide such
        guidance to help reduce the incidence of improper earnings
        management.

     Still permit auditors to consult on the design and structuring
        of transactions which reduce, rather than improve the transparency
        of disclosures, despite two previous requests from the SEC, as well
        as a renewed request in recent weeks to address this abusive
        practice.

     Have recently adopted a new standard that will set the
        requirements for auditors documenting their work that still does
        not require sufficient documentation to permit an independent third
        party to validate the work auditors have performed.

        Simply put, auditing standards today, which are often reviewed and
    edited by the legal counsels of the firms, are written to protect the
    interests of the firms, not ensure quality audits that will protect
    investors. Perhaps the greatest chief accountant of all times, Sandy
    Burton was way ahead of his time in 1978 when he testified before
    Congress stating that the current system would not serve investor
    protection.
        I do give the current chairman of the ASB credit for trying to
    improve recently the quality of the auditing standards. Guidance has
    been forthcoming on topics such as auditing revenues in selected
    industries, as well as financial instruments many companies have
    invested in. However, it has been the age-old story of too little, too
    late. We need to change the process to one that will develop standards
    for auditors and provide them with timely guidance before they and
    investors hit the iceberg. Again, I point out that in the new system in
    the United Kingdom, the establishment of auditing standards has been
    lifted from the profession itself and been given to a new organization
    under the auspices of the new independent oversight board.

    Auditor's Independence
        Auditor's independence has long been a hotly contested issue to the
    profession and the SEC. But after cases such as Waste Management and
    Enron, no longer are people asking, ``where is the smoking gun.''
    Disclosures of consulting fees that run into tens of millions of
    dollars and multiples of the audit fees are generating an outcry for
    action. Once and for all, we need to adopt rules that will truly
    protect the independence and integrity of the audit, and gain the
    public's confidence that the auditors are working for them, not
    management. Rules that will ensure investors that when they get the
    auditor's seal of approval, they can trust the numbers. To accomplish
    that we need to:

     Close the revolving door between the audit firms, its partners
        and employees, and the company being audited.

     Require that in order for the auditor to be considered
        independent, the firm must be hired, evaluated and, if necessary,
        fired by the audit committee.

     Adopt a rule that allows auditors to provide only audit
        services to an audit client, unless the audit committee makes a
        determination and discloses that the services provided by the audit
        firm are (1) in the best interest of the shareholders, and (2) will
        improve the quality of the company's financial reporting. This is
        sometimes referred to as the exclusionary ban approach to auditor's
        independence.

     Prohibit an independent auditor from assisting a company
        design and structure transactions, then provide their accounting or
        tax opinion on what the appropriate accounting is for the
        transaction, and then audit the accounting for that transaction.
        This was discussed in the original SEC rule proposal. However,
        companies and their auditors should be permitted to consult on the
        proper accounting for a nonhypothetical transaction that the
        auditor has not designed and structured, as that is a normal and
        important process in any audit.

     Require mandatory rotation of the audit firm every 7 years.

        Some will argue that the exclusionary ban will have a negative
    impact on the quality of audits or the financial strength of an
    accounting firm. Others argue that tax services are an integral part of
    performing an audit. To that I respond that if the service is integral
    to the audit, then no one should be better situated to make that
    assessment on behalf of investors than the audit committee. Under the
    proposed recommendation the audit committee will have the option of
    agreeing to those services that are in the best interests of the
    investors.
        Trying to make an across the board cut on which of these services
    will or will not impair an auditor's independence, in a quickly
    changing business environment, is not a long-term solution. As soon as
    a new statute or rule is adopted, new services will be developed and
    the issue will reappear.
        The fact that auditors are paid by the management of the companies
    they audit has also been brought up time and time again in recent
    months. Some argue that the auditor would never risk their reputation
    for the fees from a single audit. Yet at the Commission we saw
    situations, some of which are now public, where the auditors identified
    the problems with the numbers in the financial statements, discussed
    them and still issued their unqualified reports. In fact, it is not the
    magnitude of the fee to the firm that matters as much as it is the
    magnitude of the audit and consulting fees to the profitability of the
    office or the engagement partner's portfolio of business.
        Ellen Seidman, then Director of the Office of Thrift Supervision or
    OTS, testified before this Committee on September 11, 2001, regarding
    the audit of the failed Superior Bank. In her opening statement the
    Director stated ``Congress or the FBA's [Federal Banking Agencies]
    could also encourage the AICPA and SEC to establish an `external
    auditor rotation requirement' . . . its adoption would result in a
    `fresh look' at the institution from an audit perspective, to the
    benefit of investors and regulators.''
        But others will argue that there is greater risk in the first year
    of an audit, as the auditor has to get an understanding of the business
    to ensure the proper issues are identified and dealt with. I do not
    dispute the fact the auditor has a higher learning curve on the first
    year of an audit. But in all my years in public accounting, I never
    once heard my former firm or any other firm for that matter, say they
    did not do what they needed to do, to get the necessary background to
    perform a proper audit. Perhaps the real fact is that in some cases,
    auditors propose a lower fee in the first year of an audit relationship
    in order to gain the account, and this has a negative impact on the
    quality of the first year audit.
        Remember that investors have suffered their largest losses on
    audits of companies that did not involve an initial audit, but rather
    an ongoing relationship. Examples include:

     Enron
     MicroStrategy
     Cendant
     Rite Aid
     Livent
     Informix
     WR Grace
     Sunbeam
                                   Lernout and Hauspie
                                   Xerox
                                   Lucent
                                   Oxford Healthcare
                                   Superior Bank
                                   HBO McKesson
                                   Waste Management

        One final argument you will hear against the rotation of audit
    firms is that they already do an internal rotation of audit partners on
    the companies they audit. That will probably also be true for some of
    the above companies. But once a firm has issued a report on the
    financial statements of a company, there is an inherent conflict in
    later concluding that the financial statements were wrong. This is
    especially true if the company has accessed the capital markets using
    those financial statements and as a result, that the accounting firm
    has significant exposure to litigation in the event of a restatement of
    the financial statements. By bringing in a new firm every 7 years, you
    get an independent set of eyes looking at the quality of the financial
    reporting that have no ``skin in the game'' with respect to the
    previous accounting.

    Engaging Audit Committees
        It was in 1940, after the discovery of a large fraud at McKesson &
    Robbins that the Commission first encouraged the establishment of
    independent audit committees. More recently in 1999, with the strong
    support of the stock exchanges and the accounting profession, the audit
    committees adopted new rules effective in 2001, to enhance the
    oversight of the financial reporting, disclosure and audits of public
    companies.
        In light of Enron and questions surrounding the oversight of its
    audit committee, recommendations that can further enhance the vital
    role and quality of audit committees include:

     The audit committee should directly hire, evaluate and, if
        necessary, fire the auditor. This process should not involve the
        management team making the selection or recommendation to the audit
        committee. It needs to be a truly independent process.

     The exceptions provided for in the rules of the stock
        exchanges, which permit an audit committee member who is not
        independent, should be eliminated.

     The definition of an independent director should be modified
        to prohibit the company from engaging the director for any services
        other than those provided as a director, and ban financial payments
        on behalf of the director, such as contributions to charitable
        organizations or similar types of payments.

     The audit committee, consistent with the recommendations of
        the Panel on Audit Effectiveness, should be required to preapprove
        all nonaudit services.

     The audit committee, consistent with the recommendations of
        the Panel on Audit Effectiveness and legislation previously passed
        for financial institutions, should require the CEO and CFO to
        provide to the audit committee a report by management that clearly
        states management's responsibility for establishing, maintaining
        and ensuring an effective system of internal accounting controls
        exists. In the Rite Aid and Xerox cases, investors learned that
        there had been material weaknesses in internal controls but only
        when the auditor was fired and a report filed with the SEC, months
        after the audits had been completed. The report on internal
        controls should be audited by the independent auditor and provided
        to investors in the annual report. The investors have a right to
        know whether adequate controls exist to ensure that the financial
        statements and disclosures comply with Generally Accepted
        Accounting Standards. If the executives are nervous about signing
        such a report, I suggest investors should be nervous about the
        numbers.

     As in some foreign jurisdictions, the CEO and CFO should be
        required to sign and certify to the audit committee and investors
        that the financial statements comply with the applicable rules and
        include disclosure of all material information. There should be
        criminal and civil penalties for intentional misrepresentations to
        the public or to the auditors.

     Companies should be required to provide their audit committees
        with appropriate training and understanding of the business and its
        financial reporting to ensure their ability to carry out their
        obligation to investors.

    Enhancing the Quality and Transparency of U.S. Accounting Standards
        Let me shift gears and switch to the topic of accounting standards.
    I believe our financial reporting system, including the accounting
    standards we use in assembling the numbers, remains the best in the
    world. That is difficult to comprehend in light of Enron, but one only
    has to examine closely the Asian crisis of a few years back to
    appreciate the quality of our financial reporting. The SEC staff report
    did include a section on international issues affecting the quality of
    financial reporting. Many of the recommendations that would have been
    in that section are included in the 2000 Annual Report of the SEC to
    Congress or a paper I presented in November 2001 presented at the SEC
    Major Issues conference and published in Accountancy Regulation. As
    that paper notes, there have been many earnings restatements required
    for foreign issuers. In fact, the SEC staff will review a draft of the
    financial disclosures of foreign issuers in part to help them
    facilitate getting the numbers right the first time.
        I would like to digress a moment to thank the Chairman and his
    staff for their unyielding support of our efforts during the recent
    years, as we at the SEC tried to improve the quality of financial
    accounting standards and reporting with initiatives on earnings
    management and auditor independence. The SEC and its staff became the
    targets of a constant barrage of criticism from some members of
    industry, the accounting profession and Congress for issuing Staff
    Accounting Bulletins that would hopefully stem the tide of restatements
    from improper ``big bath'' charges, recognition of revenue before it
    was earned, and intentional misstatements of earnings while hiding
    behind the disguise of ``materiality.'' Yet, Senator Sarbanes and his
    staff never wavered in their commitment and stood by us in getting
    these changes made to protect investors. He also stood with us on the
    proposed rules on auditor's independence. For that I am very grateful.
        But the job of improving accounting standards is not complete. Our
    rules and standard setting process here in the United States requires
    significant improvements to provide investors and regulators with
    greater transparency. Improvements that need to be made include:

     Revising the structure of the Board of Trustees to bring it in
        line with the Trustees of the International Accounting Standards
        Board (IASB), chaired by former Federal Reserve Chairman Paul
        Volcker. Currently the majority of the members of the Financial
        Accounting Foundation (FAF), who serve as the trustees for the
        Financial Accounting Standards Board (FASB), are selected based
        upon their representation of a particular constituent group. As
        with the IASB, these selection criteria should be changed to one
        where the board members are all representatives of the public
        rather than any particular special interest.

        One way to accomplish this would be for the Independent Public
    Accounting Oversight Board I previously discussed, to serve as the
    Trustees for the FASB. One of the major advantages to this would be the
    accounting standard setting, and enforcement of those standards
    residing within a single organization. In turn when the disciplinary
    process identifies shortcomings in the standards, they could then be
    promptly referred to the standard setter for timely action.
        It should also be pointed out that several years ago, after a drawn
    out discussion with the SEC, the FAF agreed to place a minority of
    public members on the Board of Trustees. However, the FAF has refused
    the request of the SEC to modify its bylaws to make this change
    permanent.

     Create an independent ``no strings attached'' funding
        mechanism for the FASB. This again could be accomplished by a fee
        charged to issuers and/or members of the exchanges, all of who
        greatly benefit from the work of the FASB.

     The FASB needs to develop accounting standards that reflect
        the reality of the actual economics of the underlying transactions.
        Senator Allard from my own State of Colorado has recently
        highlighted the need for timely issuance of such standards and I,
        as I am sure other investors do, commend him for that position.
        Standards that permit hundreds of billions of dollars in synthetic
        lease financing off balance sheet liabilities to be hid from the
        eyes of investors; that permit companies to avoid consolidation of
        special purpose entities for which the company itself has the
        majority, if not practically all of the risks and rewards of its
        operations; and that result in the value of compensation in the
        form of stock options to be excluded from the income statement are
        not transparent standards. They are better described as a chapter
        from Grimm's Fairy Tales.

     The FASB needs to develop and implement a project management
        system that prioritizes the needs of investors, and then
        establishes accountability and responsibility for meeting those
        needs in a more timely fashion. For example, in the mid-1970's the
        SEC asked the FASB to address the issue of whether certain equity
        instruments like mandatorily redeemable preferred stock are a
        liability or equity. Investors are still waiting today for an
        answer. In 1978, the Cohen Commission requested the FASB to require
        disclosure in a single footnote of all the transactions that were
        affecting the comparability of the financial statements from one
        period to the next. This is a disclosure that would have gone a
        long way toward addressing some of the problems created by pro
        forma earnings but again nothing has been done. In 1982, the FASB
        undertook a project on consolidation. One of my sons born that year
        has since graduated from high school. In the meantime, investors
        are still waiting for an answer, especially for structures, such as
        special purpose entities (SPE's). In 1985, the SEC asked the FASB
        to provide guidance for financial instruments, a project still
        underway today. In 1998, the FASB was asked to provide guidance to
        reduce some of the abuses of ``big bath'' charges, but they
        continue to this day unmitigated. Time and time again the FASB has
        asked the SEC to defer to it to establish standards. Yet the
        standards never come. As a result, in the future the SEC should
        give the FASB a timetable for completion of these standards and if
        that timetable is not met, the SEC should act promptly to protect
        investors.

     The FASB Trustees should undertake to restructure the Emerging
        Issues Task Force (EITF) of the FASB. The EITF establishes
        Generally Accepted Accounting Principles for many of the new and
        emerging types of accounting transactions but does not have
        investor protection and transparency as a key part of its mission
        statement. Rather it often establishes rules that ``grandfather''
        past accounting practices that are questionable at best. This
        should surprise no one as the EITF comprised solely of members from
        industry and the accounting profession. The EITF needs major
        revisions to its charter, should require public representation, and
        as with the IASB, should not be able to pass a new rule without the
        explicit approval of the FASB.

     The SEC should require that companies disclose key performance
        indicators or KPI's. KPI's, such as backlog, plant utilization
        rates, revenues generated from new product introductions, etc.
        provide a very powerful useful tool that gives investors greater
        predictive capability with respect to trends in the business.

     The SEC proposed new rules to increase the transparency of
        ``reserves'' and large writedowns in the value of assets such as
        plant and equipment and goodwill. As the Association for Investment
        Management and Research (AIMR) has recently requested, the SEC
        should quickly issue final rules similar to those proposed.

     The SEC should ensure financial statements are written using
        ``Plain English'' through its review and comment process. While
        complex financial instruments transactions may be beyond simple
        descriptions, there are plenty of opportunities to improve the
        readability of financial statements.

        In recent weeks the AICPA has seemingly laid the problems
    associated with Enron at the doorstep of the FASB. They have argued
    that the lack of transparent accounting standards was the cause of
    Enron's financial reporting standards. They fail to acknowledge there
    were problems with the audits while stating the financial reporting
    model is broken. But as Jack Bogle, the highly respected founder of the
    Vanguard funds has stated, perhaps it has been the markets and not the
    model that were wrong. Perhaps the ostrich is once again placing its
    head in the sand.
        Another issue being bantered about involves the issue of whether
    today's accounting standards should be principles based rather than
    detailed rules. This is not the first time this issue has been raised,
    and I can assure you it will not be the last. The predecessor to the
    FASB, the Accounting Principles Board (APB) did write some principles
    based standards. For example, in 1964 the APB issued a standard on
    accounting for leases. That standard stated in principle when a lease,
    as many are, is an installment purchase of the equipment, it should be
    reported as a liability on the financial statements. But this standard
    was no more successful than the current detailed FASB rule on getting
    this off balance sheet debt back on the balance sheet. We also have
    broad guidance on accounting for property, plant, and equipment and the
    associated depreciation. But that has not stopped the abuses of
    understating depreciation and then taking large write-offs of assets
    when it is convenient. The predecessor to the APB issued what some
    consider broad principles standard for reporting of inventories. But a
    recent survey by Andersen and a 1999 report by the Committee of
    Sponsoring Organizations (COSO) illustrate that overstatement of
    inventories continue to be a major source of earnings misstatements and
    SEC enforcement cases. And finally, the FASB standard that establishes
    when many liabilities are to be reflected in the financial statements,
    Standard No. 5, is a very broad principle standard that has been
    responsible for such aggressive accounting practices like ``big bath''
    charges and understatement of liabilities for environmental costs. The
    real issue is not simply one of broad versus narrow detailed rules. It
    is a cultural issue of a lack of compliance with both the spirit and
    intent of the standards. It is an issue of professionalism.
        One stark reality today is that before the ink dries on a new FASB
    standard, the investment banking community and accountants are joining
    forces to find ways to structure transactions to get around the new
    rules. And while the spirit of a rule may clearly say no, I have heard
    time and time again from a CFO or auditor, ``where in the rules does it
    say I cannot do it.'' It is time to get away from this mentality and a
    good starting point would be to prohibit auditors from designing and
    structuring transactions, such as SPE's, that result in less, rather
    than more, transparency for those they are reporting to.

    Strengthening the SEC

        Let me move on to perhaps one of the most important thing for the
    markets today. That is ensuring we have an adequately staffed and
    resourced securities regulator. Today, that does not exist.
        There are approximately 12,000 actively-traded public companies who
    file 12,000 annual reports, 36,000 quarterly financial statements, and
    thousands of initial public offerings, registration statements,
    proxies, and tender offers. In recent years, the Division of
    Corporation Finance has been staffed with approximately ninety
    accountants to review these documents. In the Division of Enforcement,
    the typical caseload is around two hundred to two hundred and fifty
    cases. There are approximately twenty to twenty-five accountants in the
    Washington, DC office and maybe another thirty or forty around the
    country to investigate these cases. In the private sector, it is not
    unusual that three to four accountants assist in preparing for
    testimony on a financial fraud case. In a case such as Enron, many more
    staff would be dedicated to such a project. Finally about twenty to
    twenty-five accountants are working in the Office of the Chief
    Accountant. This Office provides a service to the public accounting
    firms and companies, similar to what the national accounting and
    auditing offices of each of the Big 5 accounting firms provides to
    their own audit clients and offices. They also have oversight
    responsibility for all the activities of those entities in the alphabet
    soup. Comparatively speaking, the national offices of the Big 5
    accounting firms are each typically a multiple or two larger than the
    Office of the Chief Accountant.
        As you can plainly see, it is physically impossible within their
    current budgetary handcuffs for the SEC staff to carry out their
    mandate to ensure full disclosure and timely enforcement of the laws
    and regulations. The Panel on Audit Effectiveness recommended the SEC
    provide additional resources to combating financial fraud. I hope
    Congress will respond to the Panel report and provide the necessary
    funding for doubling the size of the accounting staff in the Division
    of Corporation Finance and the Office of the Chief Accountant, as well
    as reasonable compensation levels for existing staff. The SEC Division
    of Enforcement should also double or triple the number of accountants
    and attorneys involved with combating financial fraud. Its Financial
    Fraud Task Force needs to become a permanent fixture within the
    Division of Enforcement.
        The SEC also needs to be provided with the resources to acquire
    technology that can aid in the electronic screening of filings for
    potential issues and unusual trends in financial performance. SEC
    Chairman has indicated he wishes to hire a highly qualified Chief
    Information Officer. This is long overdue and will require additional
    funds. But new and enhanced technologies can be a powerful, efficient,
    and effective tool in identifying problems at an earlier date.
        The statutory authority of the SEC to undertake certain types of
    actions should also be evaluated. Recent cases involving Baymark and
    California Micro Devices have raised serious questions as to whether
    the standard of recklessness the SEC applies to Rule 102(e) proceedings
    against accountants, is too high a standard by which to measure
    unprofessional conduct by an accountant or auditor. Rule 102(e) is the
    regulation by which the SEC may censure an accountant in a public
    company or an auditor and deny them the right to practice before the
    Commission. The rule is used to protect the integrity of the system and
    processes that are key to efficient markets. It requires that an
    accountant must be reckless, or have multiple incidences of improper
    professional conduct in order to be sanctioned. As a result, in cases
    involving negligence or other unprofessional behavior that is less than
    recklessness, a Rule 102(e) sanction baring the practice of the
    accountant before the Commission or in a public company cannot be
    pursued.
        It should be noted that some professionals have challenged the SEC
    with respect to whether a Rule 102(e) proceeding may be initiated
    against an accountant within a public company, if they are not a
    currently licensed CPA. Today, many of the CFO's, Controllers, and key
    financial reporting people do not have, or have not maintained a
    current CPA license. In essence, the lack of current SEC actions
    pursuant to Rule 102(e) against nonlicensed accountants sends a strong
    message. I think it is the wrong message that CFO's and Controllers are
    better off without their licenses than they are with them.
        Let me switch briefly to the subject of the chief financial and
    principal accounting officers. Today, CFO's at the major American
    corporations turn over approximately four times faster than they did at
    the beginning of the 1990's. And while the turnover 10 years ago was
    often tied to one's retirement, it is much more likely today to be tied
    to a company missing an earnings estimate. Way too often today the CFO
    becomes the ``fall guy'' for such misses while the CEO's, chief
    operating officers, vice presidents of manufacturing, marketing and
    other key management positions stay on. And as surveys have shown, it
    is all too often the CFO who is pressured by these other members of
    management to stir the pot and cook the books. When the CFO doesn't
    like the recipe that is handed to him or her, they are shown the door.
        As a result, I also believe the SEC should make a change to its
    rules for Form 8-K. A Form 8-K should be required to be filed whenever
    a chief financial officer or chief accounting officer is terminated.
    The report should require disclosure of whether the audit committee
    approved the termination and whether there were any disagreements
    regarding financial accounting or disclosure matters. Perhaps a similar
    disclosure should be required for audit committee members.
        Another challenge to the authority and ability of the SEC to
    enforce the securities laws involves access to the work papers of
    auditors of foreign issuers, or U.S. issuers with operations audited by
    a foreign affiliate of the U.S. firm. Time and time again I watched as
    the public accounting firms failed to provide timely access to the
    foreign work papers, thereby dragging out the case and hoping it would
    be dropped due to turnover in the assigned SEC staff. In its
    international concept release issued in 2000, the SEC noted this was a
    significant issue it faced in enforcing the SEC's rules. And the SEC is
    not the only regulator to have been confronted by this issue. In the
    BCCI case the Federal banking regulators also had to endure
    difficulties in gaining access to the work papers of the foreign
    affiliates of the accounting firm. With foreign registrants now
    comprising approximately 10 percent of all actively traded companies,
    either the Congress or SEC should act quickly to protect investors
    before investors are unwittingly exposed to greater risk.
        Finally, Section 10A of the Securities Act needs to be modified.
    Currently, auditors are only reporting a small handful of violations of
    the law. They define their responsibility very narrow to require
    reporting only when they have identified an illegal act, have
    unquestionably proved it is an illegal act, and did not resign before
    they had to report it. As a result, when financial reporting is
    questioned as it has been at Enron, this narrow definition of the rule
    will not result in a Section 10A report to the SEC. I think most
    investors would agree that is a definition that is too narrow and that
    fails to protect the public.

    Bringing Education Current with the Times

        I have discussed recommendations for standard setters, regulators,
    and preparers. Let me shift for a moment to a group that all too often
    is missed in the equation. That is the educators and the all-important
    role they play.
        The most valuable asset of the accounting profession and public
    accounting firms is the people who make up our organizations. Great
    people who are talented, well educated, and motivated make for great
    organizations while ``weak'' people are nothing less than as the
    television show aptly calls it, the weakest link!
        Accordingly, I give credit to the current leadership of the AICPA
    for its efforts to boost enrollment in our colleges and universities of
    the best high school students and its efforts to interest them in the
    accounting profession. It is important that accounting firms and
    industry provide support for this initiative.
        During the recent debate on auditor's independence we noted that
    the salary gap between the starting pay for accounting college
    graduates entering the profession, and those who chose other fields of
    study or employment opportunities in business, had grown very
    significantly over the past 10 years. This salary differential sends
    the wrong signal to students about to choose a major field of study.
    Clearly, we need to correct this problem in addition to considering the
    level of investment going into those who choose to enter the accounting
    profession as auditors, as well as the tools they need to perform
    effectively.
        Today, we also need to bring down the ``silos'' that still exist in
    the business colleges. Educators need to take concrete steps to change
    the all too typical dinosaur of an accounting curriculum that is based
    on the accounting silo. They need to stop competing with the finance,
    management, marketing, or computer science ``silos'' and seek to
    integrate these programs in a broad-based accounting curriculum. Today,
    these ingredients need to be blended together to meet the needs of
    students and the profession.
        Good auditors and financial managers need a broad spectrum of
    knowledge. For example, to be a good auditor today, you must understand
    marketing and distribution channels, how risk management is effectively
    and efficiently achieved through the use of various financial as well
    as managerial techniques to develop effective strategic and tactical
    plans. And of course, each of these areas of study is affected by the
    rapid change in technology.
        Universities need to reflect these changes in their curriculum now.
    Certainly this will in all likelihood require more than what a student
    is able to learn in a 4 year program. Keep in mind, while many of us
    were in college, technology meant punched cards fed into a computer,
    management was done in an environment of paper and calculators, not in
    a real time on-line mode, and almost all of the financial instruments
    used today had not yet been created. In the past, we talked about
    interstate business and commerce, now it is the integrated global
    economies. In simple terms, this means we must also realize that if our
    new hires are to have the basic understanding they will need to be
    successful in their respective roles, they will need an enhanced course
    of study. The enhanced program must be both more broadly based in
    business, more integrated and still steeped in the accounting
    contribution unique to our discipline. At the same time, it is
    imperative that the basic skills taught in financial accounting and
    theory, income tax and auditing courses today, must continue as part of
    the curriculum. Accordingly, I do not believe this can all be
    accomplished in 4 short years. I believe we need advanced programs. The
    result will be students who leave the university with a better
    education, as compared to the body of knowledge new graduates had 10 or
    20 or 30 years ago. However, the accounting firms and business must be
    willing to compensate the students who invest in this greater body of
    knowledge.

    Independent Analysts
        The last piece to ensuring quality financial information is
    provided to investors is to reestablish the independence of analysts. I
    would encourage the Committee to gain a clear understanding of how
    analysts are evaluated and ranked, how and by whom their compensation
    is set, and who has access to, edit privileges or control over their
    research reports. As long as the investment-banking arm of Wall Street
    has influence over the work of the research analysts or their
    compensation, analysts will not be able to provide independent
    research.
        I would also encourage the Committee to ask the question of what
    role the investment bankers played in structuring the off balance sheet
    partnerships of Enron, what access to nonpublic information they
    received, and whether any of that information was used in an improper
    or illegal fashion.

    Instruments of Justice
        One last piece of the Enron puzzle that has received increasing
    public attention, is the role the attorneys played. As the general
    counsel of the SEC so eloquently stated just last week, the legal
    profession is the one profession engaged in the business of justice.
    Lawyers are the instruments of justice.
        Yet the investing public and employees of Enron are wondering how
    justice has been served. Those who have lost their jobs or their life
    savings see a system blind to justice.
        I hope that this Committee will explore this important issue, and
    consider if the influence of a few, through the power of the dollar,
    won out over truth and justice for all.

    Closing
        Hopefully the recommendations I have made today have given you an
    understanding of what the SEC staff was striving for in their report to
    the Commission. As you can see, it provides a benchmark for measuring
    the progress, or lack thereof, by the profession in making substantive,
    meaningful change. As you can also see from the attached chart, these
    recommendations for a new system of regulation will also result in a
    much simpler, reliable, and effective system of oversight of financial
    reporting.
        So let me just finish as I began, with independence. One out of
    every two adult Americans have invested in the U.S. capital markets
    that are the crown jewel of our economy. They have done so because they
    had trust and confidence in a system that provides the numbers
    investors need to make wise investment decisions. They have trusted
    that an independent public watchdog was on the beat.
        But that trust now lies shattered and will not be easily restored.
    In the 200 plus year history of the markets, every time that confidence
    has been shattered, our markets have sustained losses, investors have
    fled to safer havens and the capital vital to funding American business
    and job opportunities has dried up. We cannot let that happen again. We
    must act quickly to make real, not just cosmetic changes that will
    restore the confidence of investors and the American public. The public
    deserves nothing less from Congress, the accounting profession,
    regulators, analysts, and other members of the financial community.

                   PREPARED STATEMENT OF DENNIS R. BERESFORD

             Former Chairman, Financial Accounting Standards Board
                                  1987 to 1997
                               February 26, 2002

        Good morning, Chairman Sarbanes, Senator Gramm, and other Members
    of the Senate Banking Committee. I am Denny Beresford, a Professor of
    Accounting at The University of Georgia, and I am honored to have been
    invited to appear before you today.
    My Background

        First, let me briefly describe my background. Before joining the
    faculty at The University of Georgia in July 1997, I served for 10\1/2\
    years as Chairman of the Financial Accounting Standards Board. Before
    my FASB appointment, I was a partner with the accounting firm now known
    as Ernst & Young. I spent 10 years in the Los Angeles office of E&Y and
    then 16 years in the firm's national office in Cleveland. For the last
    10 years of my time with E&Y I was partner in charge of accounting
    standards. I am now a retired partner of E&Y and I collect a fixed,
    monthly retirement amount from the firm.
        In addition to my full-time teaching duties, I am involved in
    professional committees that follow and comment on new financial
    reporting developments. I also continue to speak and write on financial
    reporting matters. Additionally, I have served as a consultant to audit
    committees of public companies and I have provided expert witness
    services to several corporations and accounting firms. Finally, I am a
    Director of National Service Industries, Inc., a New York Stock
    Exchange listed company, and I am Chairman of NSI's Audit Committee.
        One other fact that probably should be noted for the record is that
    I was a shareholder of Enron Corp. (Enron) for a very brief period last
    fall. I purchased 2,000 shares on November 5 and sold them on November
    14, incurring a loss of $7,241. I blame no one but myself for this poor
    investment decision.
        The comments that follow are my personal views. They should not be
    attributed to Ernst & Young, The University of Georgia, or any other
    organization or individual with whom I may have some association.

    What You Have Asked Me to Do
        The letter inviting me to appear today asked for my comments on
    ``financial reporting by public companies, accounting standards, and
    oversight of the accounting profession'' in light of recent high-
    profile business failures including Enron. The letter also invited my
    recommendations about ways to deal with the issues I discuss.
        In considering my response to those requests, please keep in mind
    that I am no longer an ``insider.'' There are, no doubt, certain
    changes that have taken place in the accounting and auditing world of
    which I am not fully informed at present. But with over 40 years of
    total experience and about 25 years working at reasonably high levels
    in the accounting profession, I hope that my comments will be of some
    value to you.

    Overview
        My comments will relate primarily to financial reporting matters
    because that is the area where I spent most of my professional career.
    To put things in perspective, this statement begins with some comments
    about the current state of financial reporting. It then moves to
    several areas in which I have both comments and recommendations for
    improvement. The last section summarizes the most important of my
    recommendations.

    An Admonition
        Recently, there has been a great deal of criticism of accounting
    and auditing practices in the United States relating to Enron and
    several other high profile cases. It is quite appropriate that your
    Committee and other groups in Washington try to determine the root
    cause of the Enron matter and penalize any deserving individuals or
    organizations after determining the facts. It is also quite appropriate
    that your Committee and other groups in Washington consider whether
    there are changes that can be made to accounting or auditing rules and
    regulations to lower the chance that similar problems will occur in the
    future. However, I believe it is critical that these latter efforts
    keep in mind that our current system of financial reporting produces
    excellent information in the vast majority of situations. Care must be
    taken to see that criticism is constructive--that it leads to
    improvements in the current system and not to damaging it.
        I do not think that any of us fully understand all that happened in
    the Enron matter. Even with the restated financial information now
    available, the Powers report, and the volumes of newspaper and magazine
    articles analyzing the situation, there remain many unanswered
    questions regarding Enron's business practices and the way it accounted
    for them. However, it does appear to me that the basic accounting
    problem boils down to the fact that Enron failed to comply with
    Generally Accepted Accounting Principles (GAAP). Enron first admitted
    this when it eliminated the $1 billion plus notes receivable related to
    its stock issued to the special
    purpose entities (SPE's). Enron admitted additional accounting errors
    when it subsequently restated its financial statements to consolidate
    certain SPE's that it determined did not qualify for ``off balance
    sheet'' treatment under GAAP. As I will cover later, the accounting
    principles for SPE's certainly warrant further consideration. But the
    rules we have now would have produced more appropriate information if
    only Enron had followed them.

        As a former standards setter, I am aware of the dangers of the law
    of unintended consequences faced by all rulemakers. As you are well
    aware, often in trying to resolve one issue, a rule can create other
    problems that were never intended. The less thorough and considered the
    process leading to the new rule, the more likely this will occur.

        Some have argued that the Enron problems were ``caused'' by the
    legislative reforms designed to reduce frivolous lawsuits. Others
    believe the ``cause'' was the failure to legislate reforms to limit the
    scope of work performed by public accountants. Still others see the
    root of the problems as easy money, an investment system fraught with
    moral hazard, and/or a decline in societal ethics or moral standards,
    for which there is no lack of opinion as to where to place the blame.

        Each of these opinions certainly has emotional resonance and there
    may be some element of truth in each of them. However, what seems more
    likely, based on what we know today, is that the collapse of Enron had
    more to do with human errors, some perhaps innocent, some perhaps not,
    that remained undetected because of a massive breakdown in the systems
    and controls that either were, or should have been, designed to
    discover them.

        These are very real problems for Enron. They should be investigated
    and any wrongdoing appropriately penalized. In the process, any
    systemic problems that are discovered should be appropriately
    addressed. However, as of today, there is no evidence that the Enron
    problems extend to a majority of corporate executives, board members,
    outside accountants, or outside lawyers. Therefore, I would caution
    against immediate widespread reform that could well invoke the law of
    unintended consequences.

        I am not suggesting that this will be an easy task. I am well aware
    that Congress has an enormously difficult balancing act. It must get to
    the bottom of the Enron situation and ensure that appropriate actions
    are taken. At the same time, it must do so in a manner that does not
    unnecessarily create a chilling pall over a mostly well-designed
    economic model and the vast majority of those who play by its rules. To
    this end, generally it has been proven more effective and less
    disruptive if, when possible, deliberative, private sector action,
    rather than a legislative solution, is the chosen reform vehicle.

        The body that is responsible for establishing most of GAAP at
    present is, of course, the FASB. Much of what I will say in the
    remainder of this statement will focus on the work of the Board. That
    Board has served with distinction for nearly 30 years and I am
    confident that hearings like this will lead to suggestions to further
    improve the FASB's processes. In January 1990, I wrote an article for
    the Journal of Accountancy that included the following summary of the
    FASB:

              The FASB is unique. It is a private-sector institution
            performing a public function that is defined in a Federal
            statute. This means it carries the weight of public
            expectations as expressed both in the Securities Exchange Act
            of 1934 and in repeated Congressional investigations and
            hearings over the years. With Government looking over its
            shoulder, the Board must serve a private-sector constituency
            made up of several important segments whose interests often are
            at variance with one another. Thus, the Board's relationship
            with its constituents is a continuing test of a sophisticated
            and subtle democratic process. The process does not work unless
            divergent private viewpoints are heard and can be reconciled.
            The Board's responsibility is to try to do that--in a manner
            that will best serve the public interest.

    Understanding Financial Reports Requires Education and Diligence

        To further put into context my following remarks, I would like to
    cite one of my favorite quotes from the accounting literature. FASB
    Concepts Statement No. 1, ``Objectives of Financial Reporting by
    Business Enterprises,'' states the following:

              Financial reporting should provide information that is useful
            to present and potential investors and creditors and other
            users in making rational investment, credit, and similar
            decisions. The information should be comprehensible to those
            who have a reasonable understanding of business and economic
            activities and are willing to study the information with
            reasonable diligence (paragraph 34, emphasis added).

        It is important to keep in mind these comments about ``reasonable
    understanding'' and ``reasonable diligence'' as you and others evaluate
    the current financial reporting system and consider the need for
    further improvements. Most businesses are complicated and attempts to
    portray their economic activities in a few financial statements and
    accompanying footnotes necessarily involves numerous tradeoffs. Because
    of this, relatively few investors are experts at reading corporate
    financial reports.
        Let me illustrate this point with a personal experience. I
    presently teach both graduate accounting students and MBA candidates.
    Most of the MBA students have had relatively little exposure to
    financial accounting and at the University of Georgia we expect them to
    be able to absorb the basics in 37.5 classroom hours of instruction.
    While my students are intelligent and highly motivated individuals,
    only rudimentary principles of accounting can be absorbed in this
    amount of time. So, our MBA graduates who become business executives,
    investment bankers, etc., are not expert accountants by any stretch of
    the imagination.
        And these women and men are among the most sophisticated
    individuals in our society with respect to business and accounting
    matters. Most Americans do not have graduate degrees in business or any
    specific education in accounting matters. It is clearly unreasonable,
    in my view, to expect most Americans to understand all of the nuances
    of financial reports.
        I note this primarily to dispel the notion that financial reports
    must somehow become fully understandable to any individual who invests
    in stocks or bonds of public companies. It just is not going to happen.
    While we should strive to make those reports more accessible to all, I
    think a more realistic objective is to work on improving information so
    that financial analysts, lending officers, and other relatively
    sophisticated intermediaries can use that information to provide better
    advice to individual investors and other appropriate parties.
        Please do not misunderstand. It may sound as though I am saying
    that accounting is some sort of secret language that only CPA's with
    years of experience can speak, but that is not what I mean to
    communicate. As I indicated earlier, my MBA students can assimilate a
    good, general understanding of basic financial statements and
    accounting principles in one semester. As a further illustration, over
    the past year and a half I have written a series of articles on
    corporate reporting for our local newspaper and many readers have told
    me that the articles help them gain a basic understanding of financial
    statements.
        However, being able to generally grasp the financial reports of
    one's small business or church, for example, does not necessarily lead
    to being able to decipher Enron's incredibly complicated financial
    statements. Enron was a complex business with energy and
    telecommunications operations, extensive trading activities, and
    sophisticated financing vehicles. Being able to reduce all of that to
    something like a Reader's Digest article that nearly all adults could
    understand is not a realistic expectation.

    Congress Should Not Get Involved in Technical Accounting Issues

        I was pleased to see that one of the comments in former SEC
    Chairman Arthur Levitt's op ed piece in The New York Times on January
    17. In referring to the FASB, he said:

              This important agency must also be free from Congressional
            pressure, which is often applied when powerful corporations
            seek to undermine new accounting rules that might hurt their
            earnings.

        I strongly agree that Congress must guard against becoming a
    hindrance to the accounting standard setting process. However, as with
    all perceived conflicts of interest, lines delineating ``doing the
    right thing'' from ``helping a client or constituent'' often can become
    blurred. A case from my personal experience where Congress allowed
    itself to become too involved in the technicalities of the reporting
    process was the debate over accounting for employee stock options in
    the early and mid-1990's. As many of you may recall, the FASB had
    proposed that companies account for the expense represented by the fair
    value of stock options granted to officers and to employees. The
    business community and accounting firms strongly opposed this proposal
    and a number of corporations engaged in a lobbying effort to stymie the
    FASB's initiative.
        Certain Members of Congress were sufficiently influenced by the
    appeals from corporate executives that they were persuaded to introduce
    legislation to counter the FASB's proposal. The legislation would have
    prohibited public companies from following any final FASB rule on this
    matter. More importantly, the legislation would have imposed
    requirements that the SEC repeat the FASB's process on any new
    accounting proposals, thus effectively eviscerating the FASB. Faced
    with the strong possibility that its purpose would have been eliminated
    by this legislation, the FASB made a strategic decision to require
    companies to disclose the effect of stock options in a footnote to the
    financial statements but not record the expense in the income
    statement.
        Unfortunately, this was not the only example of Congressional
    interference in the FASB's technical decisionmaking. In the 1970's,
    Congress overrode the Board with respect to the accounting for oil and
    gas exploration costs. More recently, legislation very similar to that
    proposed in connection with the stock options matter was introduced in
    connection with accounting for derivative financial instruments. For
    the even more recent project on accounting for business combinations
    and goodwill, Congressional hearings were precipitated by corporate
    complaints of alleged unfavorable economic consequences of the FASB's
    proposals. And legislation was proposed that would have delayed
    implementation of that new accounting rule.
        I have noted that two Members of this Committee are considering
    whether the Federal Government should take over responsibility for
    setting accounting standards. In support, a recent Wall Street Journal
    article refers to critics of the FASB, who claim in part that the FASB
    has been ``too quick to cave in on critical issues.'' One of the
    examples given was the decision to scrap the proposal on accounting for
    stock compensation. I find this ironic. I am confident that the FASB
    could have and would have stood up to companies that disagreed with its
    conclusions on stock compensation. It ``caved'' only under
    Congressional pressure that would have effectively legislated it out of
    business. Contrary to being an argument for Government accounting
    standards setting, this is one of the very good reasons for the
    Government to stay out of the technical accounting standards setting
    business.
        As President Bush said in his recent State of the Union address,
    ``Through stricter accounting standards and tougher disclosure
    requirements, corporate America must be made more accountable to
    employees and shareholders and held to the highest standards of
    conduct.'' The FASB has the mandate and the will to adopt stricter
    accounting standards and tougher disclosure requirements. However, it
    cannot achieve those goals when Congress urges lesser requirements.
    Congress must guard against emotional appeals from constituents that
    accounting rules will ``ruin their businesses'' or ``destroy the
    economy.'' Reporting the substance of actual business decisions and
    activities is unlikely ever to have that result.
        Congress, of course, has both the right and responsibility to
    provide strong oversight in this area. The FASB holds a public trust
    and Congress is entitled to examine how the Board is carrying out that
    duty, particularly in trying times like those at present. However, my
    view is that Congress' primary role in this area should be to see that
    the FASB is fulfilling its public obligations appropriately. Congress
    ought not to interfere with individual technical decisions.
        Let me offer an example, of a situation about which I am very
    familiar, of how Government oversight activities have been successful
    in influencing positive change in the private sector. The FASB
    currently is subject to oversight by the Financial Accounting
    Foundation (FAF). In turn, the SEC actively oversees the FAF, and
    Congress oversees the SEC and determines that the Commission carries
    out its responsibilities with respect to both the FAF and the FASB.
        The Trustees of the FAF are responsible, by charter, for three
    major things. First, they appoint the members of the FASB (as well as
    its sister organization, the Governmental Accounting Standards Board).
    Second, they raise the funds necessary to finance the FASB's
    activities. Third, they oversee the FASB to make sure that the Board is
    carrying out its responsibilities in an unbiased and appropriate
    manner. By charter, the Trustees are not allowed to interfere with or
    otherwise influence the FASB's technical decisions on accounting
    standards matters.
        During Arthur Levitt's tenure at the SEC, he (and others) perceived
    that the Trustees of the FAF were not always sufficiently supportive of
    the FASB. He felt that there were instances where the Trustees acted in
    a way that might have been seen as endorsing the business community's
    views on specific technical issues rather than supporting the FASB's
    independence and due process. He, therefore, proposed changes in the
    composition of the FAF Board of Trustees. He suggested that several
    more ``public'' members be added in place of some with close ties to
    the accounting profession and business community.
        After months of debate, the FAF agreed to reorganize and several
    public members were added, including the current Chairman, Manuel
    Johnson (former Federal Reserve Vice Chairman), and David Ruder (former
    SEC Chairman). In my view, this was a significant improvement. It is
    now more evident that the FAF Trustees are acting to support the FASB
    and to make sure it is doing its job properly rather than the earlier
    perception that it was somehow trying to influence the Board's
    decisions.
        This is a very good example of how Government oversight led to
    actions that resulted in positive changes in the private sector. It is
    particularly noteworthy that these changes were accomplished in a
    manner that supported, rather than undermined, private sector
    accounting standards setting activity.

    The SEC's Role is Vital
        A fair amount of the rhetoric surrounding the Enron situation has
    focused on the SEC and particularly Chairman Harvey Pitt. Some
    journalists and other commentators have pointed to Chairman Pitt's
    background as counsel to the AICPA, Andersen, and other accounting
    firms and have raised questions about whether he will vigorously pursue
    whatever remedies are called for with respect to Enron and to Andersen,
    as well as appropriate system wide changes. Some of those individuals
    also have pointed to Chairman Pitt's remarks to the AICPA Council
    meeting a few months ago as an indication that there will be a ``kinder
    and gentler'' SEC with respect to dealing with accounting matters.
        I have a different perspective. I do not know Chairman Pitt well,
    although I did meet him a number of years ago in his previous
    employment at the Commission. But I have worked closely with SEC
    Commissioners, accounting staff, and many other SEC staff members for
    the past 25 years or so. I have found them to be first-class
    professionals who are dedicated to the public interest. While my
    knowledge of Federal Government agencies is limited, it would be hard
    for me to believe that there could be another agency that is as
    professional and accomplished in performance of its responsibilities
    than the SEC. I am confident that Chairman Pitt will carry on the
    distinguished record of the SEC.
        Having said that, it is my perception that working relationships
    between the SEC and the accounting professionals had become
    increasingly strained and even confrontational in the past several
    years. Based on many conversations with auditors and corporate
    executives, I sensed a much more cynical attitude on the part of many
    of the SEC's accounting staff members. I also experienced this directly
    in a couple of cases in which I consulted with companies that had to
    discuss an accounting issue with the SEC staff. Rather than a spirit of
    cooperation in order to achieve the most appropriate outcome for the
    investing public, too often an attitude of ``you are obviously guilty
    of some wrongdoing if you have to come see us'' seemed to have existed
    when some companies or auditors approached the SEC staff to discuss
    contentious issues. In fairness to the SEC, some business executives
    and their auditors and lawyers pride themselves on finding the
    loopholes in the rules that will allow them to do what they want
    regardless of the substance of the transaction or the spirit of the
    rules.
        Whatever the cause, the trend has been much more reluctance by
    companies to seek SEC input on the front end of difficult accounting
    matters. Recent comments by Chairman Pitt and Chief Accountant Bob
    Herdman encouraging companies and auditors to talk to the SEC on the
    front end represents an extremely positive step, in my opinion. While
    the SEC has enforcement powers to correct reporting that is identified
    as being inappropriate, it does not have the resources to review all
    companies' reports and determine their propriety. It must rely on the
    private sector (corporate executives and independent auditors) to do
    the right thing. There must be a high degree of trust among regulators,
    reporting companies, and auditors for the reporting system to work
    best. Therefore, I commend Chairman Pitt and Chief Accountant Herdman
    for their efforts to create a more positive environment in which all
    interested parties can work together to improve both individual
    companies' reporting and the overall system. At the same time, I am
    confident that the SEC will act decisively when individual companies or
    their auditors have not performed in a professional manner.
        On January 22, the SEC issued FR- 61 ``Commission Statement About
    Management's Discussion and Analysis of Financial Condition and Results
    of Operations.'' This release provides SEC views on matters that public
    companies should consider disclosing in their calendar 2001 and later
    annual reports. The matters covered relate to off balance sheet
    arrangements, trading contracts for which fair values must be
    estimated, and related party transactions. This release closely
    followed recommendations from the Big 5 accounting firms on those
    matters, all of which were issues for which Enron's disclosures have
    been criticized. I believe these SEC recommendations will result in
    additional useful information to investors and other readers of annual
    reports. This is an excellent example of how positive interaction
    between the accounting profession and the SEC can lead to immediate
    gains to the investing public. Enhancing trust and cooperation between
    the parties, as the SEC apparently is trying hard to do, is likely to
    lead to additional positive actions like this one.

    It Takes Too Long to Issue Accounting Standards
        SEC Chairman Pitt's Public Statement announcing his proposal for a
    new auditing profession oversight board included the following
    admonition: ``We need more prompt action by the FASB, the Nation's
    accounting standard setter.'' I agree 100 percent with that comment.
        It simply takes too long to develop new accounting standards. When
    I was appointed as Chairman of the FASB in September 1986, an item in
    The Wall Street Journal stated, ``Mr. Beresford will likely urge the
    FASB to be more timely in setting standards.'' While I did try to
    improve timeliness, I failed miserably in actually moving things along
    more quickly. We adopted a strategic objective of completing major
    projects in no more than 3 years, but even that very modest goal has
    not been achieved. The recently completed accounting for business
    combinations project lasted approximately 5 years and many earlier
    projects lasted much longer.
        The FASB has explained many times that it only deals with topics
    for which many solutions are highly controversial. Accordingly, it
    takes a certain amount of time to properly research those matters,
    debate them among the Board members, and then seek public comment on
    the preliminary conclusions. Also, the Board's open due process
    (including comment periods for constituents to submit their views on
    proposals, field-testing of proposals, public hearings, and other
    procedural steps) necessarily adds time.
        Those due process steps are appropriate in order to give all
    interested parties an opportunity to inform the Board about pertinent
    information relating to the matter in question and to challenge the
    Board's preliminary thinking. Such an open process leads to better
    standards and also contributes to the FASB's credibility in the
    business community. Thus, efforts to achieve earlier solutions to new
    accounting challenges should not come at the expense of significantly
    shortcutting due process.
        Rather than reducing its interaction with constituents, I believe
    that the FASB could reach earlier resolution on many projects by
    streamlining its internal processes. There are at least three ways in
    which this could be done.
        First, would be for the Board to limit the content of its standards
    to the most significant matters related to the issues in question. At
    present, too often the Board members feel compelled to address great
    levels of detail in order to achieve a standard that answers all
    possible implementation questions. This is done, in large measure, to
    try to avoid the possibility of corporations applying a standard in a
    manner that the Board did not intend (sometimes referred to as
    ``scoundrel prevention''). Dealing with such great detail not only
    takes more time, it also leads to lengthy and complicated accounting
    standards that actually may result in less desirable outcomes. I will
    say more on this point later.
        Second, would be for the individual Board members to not strive for
    what they personally believe are conceptually pure answers when doing
    so would significantly delay finalizing reasonable guidance for
    practitioners. The Board bases its standards on an underlying
    conceptual framework, much like the U.S. Constitution is the
    fundamental base for legislation on specific matters. The FASB
    conceptual framework is necessarily general in many respects, and when
    Board members debate topics they often disagree among themselves on
    appropriate solutions while referring to the same underlying concepts.
        I admit to being more of a pragmatist than a theorist. However, I
    believe that the FASB (as well as other parties involved in
    establishing guidance for accounting and auditing practitioners) should
    keep in mind the overriding goal of reasonably prompt problem
    resolution. Even after 5 or 10 years of effort, reasonable people will
    disagree as to whether an individual accounting standard is
    conceptually pure or best serves the needs of financial statement
    users. A timely answer is better than an arguably more theoretically
    pure one delivered at a much later date.
        A third reason why progress is slow on most major projects at the
    FASB is the relatively small size of the staff. There are seven Board
    members and approximately 45 staff members. Nearly all of the research,
    memoranda drafting, and the other technical procedures necessary to
    prepare a matter for debate by the Board members is performed by the
    staff. The Board members become deeply involved in projects by studying
    staff memos, reading all comments letters from constituents,
    deliberating issues in public meetings, and through various other
    procedures. However, the Board is able to move only as fast as the
    staff can prepare matters for its consideration.
        Increasing the staff by 10 -15 people would almost certainly allow
    projects to be considered more rapidly. This would, of course, require
    additional funding (see later comments on funding). It would also
    require finding enough qualified people willing and able to work for
    the FASB, which has not been easy to do in recent years. Funding and
    candidate identification are tough challenges, but the FAF Trustees
    should consider those to be critical objectives in order to allow more
    timely attention to important accounting issues.

    Accounting Rules Have Become Too Complex
        Notwithstanding the complexities of today's business world, one of
    my major concerns is that accounting rules and regulations have become
    too complicated and that has added to the burden of those who are
    reasonably informed and are reasonably diligent about studying
    corporate reports. Corporate executives and auditors who have direct
    responsibility for delivering financial reports to the public have a
    very difficult time keeping up with and understanding all of the
    accounting rules. As just one example, the FASB's pronouncement on
    accounting for derivatives is about 250 pages long and a Derivatives
    Implementation Group met for over 2 years to develop a few hundred
    additional pages of interpretive guidance. I have heard senior partners
    of major accounting firms say that only a handful of specialists within
    their firms are fully conversant with all of the rules on this
    important topic.
        I certainly do not mean to pick on the FASB--after all, much of
    what the Board did on the derivatives project was well along before my
    term ended. But it does seem as though things have become too
    complicated and it is time to step back to see if more general
    standards can work as well or better.
        It may be helpful to comment on the genesis of all this complexity.
    It was not always thus. The trend toward more detailed standards
    resulted, in part, from the attitude of some that whatever was not
    explicitly required by the rules need not be done, and perhaps more
    importantly, whatever was not explicitly excluded, was by definition
    permissible. Others, who may have understood and wished to apply the
    rules in their much broader context, nevertheless, for competitive
    purposes, called for ``more definitive guidelines'' (thus the birth of
    the term ``scoundrel prevention''). However, it seems the pendulum has
    swung too far.
        To a certain extent, the FASB took a step toward more generalized
    standards in its recently completed standards on accounting for
    business combinations and goodwill. Those standards are still pretty
    complicated, but they provide for a considerable amount of management
    judgment in deciding whether and when the value of goodwill has become
    impaired, for example. Some parties will, no doubt, call for more rules
    to specify how to make those impairment decisions and I urge the FASB
    to continue to resist those requests. The overemphasis on detail will
    not be reversed overnight. However, over time this is something I
    believe the FASB must strive for.
        Accounting standards are necessary in order to cause reports by
    various companies to be reasonably comparable. Similar to the rules of
    football, without some standardized approaches to accounting, sorting
    out the winners and losers in the business world would be much more
    difficult. However, like the compromise over Instant Replay for NFL
    games, often the parties involved in the process are willing to accept
    fewer or less specific rules so that the game flows more smoothly but
    still within some appropriate boundaries.
        In January, the FASB announced that it ``. . . discussed a number
    of potential projects to simplify the U.S. accounting literature in
    order to improve its effectiveness and usability.'' Among the actions
    that the Board decided to take was to ``Evaluate the feasibility of
    issuing standards that are less detailed and have few, if any,
    exceptions or alternatives to the underlying concepts.'' This is a good
    first step and I look forward to the FASB devoting more time to
    reducing complexity of accounting standards over time.
        Some will argue that if the Board makes its standards more general
    and limits the amount of detailed guidance they provide, it may lead to
    more inconsistencies in financial reporting. However, to the extent
    that the FASB staff, the SEC, accounting firms, or others identify such
    inconsistencies, the FASB Emerging Issues Task Force can deal with them
    on a timely basis. The SEC Chief Accountant has indicated a desire to
    work more closely and cooperatively with the EITF in providing guidance
    on new issues that demand quick attention. The FASB should keep this in
    mind and be willing to limit its standards to more general approaches
    in the future.

    The Consolidation Project and SPE's
        In spite of the fact that the real accounting issues in the Enron
    matter had to do with a lack of substance in certain transactions,
    attention has centered on the accounting for SPE's largely because they
    were the vehicles used to obscure the transactions' substance.
    Originally, the SPE's were accounted for ``off balance sheet,'' which
    means that the entities were not included in Enron's consolidated
    balance sheet, income statement, and other financial statements.
    Subsequently, the company restated its information for several years to
    consolidate those SPE's with Enron's other assets, liabilities,
    revenues, expenses, etc. The result was a significant increase in the
    liabilities reflected in Enron's balance sheet and a significant
    reduction in Enron's net income for those earlier years.
        The FASB's Emerging Issues Task Force developed the existing
    accounting guidance for SPE's about 10 years ago with considerable
    input from the SEC accounting staff. The need for this arose because
    the existing authoritative accounting guidance on consolidation related
    primarily to situations involving ownership of voting interests. The
    general rule was then, and is now, that entities in which a corporate
    parent owns more than a majority of the voting equity interests should
    be included in consolidated reports. Those entities for which ownership
    was 50 percent or less generally are not included in consolidation (are
    off balance sheet). (In the case of SPE's, to qualify for off balance
    sheet treatment the sponsor must own no equity in the SPE. At least 3
    percent of the capitalization of the SPE must come from unrelated
    parties--the remaining 97 percent generally comes from borrowings from
    financial institutions. Thus, the 3 percent of capitalization
    represents 100 percent of the equity ownership of the SPE.)
        Many parties believe, however, that there are situations where one
    entity ``controls'' another even without majority stock ownership. The
    FASB has been working to develop a definition of control and
    implementation guidelines for at least 15 years (since Statement 94 on
    consolidation of majority owned subsidiaries was issued in 1987). Two
    separate exposure drafts of proposed new rules for consolidation based
    on control were issued for public comment but most constituents
    vociferously opposed them, and they were not adopted as final rules.
    Many of the comments on the most recent proposal urged the Board to
    defer consideration of the broader control/consolidation matter but
    work to develop better accounting for the increasing number of special
    purpose entities. A few months ago the Board agreed that it should
    concentrate its near term efforts related to the consolidation project
    on SPE matters. According to the Board's most recent Technical Plan, it
    expects to issue proposed new guidelines in this area no later than
    June 30, 2002.
        Why has it taken the FASB so long to resolve this matter? I am not
    sure that I have a fully satisfactory answer to that question. However,
    let me mention some of the concerns I had with the control notion
    during the time I was at the Board, as well as subsequently when I sent
    my own comment letter on the latest proposal to modify general
    consolidation requirements.
        Control is a hard notion to define in a way that can be applied
    consistently in practice. Relatively early in my time at the FASB I
    remember a meeting where we discussed the project in an open meeting
    with SEC Commissioners. David Ruder was the new SEC Chairman at that
    time. When we brought this matter up I recall Chairman Ruder saying
    something like, ``Good luck--the SEC has been wrestling with the
    definition of control since the 1930's and we still aren't satisfied we
    have gotten it right.'' The FASB was convinced at that time that it
    could ``get it right'' but many years of subsequent debate have proven
    Chairman Ruder to be quite prophetic. With each iteration of definition
    and supporting implementation guidance, the Board has ultimately
    concluded that consistent application in practice was unlikely.
        Beyond these implementation challenges, there is the matter of what
    reporting actually best serves users of financial statements in this
    area. Should all corporate relationships somehow result in
    consolidation? I don't want to bury Committee Members in accounting
    esoteria, but let me give one example.
        Should a real estate operator have to consolidate all of the
    limited partnerships in which it serves as the general partner, even
    when its interest in each partnership is only 1 percent? If that were
    done, the consolidated financial statements would show large amounts of
    assets, liabilities, and ``minority interest'' and only a small amount
    of stockholders' equity. The income statement would show large
    revenues, expenses, and then a line called ``less minority interest''
    to arrive at a small amount of net income. The statement of cash flows
    apparently would show all of the cash receipts and disbursements of the
    limited partnerships, even though nearly all of the consolidated cash
    would not be available to the ``parent.'' Many knowledgeable
    accountants and financial analysts have said that this would not be
    meaningful or informative reporting.
        The matter above is what I would call a more general consolidation
    accounting matter. The SPE matter is a specific application. Until very
    recently, most FASB Board members believe that it was inappropriate to
    deal with a narrower topic (i.e., SPE's) without resolving the overall
    consolidation matter.
        Consolidation is only one matter relating to the overall topic of
    so-called off balance sheet financing. Off balance sheet financing
    represents a very broad and challenging accounting matter.
    Unfortunately, there is not even a common definition of this term of
    which I am aware. However, it probably would include such matters as
    SPE's, leases, take or pay contracts, through-put arrangements, and
    many more situations where a company will be able to use something in
    its future operations in exchange for agreed upon payments.
        At the extreme, this could include simple executory contracts, such
    as the University of Georgia's agreement to employ me for the 2002-2003
    school year. Should Georgia record an asset for the ``value'' of my
    future services and a liability for the amount the University has
    agreed to pay me? Most accountants probably would say no, because this
    contract involves both future services and future payments. But that is
    also the case for most of the off balance sheet financing arrangements
    that have been criticized recently.
        The accounting problem is to agree on what represents an asset and
    on what represents a liability, and when such amounts should be
    recorded in balance sheets. Some of these arrangements are treated as
    assets and liabilities under current GAAP, such as capital leases and
    SPE's that meet consolidation rules. For many other arrangements, the
    future cash obligations need to be disclosed in financial statement
    footnotes even if assets and liabilities are not recorded in the
    balance sheet.
        I have heard more than one commentator on the Enron matter say that
    we must record all of ``these'' contracts as liabilities. However, I
    have yet to hear one of those commentators say exactly what she or he
    means by ``these.'' The new disclosures recommended by the SEC to be
    included in Management's Discussion and Analysis will provide
    additional information beyond what is already required by the GAAP, and
    that is a positive step. The FASB's current attention to SPE's also is
    a positive step. However, it is important that the broader off balance
    sheet financing matter be studied carefully before cluttering up
    corporate balance sheets with amounts that might provide little or no
    incremental information to users, and may even confuse them.
        A key reason why many of these arrangements are allowed to be kept
    out of balance sheets at present is that the company does not own the
    asset in question. A third party has legal title to the asset and has
    agreed to make it available over time to the company. If you have
    signed a lease for an apartment in Washington for the next year, do you
    consider that to be an asset? I suspect that most of you do not, and
    corporations often feel the same way about their future obligations.
        In the debate about consolidation, it is important to keep the
    bigger picture in mind. Would consolidation of more entities actually
    improve users' understanding of a company's financial position and
    results of operations? In the vast majority of cases, including more
    entities in consolidation would have negligible effects on net income
    for the reporting company. It would increase both the assets and
    liabilities in the balance sheet and change certain ratios,
    particularly debt to equity. (The Enron situation, involving a very
    substantial adjustment to net income through consolidation of three
    SPE's, was fairly unique--caused by the reversal of gains on things
    that Enron had sold to the SPE's or on ``hedges'' that did not provide
    real economic protection.)
        Some would argue that more information is being provided to careful
    readers of financial statements under current GAAP as compared to what
    might result from more consolidation. This is because companies must
    disclose in footnotes certain information about entities in which they
    have a significant ownership interest but less than necessary to
    require consolidation. If all of those entities were consolidated, the
    individual amounts would become buried in the parent's balance sheet
    numbers, the footnote disclosures would no longer be presented, and the
    results would arguably be less meaningful.

    A Few Comments on International Accounting
        To some extent the degree of detail in accounting standards has
    been described as general vs. detailed, or principles vs. rules-based.
    A recent article in Business Week suggested that the off balance sheet
    financing vehicles used by Enron would never have been allowed in the
    first place under European accounting. The article noted that the new
    International Accounting Standards Board is using a principles approach
    and avoiding the United States tendency toward very detailed rules.
    Applying principles, auditors in Europe supposedly would have been able
    to stand up to clients and insist that SPE's be accounted for on
    balance sheet. Further, according to the December 13, 2001 issue of
    Accountancy Age (a United Kingdom publication), ``Sir David Tweedie,
    International Accounting Standards Board Chairman, and Allan Cook, UK
    Accounting Standards Board Technical Director have indicated Enron's
    collapse could not have happened under existing UK or global rules.''
    Mr. Cook also was quoted as saying, ``The IASB would probably have it
    on the balance sheet.''
        In evaluating such remarks, you and others should keep in mind that
    Enron corrected its financial statements to consolidate the troublesome
    SPE's in order to comply with existing U.S. GAAP. Further, any such
    remarks about other countries' accounting standards must be considered
    in the context of the rigor of auditing practice and regulatory
    enforcement, for which U.S. practice is far superior to the rest of the
    world.
        As stated earlier, I am in favor of less complicated and less
    detailed accounting principles, which is the approach being pursued by
    the IASB. That said, it is important to note that, on balance, our U.S.
    financial reporting system remains the best in the world because of the
    combination of comprehensive accounting principles, required audits by
    independent accountants, and regulation and enforcement by the SEC. No
    other country or area of the world has an overall system of financial
    reporting that is as reliable and informative as ours.
        The IASB activity should be commended and supported by U.S.
    parties. At the same time, I believe it is imperative that neither the
    SEC nor the FASB take action in the near term that would have the
    effect of watering down Generally Accepted Accounting Principles in our
    country. Convergence of accounting standards around the world is an
    admirable long-term goal. However, for the next 5 to 10 years, at a
    minimum, we must not dilute United States reporting solely for the
    purpose of harmonization.

    Funding of the FASB
        One of Arthur Levitt's recommendations in his New York Times op ed
    piece is that alternative funding be put in place for the FASB in order
    to improve its independence from the business community and accounting
    firms. This would allow the organization to cover its operating
    expenses through a ``broad-based user fee,'' in Mr. Levitt's words. A
    number of alternatives for funding the FASB have been suggested in the
    past and this matter is certainly worth further consideration by the
    Trustees of the FAF and other interested parties.
        At present, approximately two-thirds of the FAF's annual budget
    comes from selling publications and from similar operating activities.
    The remaining one-third represents voluntary contributions made by
    AICPA, individual accounting firms, and approximately 1,000
    corporations. The total contributed by corporations represents about 15
    percent of the FASB's budget in total, and individual amounts generally
    do not exceed $50,000 (the vast majority are much less). Corporations
    occasionally threaten the FASB that they will cease contributing if the
    Board adopts a certain technical position. By and large, however, the
    number of donors who actually do this is very small.
        One suggestion that has been made in the past is that permanent
    funding should somehow be put in place. To cover the current operating
    needs of the FASB and GASB would necessitate a permanent endowment fund
    somewhere in the neighborhood of $300 million (the FAF's current
    reserve fund is about $29 million). It is unlikely that corporations,
    accounting firms, investment bankers, and others directly involved in
    the FASB's activities would be interested in or able to provide this
    level of funding. Perhaps Congress could find a spare $300 million
    lying around, but most parties believe the strings likely to be
    attached to any such funding would undermine the private sector nature
    of the Board.
        Another possibility would be for a fee to be assessed on all public
    companies and perhaps other parties interested in the financial
    reporting process, such as accounting firms and investment bankers.
    This apparently is what Mr. Levitt has in mind. If this could be done
    through the stock exchanges or in some other way that does not involve
    the Government, this idea might be worth pursuing. However, it is more
    likely that the SEC or even Congress would have to get involved in this
    kind of arrangement and such a relationship to the FASB's funding would
    be detrimental to the Board's independence.
        An advantage of the present system is that having some dependence
    on voluntary contributions means that the FASB is subject to a sort of
    market test of its effectiveness. The Board's technical actions are,
    and should be, independent in nature. However, it is also important
    that the FASB not be so distanced from its constituents that too large
    a number of them become unwilling to continue financial support. Most
    contributing accounting firms and corporations recognize that they are
    not going to get their way on technical issues just because they make a
    contribution. But if the Board begins acting in a way that somehow
    ignores the input from constituents, the contribution mechanism is a
    way for them to express their significant dissatisfaction.
        To be clear, no contribution to the FAF, or threat of withholding a
    contribution, affected any of my decisions at the FASB in any way
    whatsoever. And I know that that was true for all of the individuals
    with whom I worked at the Board.

    Audit Committees
        As was noted earlier, I recently became the Chairman of the audit
    committee of a public company. Even before doing this I had worked with
    a number of the audit committees while I was still in public accounting
    and I have consulted with some committees in my present position. Based
    on these experiences, I believe that audit committees can and do serve
    an important function in the financial reporting system. And I was
    particularly pleased to see the changes over the past few years that
    require audit committee members to be independent board members and
    require those members to be reasonably qualified for their
    responsibilities.
        While audit committees play an important role in the reporting
    system, they do not have primary responsibility for appropriate
    financial reporting. That duty rests with corporate financial
    management, and independent auditors play a critical part as well. But
    the audit committee can set an important tone at the top. Audit
    committee members also can ask tough questions of management and
    outside auditors, and demand answers that are understandable to them.
    But even the best audit committee is not going to guarantee that a
    financial reporting problem will not occur.
        There is one area where I think audit committees can be improved.
    That is in the qualifications for membership. While all members are
    presently required to be ``financially literate'' and at least one must
    have ``accounting or related financial management expertise,'' I
    believe those requirements can be clarified and strengthened. At least
    a majority of audit committee members should have significant
    accounting, auditing, finance, or legal expertise. General management
    responsibility without direct involvement in one of those areas should
    not be sufficient for those individuals.
        Also the person with ``accounting or related financial management
    expertise'' should have strong skills in that area. Since the
    introduction of the new audit committee membership requirements, it
    appears as though there has been only a trickle of new board member
    appointments from backgrounds as chief financial officers or
    controllers of corporations, or as audit partners from accounting
    firms. Making these requirements more stringent could encourage
    companies to invite more individuals with CFO/audit partner background
    to join their boards. And adding legal expertise to audit committees
    could assist committee members in understanding the complex
    organizational and transaction structures employed by many companies
    today.
        Significant accounting, auditing, finance, and legal expertise are
    essential prerequisites for members so that the complex issues that may
    be presented to them will not intimidate them. Members with such
    qualifications are more likely to ask management the probing questions
    necessary to ensure an understanding of the substance of the issues
    brought to their attention. In particular, members with audit expertise
    will be better able to effectively judge the performance of the
    internal and outside auditors.
        Raising the bar for audit committee membership will not by itself
    protect against future Enrons, but it should certainly help improve the
    overall quality of financial reporting.

    Summary
        To summarize, this is a critical time for financial reporting and
    the auditing profession. It is important that the issues raised by the
    Enron matter and other recent business/accounting/auditing failures be
    studied and used to evaluate what changes can be made to improve the
    system. However, it is equally important that the baby not be thrown
    out with the bathwater. The current system is not foolproof but it
    works well in the vast majority of cases. Consideration of changes
    should call attention to and build on the strengths of the current
    system rather than undermining it. My principal suggestions for
    improvement are as follows:

     In discharging its important oversight of the effectiveness of
        the current system of financial reporting and auditing, Congress
        should take care not to become involved in individual technical
        accounting issues.

     Business executives, outside lawyers, the accounting
        profession, and the SEC must work as cooperatively as possible on
        both general reporting matters and individual company matters.

     The FASB needs to improve its processes in order to resolve
        accounting issues much more quickly. This can be done through a
        combination of less detailed standards, less concern about
        ``conceptually pure'' answers in all cases, and additional staff.

     An ongoing goal of the FASB should be to lessen the detail of
        accounting standards. In return, outside lawyers and accountants
        must ensure they balance client advocacy with protection of the
        public trust.

     The FASB needs to quickly develop better guidelines for when
        SPE's should be consolidated and what disclosures about SPE's are
        appropriate.

     The goal of long-term internationalization of accounting
        standards should not diminish in any way the current quality of
        reporting in the United States.

     Qualifications for audit committee membership should be
        further clarified and strengthened.

     RESPONSE TO QUESTION RAISED BY SENATOR MILLER FROM DENNIS R.
                               BERESFORD

    Q.1. Mr. Beresford, I asked Mr. Schuetze what would have
    happened in the Enron situation if we had had mark-to-market
    accounting. You restated my question and answered ``no''
    meaning it would not have stopped the Enron situation. Can you
    tell me why?

    A.1. Enron had to correct its previous financial statements
    because of three matters:

     Improperly recording notes receivable for the issuance
        of Enron stock to special purpose entities (SPE's) as
        assets and increases in stockholders' equity.

     Failure to consolidate certain SPE's for which ``off
        balance sheet financing'' treatment was not permitted under
        Generally Accepted Accounting Principles.

     Certain other adjustments that Arthur Andersen
        previously had permitted Enron not to record because they
        were considered immaterial at the time.

        These errors do not involve mark-to-market accounting
    matters. Mark-to-market generally means that amounts recorded
    as assets or liabilities in the balance sheet are adjusted at
    the end of each accounting period to the estimated fair value
    at that date. The above items were either omitted from Enron's
    financial statements or incorrectly shown as assets and equity
    rather than being offset.
        On the other hand, Enron did use mark-to-market accounting
    in connection with its energy and other trading activities. To
    the best of my knowledge, no one has suggested that Enron was
    not following Generally Accepted Accounting Principles in doing
    so, However, I understand that for many of these contracts the
    estimates of period end values involved predictions of energy
    and other prices several years into the future. While mark-to-
    market accounting is considered by many accountants to be the
    most relevant way to report contract positions, others point
    out that the resulting values may not be very reliable in some
    cases.
        It appears that Enron's need to correct certain of its
    earlier financial statements caused investors, lenders, and
    trading partners to lose confidence in the company. This
    apparently led to liquidity problems, and the subsequent
    bankruptcy, as loans became due earlier than expected. Thus,
    accounting errors played an important role in Enron's demise.
    However, a greater use of mark-to-market accounting would not
    have prevented those particular errors nor provided any
    obviously superior information to users of Enron's financial
    statements.

              This article by Walter P. Schuetze appears in Abacus
             A Journal of Accounting, Finance, and Business Studies
               Volume 37, Number 1, February 2001, ISSN 0001-3072

         Published for the Accounting Foundation, University of Sydney
                            by Blackwell Publishers

                        WHAT ARE ASSETS AND LIABILITIES?
       Where is True North? (Accounting that My Sister Would Understand)
                             by Walter P. Schuetze

        This is a paper about what I think financial accounting and
    reporting ought to look like--about my vision that the singular focus
    of financial accounting and reporting should be on cash, that is, cash
    itself, contractual claims to cash, things (assets) that can be
    converted into cash, and obligations to pay cash, and that assets and
    liabilities should be stated at fair value in corporate balance sheets.
    I call this formulation True North.
        I previously have written about how we should keep financial
    accounting and reporting simple. (See, ``Keep It Simple,'' Accounting
    Horizons, pp. 113 -117, June 1991.) I also have written about how
    assets should be defined for accounting purposes. (See, ``What is an
    Asset?'' Accounting Horizons, pp. 66 -70, September 1993.) This piece
    builds on those two earlier pieces. This piece deals with definitions
    of assets and liabilities that should be recognized (that is,
    displayed, shown, or reported) in corporate balance sheets and how the
    recognized assets and liabilities should be measured when reported in
    those balance sheets.
        The rules for financial accounting and reporting in the USA have
    become vastly too voluminous, too detailed, too complex, and too
    abstruse. At this writing in July 2000, the Financial Accounting
    Standards Board has issued 139 Statements on Financial Accounting
    Standards (Standards). Public companies in the USA, and foreign
    companies whose securities are listed in the USA, must follow the
    Standards in the preparation of their financial statements or in the
    reconciliation of their home-country financial statements to USA
    Standards. Because some of those 139 Standards superseded a prior
    Standard, the count of the currently effective Standards is about 100.
    In addition to Standards, there is previously issued literature
    inherited by the FASB at its formation in 1973 from the American
    Institute of Certified Public Accountants, namely, Accounting Research
    Bulletins and Accounting Principles Board Opinions. This legacy
    literature has the standing and authority of a Standard. The FASB
    itself also has issued numerous Interpretations of Standards and also
    has issued Technical Bulletins prepared by the FASB's staff. The FASB's
    staff also has issued numerous Special Reports dealing with various
    accounting matters dealt with in Standards, for example, ``A Guide to
    Implementation of Statement 125 on Accounting for Transfers and
    Servicing of Financial Assets and Extinguishments of Liabilities,'' and
    guidance for implementation of Statement of Financial Accounting
    Standards No. 133, ``Accounting for Derivative Instruments and Hedging
    Activities.'' The FASB's Emerging Issues Task Force has issued several
    hundred ``consensuses,'' each dealing in extreme detail with quite
    specific accounting problems. (The ``Issues Summaries'' for the July
    2000 meeting of the Emerging Issues Task Force run to more than 300
    typewritten pages, of which many pages are single spaced.)
        The American Institute of Certified Public Accountants has issued
    numerous Audit and Accounting Guides, Statements of Position, and
    Practice Bulletins, with most of these documents having been vetted by
    the FASB and its staff prior to the issuance of those documents by the
    AICPA. The AICPA also has issued Technical Practice Aids, which are not
    vetted by the FASB or its staff prior to issuance.
        As well, the Securities and Exchange Commission and its staff have
    issued numerous rules, regulations, releases, and bulletins dealing
    with financial accounting and reporting.
        All of this literature constitutes Generally Accepted Accounting
    Principles, which is required accounting by public companies in the
    USA. As well, the large public accounting firms have issued their own
    guidance or interpretation or ``how to'' guides that instruct the
    firms' partners and staff on various FASB, AICPA, and SEC
    pronouncements. These firm-prepared documents often run to hundreds of
    pages. For example, shortly after the FASB issued Statement 133,
    ``Accounting for Derivative Instruments and Hedging Activities,'' in
    June 1998, itself more than 200 pages in length, several accounting
    firms issued their own guidance on how to apply Statement 133, which
    guidance constituted more than 400 pages in the case of one firm and
    500 pages in the case of another firm. I have all of these documents in
    my office, but many are on the floor because my bookcase is full. And
    all of this is before mentioning Standards issued by the International
    Accounting Standards Committee since its inception in the early 1970's.
        The volume and the complexity of those pronouncements have become
    overwhelming--on a par with the Internal Revenue Code and the related
    Regulations in the USA. The volume and complexity have become too, too
    much for: (a) those insiders who are responsible for and prepare
    financial statements and reports; (b) those outsiders who audit those
    financial statements and reports; (c) those outsiders such as
    investors, creditors, underwriters, boards of directors and audit
    committees, and analysts, who use those financial statements and
    reports; and (d) those outsiders who regulate the preparation, audit,
    and dissemination of financial statements and reports.
        The hapless user of the financial statements and reports has almost
    no grip on the rules governing financial reporting and thus, in many
    cases, does not understand the financial statements and reports.
    Indeed, in a survey of 140 star, sell-side analysts, Epstein and Palepu
    found that, ``Footnotes [where asset and liability recognition and
    measurement are described] seem to frustrate analysts the most. When
    asked which components of the annual report they often have a hard time
    understanding and which they would like explained more, star analysts
    rated the footnotes first. Thirty-five percent of the analysts have
    difficulty understanding the footnotes, and 55 percent would like
    further explanation of the footnotes.'' (See, ``What Financial Analysts
    Want,'' by Marc J. Epstein and Krishna G. Palepu, Strategic Finance,
    April 1999.) Imagine that. Star, sell-side analysts do not understand
    the accounting. Buy-side analysts (institutions) cannot be any better
    equipped to understand the accounting. Is it any wonder that the London
    School of Business advertises a Financial Seminar for Senior Managers
    that enables Senior Managers to ``decode published financial
    statements.'' (See, The Economist, November 14, 1998, p. 101.)
        Financial analysts are not alone. I was Chief Accountant to the SEC
    (January 1992 to March 1995) and was Chief Accountant of the SEC's
    Division of Enforcement (mid-November 1997 to mid-February 2000). While
    on staff at the Commission, I tried to explain relatively simple
    accounting issues and accounting rules to the Commission's legal staff
    and its litigators, FBI agents, U.S. Postal Inspectors, and Assistant
    U.S. Attorneys in the Department of Justice so that they could bring
    and prosecute civil and criminal cases before administrative law
    judges, Federal judges, and juries. I had minimal success even on
    simple issues. The litigators and prosecutors are very reluctant to
    bring accounting fraud cases unless smoking guns are evident, such as,
    for example, fake invoices or boxes filled with bricks instead of lap
    top computers or incriminating memos.
        Financial accounting and reporting should be based on intuition,
    not inculcation. There really should be nothing complicated about it.
    It is not like medicine. It is not like the law. It is not rocket
    science. Ordinary people, chief executive officers, line operating
    managers, members of boards of directors, investors and creditors and
    regulators, who are not accountants, should be able to look at
    financial statements and reports and understand the information
    portrayed and conveyed. After all, it is the nonaccountants who use
    financial statements and reports to make investment, credit, and
    regulatory oversight decisions, not to mention corporate governance
    decisions. But ask members of boards of directors, members of audit
    committees of boards of directors, members of the investing and credit-
    granting public,
    financial analysts, and members of regulatory oversight bodies to
    explain, in plain English, the meaning of the representations in the
    financial statements and reports they use to make decisions and there
    is no response. I repeat--there is no response. They must turn to the
    accountant to furnish the explanation. The accountant's explanation
    turns out to be not in plain English at all but arcane jargon
    understandable only to other accountants and not necessarily all other
    accountants but only the initiated ones. The much-proclaimed
    transparency in corporate financial accounting and reporting in the USA
    is in fact a considerable illusion insofar as the numbers (dollar
    amounts) in the financial statements and reports are concerned. The
    numbers are not very transparent at all. Only accountants know how the
    numbers are derived, and sometimes only a very few accountants.
        I say again, preparation of financial statements and reports, their
    use, and their regulation should be based on intuition, not
    inculcation. The way it is now, however, to be fully conversant with
    all of the financial accounting and reporting requirements means that
    one has to live in a medieval, unheated, stone building in the
    Pyrenees, wear a brown robe with a rope belt, a skull cap, and clogs,
    and memorize accounting literature (dogma). I recently received a
    mailing from the AICPA advertising a 2 day course on Accounting for
    Business Combinations at a price of $1,295 or at $1,035 for AICPA
    members. Can you believe that? Two days and over a thousand dollars to
    learn about one accounting problem.
        There are more than 330,000 CPA's in the USA. No more than a few
    hundred of them know the workings of the Standards on (1) leases, (2)
    foreign currency translation, (3) pensions, (4) post-retirement
    benefits other than pensions, (5) interest (whether and when to
    capitalize interest cost), (6) deferred income taxes, (7) investments
    in debt securities, (8) impairments of carrying amounts of loans
    receivable or long-lived operating assets, (9) transfers and servicing
    of financial assets and extinguishments of liabilities, and (10)
    derivative instruments and hedging activities. Moreover, each one of
    these areas has such detailed, complex, abstruse rules that the few
    hundred CPA's who are expert in accounting for derivatives often are
    not the same few hundred CPA's who are expert in accounting for
    pensions. Each monk knows one Book of the Bible.
        I liken the use of financial statements and reports to driving an
    automobile. Automobiles are powered by internal combustion engines, but
    drivers of autos do not need to know anything about what makes the auto
    go except that gasoline (or petrol) is necessary and that the engine
    oil needs to be replaced occasionally. That is virtually all that I
    know about my auto. Comparing accounting to the auto, one needs to be
    the equivalent of a mechanical engineer to use and drive the auto
    called financial accounting and reporting. We accountants are doing
    accounting for accountants' sake, not for use by investors, creditors,
    underwriters, analysts, boards of directors, and the regulators who are
    the people that we accountants should aim to please.
        How overwhelming today's accounting is demonstrated by the response
    to a proposal for improving the effectiveness of audit committees. The
    Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit
    Committees, co-chaired by John Whitehead and Ira Millstein, in one of
    its ten recommendations about improving the effectiveness of Audit
    Committees, recommended that the Audit Committee, in the annual report
    to shareholders, attest that Audit Committee members believe, based on
    discussions with management and the external auditor, that the
    financial statements conform to Generally Accepted Accounting
    Principles. (See, Recommendation 9 of the Report and Recommendations of
    the Blue Ribbon Committee on Improving the Effectiveness of Corporate
    Audit Committees, issued in 1999, at www.nyse.com.) That recommendation
    was soundly rejected by commentators in financial and legal circles. In
    response to a reporter, the General Counsel of the Securities and
    Exchange Commission said that, ``The reference to Generally Accepted
    Accounting Principles has created some fear and confusion because audit
    committee members have been concerned that they do not know the
    intricacies of the accounting rules. Audit committees understand
    accurate, full, and fair disclosure, and that things may not be
    materially misleading, but they do not necessarily understand the
    nuances of Generally Accepted Accounting Principles.'' (See, The Wall
    Street Journal, July 14, 1999, p. C14.) (The SEC, in its new rule on
    Audit Committees, did not require that the Audit Committee give the
    opinion suggested by the Blue Ribbon Committee. Instead, the SEC
    amended its rule to require only that the Audit Committee publicly
    state that it reviewed and discussed the audited financial statements
    with the auditor and that the Audit Committee recommends the inclusion
    of the audited financial statements in the Form 10 -K or 10 -KSB.)
    (See, SEC Release 34.42266, December 22, 1999.) The new rule does not
    require the Audit Committee to give an opinion about compliance with
    Generally Accepted Accounting Principles. In my opinion, most members
    of audit committees, if not virtually all members of audit committees,
    could not give the opinion suggested by the Blue Ribbon Committee
    because the accounting is beyond their ken. Incidentally, I think it is
    a fair question to ask: How can boards of directors and audit
    committees satisfy their governance responsibilities if they do not
    understand the accounting numbers?
        I use my sister as a guidepost when I think about accounting
    issues. She has no university education. She runs a successful, small
    business located near my home town of Comfort, Texas. She prepares
    financial statements for her business to run her business and so that
    the other owners of the business may see how well the business has done
    under her leadership. In the financial statements of her business,
    assets are cash, contractual claims to cash, and things that the
    business owns and that can be sold for cash--all at fair value, that
    is, the amount of cash any of the noncash assets would fetch in an
    immediate sale for cash less cost to sell the asset. When she consults
    me about the preparation of the financial statements for her business
    and I try to explain to her the Standards that we accountants use to
    prepare financial statements, her eyes glaze and she blames my
    accountababble on my having sat for too long in the hot Texas sun. She
    recently bought out one of her competitors and paid about $100,000 in
    excess of the fair value of the identifiable net assets acquired. The
    competitor agreed not to compete against my sister's business for 5
    years. I told her that the $100,000 represented the cost of the
    noncompete agreement and purchased goodwill, which, under Generally
    Accepted Accounting Principles, should be reported as assets. She
    laughed at me. Try to pay salaries, rent, the electric, or dividends
    with those assets, she says. That kind of accounting may be okay for
    Wall Street but not for Main Street in Comfort, Texas. Moreover, she
    says, those so-called assets will not earn a penny. The $100,000 is
    gone--irretrievably gone. It is spent money. Whether her business earns
    any additional net-after-tax cash flows as a result of buying out her
    competitor and getting him to agree not to compete with her business
    for 5 years will be decided by the former competitor's customers--
    whether they decide to patronize her business and buy her business'
    services. She does not control what those potential customers may do.
    Not an asset today, she says. Maybe tomorrow, if and when those
    customers buy her business' services and generate additional, after-tax
    cash for her business. Not a fit and proper asset to be recognized in
    advance of sales to customers, however. In short, in accounting
    parlance, the $100,000 is a quintessential ``gain contingency'' that
    should not be recognized as an asset until it materializes in the form
    of cash.
        Moreover, there is no over-arching theme to this huge body of
    literature governing financial statements and reports to which the
    uninitiated, or even the initiated, may refer. The FASB says that the
    information in financial statements and reports has to have ``decision
    usefulness.'' But the numbers in balance sheets for reported assets and
    liabilities are the result of mechanically applying all of the rules
    and literature described above without regard to whether the result is
    understood by and makes sense to the people who actually use it.
    Remember my reference earlier to the findings of Epstein and Palepu
    about star, sell-side analysts who do not understand the notes to the
    financial statements. As a guide or standard, ``decision usefulness''
    is so nonspecific and allows so much judgment and leeway that it is not
    helpful. What we need instead is a definition of True North in
    accounting. Everyone knows where North lies on a compass, and we can
    navigate toward it in our daily journeys in accounting. Decision
    usefulness, on the other hand, can lie anywhere on the compass. Under
    the current rules, in addition to cash, we have the following as to
    assets representing contractual claims to cash:

              (a.) Receivables, generally at the amount of cash expected to
            be collected and generally not reduced for the time value of
            money or otherwise reduced to fair value. This category
            includes such items as trade receivables, amounts due to the
            reporting enterprise by a counterparty under a currency or
            interest rate swap agreement, insurance premiums due from the
            owner of an insurance policy, income tax refunds, and amounts
            due from vendors/suppliers under cooperative advertising
            agreements. Amounts of receivables not yet billed are included
            in this category. For example, companies that perform
            construction work for the U.S. Government often show ``unbilled
            receivables'' as assets on their balance sheets.
              (b.) Loans receivable having fixed or determinable amounts.
            Examples are commercial or residential mortgage loans and loans
            made by banks and insurance companies to individuals as a
            result of the individuals' using credit cards to buy goods and
            services, to small businesses, and to large commercial
            customers, at the present value of the amount of cash expected
            to be collected based on the effective interest rate in the
            loan. If the carrying amount of a loan is deemed not to be
            collectible in full, then the carrying amount of the loan is
            reduced to (i) the fair value of any collateral, (ii) the
            market price of a similar loan if such a price exists, or (iii)
            the revised, expected cash flows reduced for the time value of
            money using the interest rate implicit in the loan at its
            inception. (The cost of originating loans is added to the
            ``cost''--cash advanced to the borrower--of the loans.)
              (c.) Securities representing an interest in indeterminate
            cash flows from ``securitized'' loans receivable, at the fair
            value of the security, with changes in that fair value being
            recognized (i) in income by traders such as broker-dealers and
            some banks and (ii) in shareholders' equity (net assets) by
            other holders such as banks if the security is classified as
            ``available for sale.'' Classification of such a security as
            ``held to maturity'' by the owner would have the security being
            reported at historical cost. These kinds of securities arise in
            transactions where the originator of loans, such as mortgage
            loans and automobile loans, sells tranches of the loan
            portfolio to investors such as insurance companies, mutual
            funds, and trusts administered by banks.
              (d.) Securities representing contractual, fixed, or
            determinable cash flows, such as bonds, based on fair value or
            historical cost of the security.
              (e.) Refundable cash deposits, such as the portion of an
            insurance premium that would be recaptured if the policy were
            cancelled.

        As to assets such as inventory, land, plant, equipment, and patents
    (sometimes called ``nonmonetary items'') that are not cash and claims
    to cash, we have the following:

              (f.) The amount of cash paid, at some time in the past, for
            an item other than cash or a claim to cash plus related
            expenditures, which is called ``historical cost.'' For example,
            the amount of cash paid for land plus brokers' fees, legal
            fees, appraisal fees, documentary fees, and other fees
            applicable to the acquisition of the land. These fees could be
            material in relation to the cash price paid for the land. Other
            examples include amounts of cash paid for such things as plant,
            equipment, copyrights, patents, and TV or radio broadcasting
            rights. The amount of cash paid--the cost--is reduced by
            periodic charges made to income so as to allocate the cost to
            periodic income on what is said to be a rational and systematic
            basis.
              (g.) The portion of a lump-sum purchase price paid for two or
            more assets acquired together, as, for example, in a business
            combination, that is allocated to one of the assets acquired,
            which amount generally would be the fair value of the asset.
            For example, the amount of cost allocated to land acquired in a
            business combination would be the fair value of the land but
            would not include the various fees described in (f ) above.
              (h.) The fair value of an asset at the time it was received
            by the reporting enterprise in return for the issuance of a
            debt or equity instrument, also said to be ``historical cost''
            of the asset--for example, the fair value of land contributed
            to the reporting enterprise in exchange for stock. If, however,
            the land is contributed to the reporting enterprise by a
            promoter or controlling shareholder, then the cost to the
            reporting enterprise is not the fair value of the land but
            instead is the historical cost of the land to the contributor
            (an SEC rule). (Note that the ``historical cost'' of land under
            f, g, or h could be three different, possibly materially
            different, amounts for the same parcel of land.)
              (i.) Net realizable value, the amount of proceeds expected on
            sale of an asset such as work-in-process or finished goods less
            cost to complete and cost to sell.
              ( j.) Current market prices in the case of certain equity
            securities but not others such as when the owner of the equity
            security is said to have significant influence but not control
            of the investee in which case the so-called equity method of
            accounting is required (See k.).
              (k.) Historical cost of certain equity securities plus the
            arithmetic share of the investee's earnings and other changes
            in the investee's net assets said to be attributable to the
            investor (accounting by formula).
              (l.) Fair value of assets at the date of the write-down of
            the carrying amount of those assets whose carrying amount was
            deemed to be impaired, which carrying amount after the write-
            down is then said to be ``new historical cost.''
              (m.) Fair value of exchange-traded and over-the-counter
            derivative contracts having a positive value.
              (n.) Deferred income taxes, which are solely the result of
            computations done only by accountants, reduced, in some cases,
            by an allowance, the need for and amount of which is determined
            solely by management based on its judgment.
              (o.) Valuation allowances for certain assets, some allowances
            involving discounting, such as allowances for losses on
            individual loans where the discount rate is the rate of
            interest inherent in the loan when it was originated, and some
            allowances involving no discounting such as allowances for
            deferred tax assets and allowances for loan losses that are
            said to relate to portfolios of loans instead of individual
            loans. The amounts of these allowances are determined solely by
            management based on its judgment.
              (p.) The amount of cash paid for certain services to be
            received in the future such as advertising (prepaid
            advertising), placement of a manufacturer's product on shelves
            in grocery stores (slotting fees), and cash advances to writers
            for books or movies to be written or scripted, at the amount of
            cash paid reduced by periodic charges made to income to
            allocate to income the amount paid on what is said to be a
            rational and systematic basis.
              (q.) The right, perhaps through a so-called barter exchange
            or by use of barter credits issued by a barter exchange, to buy
            goods or services at a price less than the posted price or rack
            price. Examples are advertising space, radio or TV time, or
            hotel ``nights.'' Such rights also arise when vendors agree
            that customers may, based on the volume of their prior
            purchases, buy goods or services in the future at a discount
            from the posted price. (Do you have credits for airline miles
            that you have earned that you can use for upgrades to first
            class or for free tickets?) Some people believe that such a
            right or credit is a future economic benefit that should be
            recognized as an asset. Let me illustrate with an example.
            Suppose I buy groceries from the nearby supermarket. The bill
            is $42.00. When the cashier checks me out and gives me my
            receipt, the cashier also gives me a coupon that allows me to
            buy a bottle of 100 aspirin tablets at $5.75 instead of the
            shelf price of $6.75. The price reduction of a purchase in the
            future of a bottle of aspirin tablets at $5.75 instead of $6.75
            is, in the minds of some, a future economic benefit that should
            be recognized as an asset under today's Generally Accepted
            Accounting Principles--recognized as an asset by allocating a
            portion of the $42.00 to the ``value'' of the coupon, I
            suppose. I am not making this up. But that is the kind of goofy
            answer that one can get under today's accounting for ``future
            economic benefits.'' (More on ``future economic benefits''
            later.) My sister would shake her head in disbelief.
              (r.) The amount of cash paid for certain things that only
            accountants call assets, for example, the cost incurred by
            banks to originate loans receivable, the cost incurred by
            insurers to originate certain types of insurance policies, the
            cost of so-called direct-response advertising, interest cost,
            and finally, the cost of purchased goodwill. (At this writing,
            some commentators are urging the FASB to rescind FASB Statement
            2 (and Interpretation 4 thereof) which requires that the cost
            of R&D be charged to expense when incurred: Those commentators
            would have corporations recognize as an asset some or all of
            its R&D expenditures.)
              (s.) And last, some items that are solely the result of
            computations done only by accountants, such as amounts produced
            by applying the Standards related to pensions and deferred
            income taxes.

        As to liabilities, under the current rules, some amounts are:

              (i) What is to be paid in cash to vendors (accounts payable),
            to employees (wages payable), to counterparties under
            derivative contracts, to owners (dividends declared and
            payable), and to taxing authorities, sometimes based on tax
            returns as filed and sometimes based on what management of the
            enterprise says will be the final tax payable after negotiation
            or litigation with taxing authorities.
              (ii) Proceeds of borrowings.
              (iii) Refundable cash collected from customers in advance of
            delivery of goods or services to those customers.
              (iv) Deferred or unearned revenue, which is an amount
            representing cash collected from a counterparty in return for
            services to be rendered, reduced by credits to earned revenue
            that are determined based on services rendered or on what is
            said to be a systematic and rational basis.
              (v) Manditorily redeemable stocks generally measured at the
            redemption amount (an SEC rule, not a Standards rule).
              (vi) A calculated amount for promises to repair or replace
            faulty product.
              (vii) Fair value of exchange-traded and over-the-counter
            derivative contracts having a negative value.
              (viii) Deferred income taxes, which are based solely on
            computations done only by accountants.
              (ix) Whatever management of the reporting enterprise says
            will be a cash outflow in the future in respect of
            noncontractual bonuses to employees, ``restructurings,'' plant
            closings, or similar events.
              (x) And last, a calculated amount for pensions and post-
            retirement benefits other than pensions.

        The preceding discussion about various assets and liabilities
    assumes that the U.S. dollar is the unit of measure in the financial
    statements. If the unit of measure is not the U.S. dollar but a foreign
    currency, then another complexity is added in that the foreign currency
    amounts, determined using U.S. Generally Accepted Accounting
    Principles, would be ``translated'' into U.S. dollars using the current
    exchange rate. This procedure produces different ``historical cost''
    amounts for identical assets if there has been a change in exchange
    rates between the time the assets were acquired and the date of the
    balance sheet: For example, three identical IBM computers, bought at
    the same time for the same price and located in three different
    countries, say Canada, Mexico, and the USA would be shown at three
    different historical cost amounts in the balance sheet.
        Then because all of these amounts are expressed in Arabic numbers,
    we add them up as if they were cut from the same bolt of cloth and call
    them ``total assets'' and ``total liabilities.'' And reporting services
    such as Moodys', Standard & Poors, and Value Line and analysts and
    investors compute and use things like return on assets and return on
    equity based on this potpourri of numbers.
        What a cacophony! What the user of the financial statements hears
    is nothing but noise. It is as if each musician in the orchestra is
    playing from his or her self-selected sheet of music, one of the Three
    Tenors is singing in Italian, the second in German, and the third in
    French, all without a conductor.
        How did all of this happen? Well, its origin lies mainly in the
    fact that the staff of the SEC, in its early days (and lately as well),
    would not accept write ups of assets to fair value, and did not require
    writedowns to fair value except in extreme cases, because it thought
    the fair value numbers were too soft. Because we accountants were told
    by the SEC that we could not put current fair values in balance sheets
    but instead had to use historical cost, we accountants set about to try
    to make income the right number. Since the 1930's when our Federal
    securities laws were enacted, we have been trying to recognize,
    measure, and present income as opposed to assets and liabilities or net
    assets. In trying to get the right income number, we often put debits
    and credits on the balance sheet so as not to ``distort'' income. So as
    to time the recognition of these debits and credits in income when the
    time is thought to be ``right'' or based on management's intent. It is
    as if the balance sheet is a holding pen for expenditures to be
    released to expense sometime in the future when the time is right.
    (Visualize a pen full of sheep awaiting their turn to be sheared.) We
    defer costs on the balance sheet and try to attach them or match them
    with revenue or allocate them to income on a causal basis or what is
    said to be a systematic and rational basis. We use different inventory
    costing methods--average cost, first in, first out, and last in, first
    out. A reporting enterprise may use almost any inventory costing method
    except what is called ``base stock.'' On occasion, we see companies
    changing from one acceptable inventory cost method to another. Methods
    of calculating depreciation, depletion, and amortization expense run
    from accelerated methods to straight line to units of production. We
    often see changes in method. Estimated useful lives and salvage values
    or end values of the same kinds of fixed assets can vary significantly
    from company to company. Whether the carrying amounts of fixed assets
    are impaired is a judgment by management, for it is management that
    estimates the future cash flows from the asset in making the assessment
    about impairment. None of these deferrals, allocations, estimates of
    future cash flows, or formula-driven amounts can be verified or
    authenticated by reference to an actual phenomenon in the marketplace.
        Most of this accounting is, in the end, highly judgmental. This
    accounting is what I call ``feel good'' accounting. The AICPA's
    Committee on Accounting Procedure (1939 -1959) promulgated accounting
    rules designed to get income to be the correct number, through ``feel
    good'' accounting. That is, we like the financial statement results
    even though we may not be able to articulate why the results are what
    they are except by referring to the manner in which the amounts were
    determined. The accounting results, in many cases, cannot be audited or
    verified or authenticated by reference to any evidential matter coming
    from an outside source, but somehow we feel good about the numbers. An
    extreme example of feel good accounting is from the Committee on
    Accounting Procedure in Chapter 10 of the Accounting Research Bulletin
    No. 43, ``Taxes: Section A, Real and Personal Property Taxes,''
    paragraphs 10 -13, which reads as follows:

              ``10. In practice, real and personal property taxes have been
            charged against the income of various periods, as indicated
            below:

              (a.) Year in which paid (cash basis).
              (b.) Year ending on assessment (or lien) date.
              (c.) Year beginning on assessment (or lien) date.
              (d.) Calendar or fiscal year of taxpayer prior to assessment
            (or lien) date.
              (e.) Calendar or fiscal year of taxpayer including assessment
            (or lien) date.
              (f.) Calendar or fiscal year of taxpayer prior to payment
            date.
              (g.) Fiscal year of governing body levying the tax.
              (h.) Year appearing on tax bill.

              ``11. Some of these periods may coincide, as when the fiscal
            year of the taxing body and that of the taxing payer are the
            same. The charge to income is sometimes made in full at one
            time, sometimes ratably on a monthly basis, sometimes on the
            basis of prior estimates, adjusted during or after the period.
              ``12. The various periods mentioned represent varying degrees
            of conservatism in accrual accounting. Some justification may
            be found for each usage, but all the circumstances relating to
            a particular tax must be considered before a satisfactory
            conclusion is reached.
              ``13. Consistency of application from year to year is the
            important consideration and selection of any of the periods
            mentioned is matter for individual judgment.''

        The best way to sum up all of those alternatives of how to account
    for property taxes is to say that the accounting is whatever makes us
    feel good.
        The AICPA's Accounting Principles Board (1959 -1973) also issued
    feel good accounting rules; witness pooling-of-interest accounting and
    amortization of the cost of purchased goodwill over 40 years. To a
    large extent the FASB is doing the same; witness gains and losses on
    derivative contracts not being entered into earnings until the time is
    right; witness deferred gains and losses under pension accounting;
    witness the manner in which the carrying amount of fixed assets is to
    be assessed for impairment by reference to management's estimate of
    future cash flows from the asset instead of the fair value of the
    asset; witness the judgmental nature by which valuation allowances for
    loans receivable and deferred income tax assets are determined. Feel
    good accounting rules can be set only by and through a political
    process, that is, who has the most votes or who can shout the loudest.
    Feel good accounting produces numbers for noncash assets and
    liabilities that are the result of keeping income smooth or steady, or
    better yet, steadily increasing, but smoothly. To take what otherwise
    would be variable, lumpy earnings and smooth the earnings. (Visualize a
    huge, yellow Caterpillar bulldozer pushing the hills of economic change
    into the valleys of economic change.)
        The FASB has been in business since 1973. The FASB said, in its
    Concepts Statement 3, issued in 1980, that it ``. . . expects most
    assets and liabilities in present practice to continue to qualify under
    the definition in [Concepts Statement 3].'' These words were carried
    forward by the FASB in Concepts 6 issued in 1985. (See, paragraphs 170
    and 177 of Concepts Statement 6.) The Board in Concepts Statements 3
    and 6 thus blessed--and poured into concrete--what was practice in the
    early to mid-1980's, which practice continues in large measure today in
    2000 in the USA. Unless the FASB changes its Conceptual Framework or
    unless the FASB itself is changed, there will not be much movement away
    from feel good accounting. The question arises: Is it time to start
    thinking about changing the FASB?
        Today, most articulated definitions of an asset refer to ``economic
    benefit'' or ``future economic benefit'' or ``probable future economic
    benefit.'' For example, the FASB's definition is ``probable future
    economic benefit.'' The full definition of assets from the FASB's
    Concepts Statement 3, which originally was issued in 1980 and which now
    is included in paragraph 25 of Concepts Statement 6, is as follows:
    ``Assets are probable future economic benefits obtained or controlled
    by a particular entity as a result of past transactions or events.'' In
    paragraph 26 of Concepts Statement 6, the FASB lists three essential
    characteristics of an asset, as follows: `` (a) it [an asset] embodies
    a probable future benefit that involves a capacity, singly or in
    combination with other assets, to contribute directly or indirectly to
    future net cash inflows, (b) a particular entity can obtain the benefit
    and control others access to it, and (c) the transaction or other event
    giving rise to the entity's right to or control of the benefit has
    already occurred.'' The FASB goes on, in the same paragraph of Concepts
    Statement 6, to say: ``Assets commonly have other features that help
    identify them--for example, assets may be acquired at a cost and they
    may be tangible, exchangeable, or legally enforceable. However, these
    features are not essential characteristics of assets. Their absence, by
    itself, is not sufficient to preclude an item's qualifying as an asset.
    That is, assets may be acquired without cost, they may be intangible,
    and although not exchangeable they may be usable by the entity in
    producing or in distributing other goods or services. . . .'' THAT IS
    MIND- BOGGLING STUFF. I can tell you from experience that most
    accountants that I know do not understand the FASB's definition of
    assets. Ordinary folk--investors, creditors, analysts, underwriters,
    CEO's, line managers, members of boards of directors, and audit
    committees, journalists, judges, and juries--are mystified by that
    babble. (That is one reason why I no longer tell people at dinner
    parties that I am an accountant. When I do, they appear to feel sorry
    for me, avert their eyes, and silently hope that the hostess has seated
    all the accountants together at one table away from the other folk.)
        The FASB's definition of an asset is so complex, so abstract, so
    open-ended, so all-inclusive, and so vague that we cannot use it to
    solve problems. It does not require exchangeability of that which is
    called an asset; therefore, it allows all expenditures to be considered
    for inclusion as assets. The definition does not discriminate and help
    us to decide whether something or anything on the margin is an asset.
    That definition describes an empty box. A large empty box. A large
    empty box with sideboards. Almost everything or anything can be fit
    into it. The FASB, in its September 7, 1999 exposure draft on
    accounting for Business Combinations and Intangible Assets, is even
    proposing to put the cost of purchased goodwill into that box. The five
    FASB members who assented to the publication of that exposure draft
    believe that the cost of goodwill is an asset. The two dissenters, who
    dissent for reasons unrelated to the initial accounting for the cost of
    purchased goodwill at the date of the business combination, in obiter
    dictum, say that they too think that the cost of purchased goodwill is
    an asset. A very large box indeed!
        I have seen numerous situations at the SEC, particularly in
    litigated enforcement cases, where there are long-winded briefs by
    issuer-registrants, their independent auditors, and their expert
    witnesses, quoting extensively from the FASB's Concepts Statement 6 to
    support a debit balance in the balance sheet as a fit and proper asset,
    fully meeting the FASB's definition of an asset. One sees similar,
    long-winded briefs in private, civil litigation. In that litigation,
    both sides, both the defendant and the plaintiff, and all of their
    expert witnesses, are citing the very same passages from the FASB's
    Concepts Statement 6 in support of their positions regarding the
    worthiness or unworthiness of a debit balance in a balance sheet as an
    asset. What we have, then, in the lawyers' words, are teams of swearing
    accountants--one swearing ``thus and so'' and another swearing ``such
    and that,'' both invoking the same words in the same literature--and
    they cannot resolve what should be a simple question: Whether something
    is an asset.
        What generally happens in practice under the FASB's definition of
    an asset is that assets are not recognized in the balance sheet unless
    the reporting enterprise acquires them by paying cash or agreeing to
    pay cash in the future, or someone contributes something to the
    reporting enterprise in return for a debt or equity security issued by
    the enterprise. Then an asset is said to have a cost. In fact,
    accountants sometimes think of the asset and talk about it in terms of
    its cost, not in terms of the asset itself or the future benefit that
    may flow from it. That is, the asset is the cost, and the cost is the
    asset. For example, if an enterprise discovers something of value, say,
    oil or gold, we do not recognize it as an asset because the enterprise
    has no cost in that something. When the FASB proposed sometime ago that
    business enterprises recognize as assets things received from others in
    a so-called nonreciprocal exchange, for example, land received from a
    government, some accountants objected. One of the reasons for the
    objection was that the enterprise receiving the asset had no cost in
    the asset. I refer to this phenomenon as the cost-per-se-is-the-asset
    syndrome.
        I will cite some examples of costs equal assets. (I am aware that
    the FASB has said in paragraph 179 of Concepts Statement 6 that costs
    are not themselves assets. In my experience, however, most preparers
    and auditors of financial statements continue to equate costs with
    assets in their conversations and in the way they prepare and audit
    financial statements. After all, the FASB said in Concepts Statement 3
    and 6 that then ``present practice'' would continue, and in that
    practice costs equal assets.) The AICPA's Accounting Standards
    Executive Committee, without objection from the FASB, issued a
    Statement of Position entitled ``Reporting on Advertising Costs'' that
    says so-called direct-response advertising costs are to be reported as
    assets if the advertising activity results in probable future economic
    benefits. Thus, the cost is the asset. In oil and gas accounting,
    either successful efforts as described by the FASB in FASB Statement 19
    or full cost as described by the SEC in Regulation S-X, the asset
    represented in the balance sheet is the cost of finding the oil and gas
    reserves, not the value of the reserves themselves at time of discovery
    or anytime thereafter. In FASB Statement 34, interest cost is an asset.
    In FASB Statement 60, the cost of issuing insurance contracts is an
    asset. In FASB Statement 86, the asset is the cost of developing
    computer software, not the future benefit that will flow from the
    software. In Accounting Principles Board Opinion 21, the cost of
    raising debt finance is an asset, a ``deferred charge.'' And finally,
    in APB Opinion 16 and in the FASB's September 1999 exposure draft
    dealing with Business Combinations and Intangible Assets, the cost that
    is left over in a business combination after the purchase price is
    allocated to the identifiable assets and liabilities is an asset; it is
    called cost of acquisition in excess of the fair value of net assets
    acquired, or cost of purchased goodwill. (In a letter dated June 15,
    2000 to the FASB commenting on the FASB's September 1999 exposure draft
    on accounting for ``Business Combinations and Intangible Assets,'' I
    call it a glob.) Along this same line, the International Accounting
    Standards Committee says that development costs, the ``D'' in ``R&D,''
    may be recognized as an asset under certain conditions. In all of these
    cases, it is the cost itself that is identified as the asset, not the
    probable future economic benefit. It is this same line of reasoning,
    that a cost can be an asset, that leads some people to suggest that the
    FASB should reconsider FASB Statement 2 and allow for recognition of
    research and development costs as an asset.
        Generally, when assets are acquired for cash, the fair value of the
    assets acquired, or the future economic benefit, is approximately equal
    to the cash paid (laying aside the difference between bid and ask
    prices and costs of actually buying assets, such as brokers' fees.) So
    at least at the date of acquisition of the asset, cost equals fair
    value and future economic benefit. (We all know that, soon after the
    acquisition of an asset, say, land, cost, and fair value begin to
    diverge and often become quite far apart.) The cost of many assets
    recognized under the FASB's definition does not, at the time of
    acquisition, represent anything close to the ``probable future economic
    benefit'' to be derived from the asset. For example, the probable
    future economic benefit of a successful, direct-response advertising
    campaign may be many multiples of the cost. The cost of prepaid
    advertising or direct response advertising only by chance will be equal
    to the present value of increased net cash flows that may result
    because of the advertising. The future economic benefit of a discovery
    of mineral deposits generally bears no relationship whatsoever to the
    cost of finding the deposits. The future economic benefits of a
    successful research and development project also bear little or no
    relationship to the cost incurred.
        Defining an asset as a probable future economic benefit is to use a
    high-order abstraction. Under such an approach, if an enterprise owns a
    truck, the truck per se is not the asset. The asset is the future
    economic benefit, that is, the present value of the cash flows that
    will come from using the truck to haul lumber, or coal, or bread. Yet,
    in today's practice, the asset represented on the balance sheet is a
    truck. Readers of the financial statements see the asset as a truck.
    The readers do not see it as the economic benefit that will come from
    using the truck to haul lumber. I think most people, even most
    accountants, think of the asset as a truck instead of an abstraction,
    instead of the present value of future cash flows, or the future
    economic benefit, to be derived from using the truck to haul lumber.
        I think that we should account for real things such as trucks, not
    abstract future economic benefits. I suggest that we adopt a different
    definition of an asset. A simple one. One that is not a large empty
    box. One that is not a high-order abstraction. I suggest that we adopt
    the following definition: ``Cash, contractual claims to cash, things
    that can be exchanged for cash, and derivative contracts having a
    positive value to the holder thereof.''
        My definition would comprehend only real things, not abstractions.
    Real things such as trucks can be sold for cash. Real things can be
    pledged as collateral for a borrowing of cash. Real things can be given
    to charity. Exchange-traded derivative contracts having a positive
    value can be closed out for cash. The positive value of an over-the-
    counter derivative contract can be turned into cash by entering into an
    equal and offsetting contract. Abstract probable future economic
    benefits cannot be sold, pledged, or given to charity. My definition
    would not accept a cost as being an asset. A critical feature in my
    definition is exchangeability of the asset, which is explicitly not a
    feature of the FASB's definition of an asset. (See, FASB's Concepts
    Statement 6, paragraph 26.)
        Let me list a few of the things my definition would include.
    Obviously, cash. Obviously, claims to cash such as trade receivables,
    loans receivable, demand deposits at banks, certificates of deposit,
    cash surrender value of life insurance policies, bills, notes, and
    bonds issued by governments, corporations, partnerships, individuals,
    and trusts. Cash paid in advance for the future use of land and
    buildings would be included as an asset if the cash could be recaptured
    from the lessor by the lessee at its option. That definition would
    include raw materials, finished goods, common stocks issued by other
    enterprises, land, buildings, equipment, mineral deposits, air rights,
    water rights, broadcast rights, patents, and copyrights. Work-in-
    process inventory and fixed assets in the process of construction might
    be included if they can be sold for cash in their present condition or
    state. Growing crops would be excluded because a crop generally cannot
    be sold separately from the land, but the value of the growing crop
    would increase the fair value of the land, which can be sold. Also
    included would be futures, forward, option, swap, and swaption
    contracts having a positive value; exchange-traded derivative contracts
    can be closed out with the receipt of cash, and over-the-counter
    derivative contracts can be offset with equal and opposite contracts
    thereby producing cash.
        Let me list some of the things that would be excluded: Any cost as
    such, such as preopening costs, debt issue costs, interest cost, and
    advertising cost. Costs of opening new stores or branches. Employee
    training costs. Costs of restructuring a business. Assets that arise in
    proportional consolidation, such as 33\1/3\ percent of cash or accounts
    receivable or plant held by a joint venture in which venture the
    reporting enterprise has a one-third interest would be excluded. (The
    one-third interest in the joint venture itself would, however, be an
    asset.) Receivables sold with or without recourse and thus owned and
    controlled by another enterprise would be excluded because the
    receivables were sold and are not owned by the seller and cannot be
    sold again by the seller. Assets owned by others and leased by the
    reporting enterprise would be excluded for the same reason unless the
    lease itself were transferable either directly or through a sublease
    and had a positive value. ``Prepaid advertising'' would be excluded
    unless the advertiser could get back its money at its option or could
    sell the advertising space, say, a billboard or an appearance on
    someone else's web site. Costs of R&D or only D would not be an asset.
    Nor would so-called deferred tax assets be assets. Cost of purchased
    goodwill, or any other goodwill, would be excluded. It is significant
    to note, in that regard, that the Association for Investment Management
    and Research, which represents stock analysts in the USA, has
    recommended that the cost of purchased goodwill not be recognized as an
    asset. (See, Financial Reporting in the 1990's and Beyond, Association
    for Investment Management and Research, 1993, pp. 48 and 49 and AIMR's
    letter to the FASB dated December 7, 1999, which is AIMR's response to
    the FASB's exposure draft on ``Business Combinations and Intangible
    Assets.'')
        The use of my definition of an asset would vastly simplify the
    practice of accounting. Vastly simplify financial accounting and
    reporting. I believe that it would appeal to investors, creditors, and
    other users of financial statements. I think that the results of
    applying my definition would appeal to ordinary men and women who walk
    up and down Main Street in the USA, and those who walk up and down Main
    Street in other countries as well. They would understand the result. My
    sister would understand the result. I think that ordinary people who
    are not accountants think that when they see an asset on a balance
    sheet that the asset is something real, and that the dollar amount
    associated with the asset represents value, that is, that the asset can
    be exchanged for cash for approximately the dollar amount at which the
    asset is represented in the balance sheet. That the asset can be
    pledged as collateral for a borrowing. That the asset may be given to
    the Red Cross. Accounting should not be done for the benefit of
    accountants. Accounting should result in the financial statements and
    reports that ordinary people can understand and therefore be able to
    use to make investment and credit decisions and regulatory oversight
    decisions.
        Accountants could use my definition as a working tool. They could
    use it to identify things to be reported as assets on balance sheets.
    They could use it to identify, through exclusion, things not to be
    reported as assets on balance sheets, which is not possible today. We
    would dispense with all of the long-winded, legal briefs about the
    fitness of debit balances as assets and the teams of swearing
    accountants. Assets would be real things. Exchangeable things. Defining
    assets as real things, and reporting those real things at their fair
    value, would make balance sheets rock solid and less prone to challenge
    and thereby reduce litigation against companies and their auditors.
    Would make balance sheets relevant, living documents instead of what
    they are now--dimly lit basement parking garages for collections of
    antique costs. Assessing and auditing the recoverability or impairment
    of something that is just a cost, a cost not associated with a real
    thing, is more than hard; it is impossible. One cannot look to the
    marketplace and find the value of a cost. All that the auditor can do
    is look at numbers that management puts on a sheet of paper or a
    computer monitor about how management believes that cost will be
    recovered. That is not gathering competent, evidential matter. That is
    not auditing. If an auditor is allowed to accept management's assertion
    about the value of that which is reported as an asset instead of having
    to find competent, evidential matter from sources outside the reporting
    enterprise to support that value, then audits have no purpose or worth.
    Scrap audits and save the costs of audits.
        I repeat, the definition of an asset that is in use today is too
    inclusive, overly complex, and vague. It does not work. I suggest that
    standard setters take another look at the definition and include the
    feature of exchangeability.
        The FASB's definition of a liability suffers from a similar
    infirmity as its definition of an asset. The FASB says in Concepts
    Statement 6, paragraph 35, that, ``Liabilities are probable future
    sacrifices of economic benefits arising from present obligations of a
    particular entity to transfer assets or provide services to other
    entities in the future as a result of past transactions or events.''
    Footnote 22 expands on those words in the definition as follows:
    ``Obligations in the definition is broader than legal obligations. It
    is used with its usual general meaning to refer to duties imposed
    legally or socially; to that which one is bound to do by contract,
    promise, moral responsibility, and so forth (Webster's New World
    Dictionary, p. 981). And it includes equitable and constructive
    obligations, as well as legal obligations (pars. 37-40).''
        Most people know what a legal obligation is. But most people do not
    know what an equitable or constructive obligation is, or what an
    obligation arising from moral responsibility is. Even the FASB does not
    know, for it has not articulated what those obligations are and what
    their characteristics are so that we can recognize them when we see
    them. Therefore, every time the FASB wants to require some accounting
    because of what the FASB sees as an equitable or constructive
    obligation, or what an obligation arising from a moral responsibility
    is, the FASB has to write a detailed rule for accountants to use in
    drawing up financial statements. Look, for example, at our accounting
    in the USA for workers' pension benefits. Long before any benefit is
    vested in the employee, the FASB instructs us to recognize a pension
    liability. The idea is that the workers are earning the pension benefit
    over time and a liability for an equitable or constructive obligation
    should be recognized prior to vesting of the benefits. But only the
    FASB knows what that equitable or constructive obligation is, how it is
    defined, when it should be recognized, and how it should be measured.
    The ensuing liability number, computed as per the FASB's formula,
    cannot be audited or verified except by checking the calculation, which
    is no audit at all. A perfect example of feel good accounting.
        Yet another example of feel good accounting is a recent phenomenon
    in the USA, dating from the late 1980's and early 1990's. That is the
    accounting for so-called restructurings. The FASB's Emerging Issues
    Task Force, in Consensuses 94-3 and 95-3, said that it is OK to
    recognize a liability to pay termination bonuses or stay bonuses to
    workers that will be discharged before the workers' rights to that
    bonus are vested. EITF 94-3 and 95-3 are the ultimate in feel good
    accounting. Management of the enterprise recognizes a liability if it
    says that it will make future expenditures although there is no
    requirement for those expenditures to be made; in fact those
    expenditures may be avoided at will. The rationale is that management
    creates, by its proclamation to make the expenditures, a constructive
    or equitable obligation. If management does not make a proclamation
    about future expenditures for termination bonuses or stay bonuses but
    simply lays off workers and pays the workers termination bonuses in the
    ordinary course of business, then there apparently is no constructive
    or equitable obligation in advance of the cash disbursement to the
    terminated employee. I wonder, how loud must management's proclamation
    be in order to create an accounting liability?
        The FASB's definition of a liability is as infirm as its definition
    of an asset. We cannot solve the question, at the margin, of what is
    and what is not a liability because the definition is so open-ended.
        I suggest that we define liabilities by reference to future cash
    outflows required by negotiable instruments, by contracts, by law or by
    regulation, by court-entered judgments or agreements with claimants,
    and derivative contracts having a negative value. I think that a
    liability recognizable for accounting purposes should be one of the
    following:

              1. A future cash outflow required by a negotiable instrument,
            such as a recourse promissory note, issued by the reporting
            enterprise, and accrued interest thereon. (The unpaid amount of
            a nonrecourse note secured only by a specific asset would be
            netted against the fair value of the asset for it is only the
            net amount of cash that the owner could get on sale of the
            asset. If the amount of unpaid debt exceeds the fair value of
            the asset, there is no liability to report because the future
            cash outflows related to the debt maybe avoided at will by
            walking away from an asset having a net value of zero.)
              2. A future cash outflow required by the terms of a contract
            under which the counterparty has completed his/her/its
            obligations. Examples are: (a) accounts payable to suppliers of
            goods, which goods have been delivered to and accepted by the
            reporting enterprise, (b) accounts payable to suppliers of
            services where the counterparty has performed according to the
            terms of the contract, (c) salaries and wages for work done by
            employees, (d) deposit accounts of banks and thrifts, (e) death
            benefits payable to beneficiaries under life insurance policies
            as a result of the insured's death (not an actuarially
            determined amount but the actual amount payable to the owner's
            estate or to other beneficiaries), (f ) vested pension benefits
            as to working and retired employees in excess of the fair value
            of any pension plan assets held by trustees, which assets may
            be used to pay only pension benefits, (g) amounts payable to
            counterparties under derivative contracts, (h) outstanding
            stock of the reporting enterprise, which stock must, by its
            terms, be redeemed for cash by the reporting enterprise
            (manditorily redeemable stock), and (i) future ``dividends'' on
            issued and outstanding stock that unconditionally must be paid
            in cash by the reporting enterprise, including cumulative
            dividends on so-called perpetual preferred stock.
              3. A future cash outflow required by a contract at the option
            of the counterparty. Examples are: (a) sales returns by
            customers, (b) warranties related to defective product (in
            which case the cash outflow may be for parts and labor to fix
            the product), (c) cash surrender value of life insurance
            contracts issued (not an actuarially determined amount but the
            actual amount refundable to owners of the policies at the
            owners' requests), (d) refundable portion of magazine
            subscriptions, (e) refundable portion of fire, flood, and other
            casualty insurance premiums, (f ) refundable portion of cash
            collected in advance from a counterparty prior to the reporting
            enterprise's having delivered goods or services to the
            counterparty, as to which amount the counterparty would have an
            enforceable claim if the reporting enterprise fails to deliver
            the goods or services, (g) claims payable to insureds under
            various kinds of insurance policies.
              4. A future cash out flow required by a Federal, State, or
            local law or regulation. Examples are: (a) amounts withheld
            from employees' salaries to be remitted to a governmental body
            by the reporting enterprise, (b) sales tax, value-added tax, or
            similar tax collected by the reporting enterprise from its
            customers to be remitted to a governmental body by the
            reporting enterprise, (c) tax based on taxable income or
            taxable capital of the reporting enterprise (the amount is to
            be determined by reference to the tax return filed or to be
            filed, not some greater or lesser amount to take into account
            contestable or negotiable matters), (d) decommissioning of
            nuclear plants, and (e) remediation of contaminated water or
            ground.
              5. A future cash outflow that would be required on default or
            rescission of an executory contract that is unperformed as to
            both counterparties. Examples of executory contracts are those
            for the use of property (leases) and those to acquire property
            (inventory purchases).
              6. Derivative contracts (futures, forwards, options, swaps,
            and swaptions) having a negative value over and above the
            amount of cash currently payable, which is included in 2(g)
            above.
              7. A future cash outflow required by a court-entered judgment
            or an agreement with a claimant. An example is a future cash
            outflow to an employee or an outsider as a result of a claim
            relating to a bodily injury.

        Under the above definition of a recognizable liability, a
    proclamation by management that it intends to make certain future cash
    disbursements, no matter how loud that proclamation, would not qualify
    as a recognizable liability. For example, a proclaimed intention to pay
    year-end cash bonuses to employees would not be a recognizable
    liability if management may change its mind and not pay the bonuses and
    if no law or regulation requires that the bonuses be paid. An announced
    intention to pay termination bonuses, or stay bonuses, to employees who
    eventually may be terminated pursuant to a ``restructuring'' also would
    not be a recognizable liability if no contract or law or regulation
    requires the enterprise to terminate the employees and pay the
    termination bonuses. An announced intention to spend more money than is
    required by law to remediate contaminated ground would not be a
    recognizable liability for the expenditure may be avoided at will
    without penalty.
        No ``reserve'' or ``valuation allowance'' or ``provision'' of any
    kind would be a recognizable liability or an offset to any asset
    amount. Journalists, judges, and other ordinary folk think that
    ``reserves'' or ``provisions'' are vessels containing green money. This
    is evident from reading The Wall Street Journal, The New York Times,
    legal briefs, and court opinions. We need to get rid of the terms
    ``reserves'' and ``provisions.''
        Computed amounts would not be recognizable liabilities under the
    definition, for example, deferred tax liabilities, actuarially
    determined amounts of pension benefits to be paid to working and
    retired employees, and actuarially determined amounts payable to owners
    of life insurance policies or the beneficiaries of the policies.
        As I define assets to be recognized in balance sheets, they are the
    reporting enterprise's cash, claims to cash, and other things that are
    owned by the reporting enterprise and are exchangeable for cash. As I
    define liabilities to be recognized in balance sheets, they are the
    reporting enterprise's future cash outflows. All recognized assets and
    liabilities would be reported at fair value. True North.
        ``Fair value'' of course needs to be defined. The FASB's definition
    of the fair value of an asset is as follows, from paragraph 7 of FASB
    Statement 121: ``The fair value of an asset is the amount at which the
    asset could be bought or sold in a current transaction between willing
    parties, that is, other than a forced or liquidation sale.'' (The
    definition of fair value for a financial instrument in FASB Statement
    107 is, except for a minor wording difference, the same as in FASB
    Statement 121.) That definition does not work very well. Owners of
    assets often contend that they would not be willing sellers at the
    prices offered by potential buyers. Owners also often contend that
    because of lack of liquidity, ``abnormal'' market conditions, whatever
    abnormal is, or because of other reasons, prices being offered by
    potential buyers are for ``forced'' or ``liquidation'' sales. Those
    matters are so judgmental that the FASB's definition does not work at
    the margin. I have seen it not work in enforcement cases at the SEC
    where respondents will not write down the carrying amount of assets
    because they say the prices being bid are for forced or liquidation
    sales and that the respondents would not be willing sellers at those
    prices. So the Standard does not work.
        I would define fair value of assets as follows: The estimated
    amount of cash the asset would fetch in an immediate sale whether or
    not under duress, without recourse or guarantees, less the estimated
    amount of cash that would have to be paid out to accomplish the sale.
    This suggested definition is clear and permits no judgments about the
    state of the market or the willingness of the seller to sell at prices
    being offered or bid by potential buyers.
        I would define the fair value of liabilities as follows: The least
    amount of cash that the counterparty would accept in an immediate and
    complete liquidation of his/her/its claim against the reporting
    enterprise.
        Let me list a few of the beneficial effects that adoption of my
    proposal would have.

              1. Users of financial statements and reports would understand
            the line-item descriptions and numbers in the balance sheet,
            namely, what the reporting enterprise owns and what it owes,
            with all measurements based on immediate cash prices. True
            North. There would be no balance sheet deferrals followed by
            (arbitrary) allocations of those deferred amounts to future
            periods. There would be no need for pages and pages of
            footnotes that describe the recondite procedures used to
            calculate amounts in financial statements as now is the case.
            However, there would need to be disclosures about the
            assumptions made in estimating the fair value of assets and
            liabilities so that users of the financial statements would be
            fully informed.
              2. Financial accounting and reporting under my approach (a)
            would be vastly simpler than what we have today and (b) would
            be understood by investors, creditors, underwriters, CEO's,
            line operating managers, analysts, journalists, editors,
            lawyers, judges, U.S. Senators and Representatives, and
            ordinary folk who walk up and down Main Street here in the USA
            and in other countries. Members of boards of directors and
            audit committees would understand the line-item descriptions
            and numbers in the balance sheet. Corporate governance would
            take a quantum stride forward.
              3. Fraud in audited financial statements would virtually
            cease to exist because opportunities for cooking the books no
            longer would be available. Auditors would be responsible, as
            they are today, for auditing cash and other transactions
            involving assets (as defined herein). Auditors would confirm
            with banks the amount of cash on deposit. Auditors would
            confirm with counterparties the amounts owed to the enterprise.
            Auditors would confirm payables with counterparties. Auditors
            would observe inventory counts. Auditors would go to outsiders
            to get opinions from outsiders regarding what the outsiders
            believe are the fair values of the enterprise's individual,
            exchangeable assets. Auditors would go to outsiders to get
            opinions about the fair value of the enterprise's liabilities.
            Auditors could not accept management's opinion about the fair
            value of assets or liabilities unless that opinion were
            corroborated by outsiders. In other words, auditors would get
            competent evidence supporting management's assertions in the
            balance sheet. That is what auditing should be about. For an
            exhaustive discussion of what auditing should be about, I
            commend to all Peter Wolnizer's book entitled Auditing as
            Independent Authentication published in 1987 by Sydney
            University Press.
              We in the USA have seen many frauds that were perpetrated by
            so-called improper revenue recognition. We have labored to try
            to write rules for when and in what amount revenue may be
            recognized. We have lots of rules telling us when revenue may
            be recognized and how to measure it. The latest iteration is
            the SEC's Staff Accounting Bulletin 101 issued December 3,
            1999. But looking at revenue recognition as being the problem
            is to look down the wrong end of the pipe. Every line item and
            every amount in the income statement (or in a statement of
            changes in net assets as I would have in my scheme of things)
            is fathered in the balance sheet. There is no sales transaction
            to report until the enterprise receives cash or a promise by
            the counterparty to pay cash. Auditors should look at the
            balance sheet. That is were the DNA is. Auditors should ask a
            commercial bank or a factor what amount of cash it would pay,
            without recourse or guarantees, for the receivable arising from
            the sale. If the bank or factor says 100 or 95 or 84 or 39 or
            zero, then report the receivable, and therefore the sale, at
            that amount. Then disclose the name of the bank or factor that
            gave the opinion so that users of the financial statements will
            know who gave the opinion. Under my scheme of things,
            fraudulent financial reporting because of improper revenue
            recognition would disappear.
              4. The FASB could stop writing complex accounting rules,
            which no one except accountants understand, and not very many
            accountants at that. The FASB, or some other body, would have
            to develop standardized valuation techniques for use by
            reporting enterprises and outside valuation experts when
            estimating the cash sales price of an asset if there is no
            liquid market for that kind of an asset. Guidance would be
            necessary to estimate the cash sales price of many fixed
            assets, for example, a railroad between Massachusetts and
            Florida, a petrochemical plant in Texas, a shoe factory in
            Brazil, a semiconductor manufacturing facility in Taiwan, and a
            salmon farm in Scotland.
              Nowadays, we have amounts in balance sheets for fixed assets
            that are just numbers; the numbers have no information content
            whatsoever. Depreciation lives, methods, and salvage values are
            (almost) whatever management wants them to be. Whether the
            carrying amount for those fixed assets is impaired is
            determined by reference to all of the future, undiscounted cash
            flows attributable to the assets--cash flows projected by
            management as far as the eye can see. What an irrelevant
            methodology.
              Let's assume that a company owns a fleet of commercial
            aircraft having a cost of 100. The value of aircraft declines
            to 80 because the price of fuel goes up but the owner of the
            aircraft cannot put through increases in the price of tickets
            sold to passengers. Under the current standard in the USA, so
            long as all future net cash flows related to the aircraft,
            projected as far as the eye can see, without reduction for risk
            and the time value of money, equal or exceed 100 no write-down
            is made to reduce the carrying amount of the aircraft to 80. I
            used as an example a fleet of aircraft because we can learn the
            going price of aircraft fairly easily and at little cost. The
            concept is the same for any asset as to which there are not
            readily available price quotations, such as a railroad or a
            petrochemical plant or a shoe factory or a computer chip
            manufacturing plant or a salmon farm. (I would point out that
            there are many kinds of assets as to which the fair values can
            be obtained from outside parties at a relatively small cost
            considering the information value of those fair value amounts.
            Examples are land-, air-, and ocean-going transportation
            equipment, pipelines, office buildings, apartment buildings,
            shopping malls, warehouses, mineral reserves, and maybe even
            satellites.)
              FASB Statement 15, ``Accounting by Debtors and Creditors for
            Troubled Debt Restructurings,'' was issued in 1977. Before
            being amended by FASB Statement 114, FASB Statement 15 said
            that the total of all future cash inflows related to a
            receivable were to be compared to the carrying amount of the
            receivable to measure any loss on the receivable. So long as
            the undiscounted future cash inflows, no matter how distant,
            equaled or exceeded the carrying amount of the receivable, no
            loss was to be recognized. Never mind that the fair value of
            the receivable or the underlying collateral might be far less
            than its carrying amount. Statement 15, issued in 1977,
            retarded the thinking of an entire generation of accountants
            and significantly increased the U.S. Government's losses in the
            S&L mess in the 1980's because losses kept growing, and piling
            up on balance sheets, but were not recognized as such in income
            statements under Statement 15 until the Federal Government took
            over the assets. U.S. taxpayers then took the hit in the S&L
            bailout. Although the FASB somewhat, but not completely, fixed
            the loan-loss measurement problem in FASB Statement 114,
            ``Accounting by Creditors for Impairment of a Loan,'' issued in
            1993, the FASB then repeated the same FASB Statement 15 mistake
            in 1995 when it issued Statement 121, ``Accounting for
            Impairment of Long-Lived Assets to be Disposed Of.'' Statement
            121 says to look to the total of future cash inflows from long-
            lived assets, no matter how distant, compare that undiscounted
            amount to the carrying amount, and recognize no loss unless the
            total cash inflows are less than the carrying amount, even
            though the fair value of the asset might be significantly less
            than the carrying amount. The thinking of yet another
            generation of accountants is being retarded now under Statement
            121.
              5. The debate over purchase versus pooling accounting would
            disappear. With all assets (as defined herein) and liabilities
            (as defined herein) being reported as such in the balance
            sheet, and all at fair value, every business combination would
            be reported by combining the assets and liabilities of each
            party to the business combination--all at fair value. No debate
            about who acquired whom. No debate about whether the cost of
            purchased goodwill is an asset.
              6. The debate over accounting for stock options issued to
            employees would not exist. No cash or other asset goes out of
            the enterprise and no obligation to pay cash arises when a
            stock option is granted or exercised, so there is no decrease
            in assets or net assets and therefore nothing to account for
            except for the cash received when the option is exercised. When
            the focus is on cash inflows and cash outflows and changes in
            the fair values of real assets and liabilities as it is in my
            proposal, it is clear that the issuance of stock options to
            employees, and exercise of those options, is a rearrangement of
            the ownership interest between the various owners and potential
            owners--not a decrease in corporate assets. The value of what
            one owner relinquishes to a potential new owner or a new owner
            is not imputed to the reporting enterprise. The reporting
            enterprise accounts for its assets and changes in them, not its
            owners' assets.
              7. Earnings management would disappear as an issue. In the
            USA, I have seen earnings being managed almost at will by chief
            executive officers and chief financial officers. Loading
            accrued liabilities or ``reserves'' in good times and drawing
            them down in lean times. Or drawing down reserves or estimated
            liabilities, such as for warranties, whenever it is necessary
            to ``make the numbers.'' Changing assumptions so as to time the
            recognition of write-downs of the cost of long-lived assets
            instead of when the value actually declined. Projecting net
            cash inflows, or increasing net cash inflows, as far as the eye
            can see to justify not writing down the cost of long-lived
            assets. Earnings management is a scourge in the USA. Earnings
            management is the ultimate in accounting gimmickry. By
            participating in this gimmickry, accountants not only have
            cheapened their image but also have raised serious questions
            about the substance of what they do as well.
              8. We could stop arguing with banks about the size of their
            allowances for loan losses. Whether such allowances may be
            recognized only for loans that are already bad or for loans
            that may go bad as well. The loans would be reported at their
            fair value, which comprehends all credit risk. I know that we
            will need guidance from the FASB, or some similar body, on how
            to estimate those fair values, but at least then we would be
            trying to get a relevant number that can be audited by
            reference to an outside source instead of an allowance that is
            determined judgmentally by management as it is today.
              9. We no longer would be arguing with banks and insurance
            companies about whether their bond holdings are for trading,
            held for sale (not trading), or held to maturity, with each of
            the three approaches producing a different income number. Going
            through these convoluted discussions gives accounting and
            accountants a bad name. Ordinary folk think that we accountants
            are practicing a dark art.
              10. Huge gains and losses, mostly losses, on sale or
            discontinuance of assets would disappear. Users of financial
            statements today have a hard time interpreting how these gains
            and losses should be factored into previously reported income
            from an analytical standpoint. Changes in fair value of assets
            would be recognized as changes take place, not on sale or
            discontinuance.
              11. It is now in vogue in the USA for the directors to
            discuss with the outside auditor what the auditor thinks about
            the ``quality'' of the company's accounting. (See,
            Recommendation 9 of the Report and Recommendations of the Blue
            Ribbon Committee on Improving the Effectiveness of Corporate
            Audit Committees, issued in 1999, at www.nyse.com.) (Also, See,
            the AICPA's Practice Alert 2000 -2002, dated February 2000,
            entitled ``Quality of Accounting Principles--Guidance for
            Discussions with Audit Committees.'') That dialogue would not
            be necessary under my proposal. The basis of every company's
            financial statements would be the same as every other
            company's: What the company owns and what it owes, with the
            fair values of those things being determined by reference to
            facts or opinions received from outsiders instead of being
            based on a management-determined number. True North.
              12. Students who aspire to be accountants could learn
            financial accounting and reporting in a very short time. As it
            is now in the USA, students must have 5 years of university
            study to become certified public accountants. Although I taught
            a few staff training courses when I was in public practice, I
            have no training on how to teach. However, I venture that I
            could teach students in 1 year, maybe less, how to do financial
            accounting and reporting my way. Thus, graduating students
            would not be so deeply in debt on student loans as they are
            today when they graduate.

        Estimating cash selling prices for assets for which there is no
    ready market would be the largest challenge in implementing my
    proposal. We cannot look up prices for most assets in business
    publications. We would need guidance from the FASB, or some similar
    body, on how to estimate those prices. The FASB soon will face that
    issue if and when it requires that all financial instruments be
    reported at fair value. Developing that guidance no doubt would give
    rise to debates about how to estimate those prices. What kinds of
    models to use in estimating those prices. What the inputs to the models
    should be. That debate would, however, be about something that would be
    important and relevant for making investment and credit decisions.
    Currently, the debates that the FASB has with its constituencies about
    when to report and how to measure various assets and liabilities are
    not debates but are (shouting) arguments about whether a particular
    expenditure is an asset or an expense and recondite procedures to be
    used to compute financial statement amounts, for example, pension
    liabilities and deferred taxes. The only reason that the FASB wins
    these arguments is a political one, to wit, the SEC requires that
    public companies in the USA follow the FASB's rules. Resolution of such
    debates should turn on relevance of information, logic, merit, and
    substance, not political clout.
        My accounting would be simple. It would have a simple, singular
    focus--cash. All assets and liabilities would be stated at fair value.
    We all would know where North lies on that accounting compass. The
    results of the accounting could be audited or verified or authenticated
    by auditors by reference to facts and opinions about the fair values of
    assets and liabilities--facts and opinions obtained from people outside
    the reporting enterprise. Real auditing. Investors, creditors,
    underwriters, analysts, CEO's, line managers, members of boards of
    directors and audit committees, lawyers, judges, regulators,
    journalists, editors, U.S. Senators and Representatives, and ordinary
    people who walk up and down Main Street here in the USA and other
    countries as well would understand that accounting. My sister would
    understand it.
                                    *  *  *
        Walter P. Schuetze was the Chief Accountant to the Securities and
    Exchange Commission of the United States of America and the Chief
    Accountant of the Commission's Division of Enforcement, a charter
    member of the Financial Accounting Standards Board, a member and chair
    of the Accounting Standards Executive Committee of the American
    Institute of Certified Public Accountants, and a practitioner of public
    accountancy with the firm of KPMG LLP.
                       2001 RJ CHAMBERS RESEARCH LECTURE
              Great Hall, The University of Sydney, NSW, Australia
                             by Walter P. Schuetze
                               November 27, 2001
     A Memo to National and International Accounting and Auditing Standard
              Setters and Securities Regulators (A Christmas Pony)
        Chancellor, Vice-Chancellor, distinguished guests. Thank you,
    Chancellor, for those kind introductory words, and thank you Dean
    Wolnizer for the invitation to present the RJ Chambers Research
    Lecture. It is indeed a pleasure for me to be here in Sydney delivering
    this lecture. I long have admired Professor Chambers' work. I wish I
    had met him.
        I graduated from The University of Texas in Austin in the summer of
    1957. I went to work on August 1, 1957 for an accounting firm in San
    Antonio, Texas by the name of Eaton & Huddle. Tom Holton, one of the
    partners of Eaton & Huddle, hired me. After Eaton & Huddle merged with
    Peat, Marwick, Mitchell & Co., now KPMG, Tom Holton eventually became
    Chairman of KPMG. Mr. Holton will attest that I have been talking
    about, making speeches about, and generally advocating and promoting,
    market value accounting since the late 1950's. By ``market value
    accounting,'' I mean estimated selling price for assets and estimated
    settlement price for liabilities. Without knowing it, I was sounding
    like Chambers in the 1950's, although not so eloquently.
        I had not read Chambers until I joined the Financial Accounting
    Standards Board. I was at the FASB from March 1973 through June 1976.
    While I was there, I read Chambers' book entitled Accounting,
    Evaluation and Economic Behavior and discovered that he and I shared
    the same view about accounting for assets. Unfortunately, there was no
    way to get market value accounting adopted by the FASB in its early
    days. The climate was just not right. In fact, in 1975, when the FASB
    issued Statement 12 on ``Accounting for Certain Marketable
    Securities,'' the FASB could muster only three out of seven votes for
    mark-to-market of marketable equity securities.\1\ Similarly, in 1985,
    in FASB Statement 87 on ``Employers' Accounting for Pensions,'' the
    mark-to-market for off balance sheet pension plan assets, mostly stocks
    and bonds, is smoothed out so as not to affect employers' pension plan
    expense too much in any particular year.
    ---------------------------------------------------------------------------
        \1\ FASB Statement 12, issued in 1975 and now superseded by
    Statement 115, required lower of cost or market accounting for the
    portfolio of marketable equity securities held, which is awful
    accounting. In Statement 12, I wanted to require mark-to-market for
    every security in the portfolio as did two other Board members, Messrs.
    Litke and Sprouse, who dissented to the issuance of Statement 12. But
    because we needed five votes to issue a standard and because our
    constituents were telling us that practice was so diverse that a
    standard, some standard, was necessary, I bit my tongue and signed the
    document without dissenting.
    ---------------------------------------------------------------------------
        The climate for introducing market value accounting into financial
    statements did not change until 1990, in the aftermath of the savings
    and loan crisis and the consequent U.S. Government bailout of insolvent
    savings and loan associations. On September 10, 1990, the U.S.
    Securities and Exchange Commission, in testimony by its Chairman before
    the U.S. Senate's Committee on Banking, Housing, and Urban Affairs,
    described how faulty accounting and the consequent improper measurement
    of regulatory capital contributed to lax regulatory oversight of the
    S&L's, which ultimately led to the bailout. The Commission in that
    testimony took the position that banks and thrifts should mark-to-
    market their bond portfolios. At that time, Richard Breeden was
    Chairman of the SEC. Chairman Breeden is a lawyer, not an accountant.
    But he strongly believed that thrifts and banks were presenting false
    pictures of their financial position and results of operations, and
    importantly the amounts of their regulatory capital, through the use of
    historical cost accounting for their bond portfolios and through
    selective timing of sales of bonds so as to trigger gains but not
    losses, a practice called ``gains trading.''
        When I interviewed with Chairman Breeden for the position of Chief
    Accountant in December 1991, it turned out that his and my thoughts on
    market value accounting were in sync. At least as far as bond
    portfolios were concerned. Chairman Breeden did not want to go further
    than the bond portfolio. I wanted to mark all assets to market, but in
    the early 1990's, I was glad to start with the bond portfolios of
    thrifts and banks. So in January 1992, I started as Chief Accountant to
    the SEC. As it turns out, I was the Commission's foot soldier getting
    thrifts and banks to mark-to-market their bond portfolios. Of course,
    there was no stopping with depository institutions. Insurance companies
    and other ``float'' companies also had bond portfolios, and they also
    had to mark-to-market their bonds. I was Chief Accountant from January
    1992 to April 1995. I spent a considerable portion of 1992 and 1993
    promoting the Commission's view that banks, thrifts, and insurance
    companies should mark-to-market their bond portfolios.
        In May 1993, the FASB, in Statement 115, required that all
    marketable equity securities be marked-to-market. Statement 115 went
    part of the way on bonds and requires that trading and held-for-sale
    bond portfolios be marked-to-market, but allows the held-to-maturity
    bond portfolio to be reported at cost. (Determining which bond is in
    which portfolio is a metaphysical, serendipitous determination that has
    always eluded my understanding.) Since 1993, the accounting for bonds,
    mortgages, mortgage-backed securities, derivative instruments, and
    hedging has become more incredibly complex than I can or want to
    describe, but gains trading out of the held-to-maturity portfolio still
    is possible. However, the FASB is moving forward to require mark-to-
    market on all financial assets and liabilities.
        Few people know that to the extent that we have mark-to-market
    accounting today, the credit for that belongs to the Securities and
    Exchange Commission, and primarily to Chairman Breeden. Incidentally,
    none of those Commissioners in 1990 was an accountant. (To my
    knowledge, only one accountant, Mr. James Needham, has served as a
    Commissioner since the Commission was established in 1934. Most, but
    not all, of the Commissioners have been lawyers. An exception is Arthur
    Levitt, the Immediate Past Chairman, who is not an attorney. Chairman
    Levitt, prior to his appointment to the SEC, was head of the American
    Stock Exchange.)
        When the SEC endorsed mark-to-market on bonds in 1990, the banking,
    thrift, and insurance companies community had to be dragged, kicking
    and screaming, into the world of relevant, mark-to-market accounting.
    In a sense, the FASB was also dragged along by the SEC because none of
    the FASB's constituencies was in favor of mark-to-market, and the FASB
    itself was not out in front leading the charge for mark-to-market. But
    come around it did, and now the FASB is moving forward on mark-to-
    market for all financial assets and liabilities.
        I think that it is now time for the SEC, the FASB, and the
    reconstituted International Accounting Standards Board, to extend mark-
    to-market to the rest of the balance sheet--to all assets and
    liabilities. Why do I say that? Well, to begin with, there is no
    question that mark-to-market produces relevant information that
    investors and creditors can use to make investment decisions. Not only
    is the information relevant, its quality is undisputed. The two ideas--
    relevance of information and quality--go hand in glove. There is no
    relevance to a datum called cost or cost minus amortization--it is just
    a number, a number having no information content. The ``quality'' of
    the datum called cost or cost minus amortization for assets such as
    inventory, factories, mines, oil and gas reserves, salmon farms,
    machinery and equipment, copyrights, and patents is indisputably awful;
    worse, it can be and often is misleading. We have seen many situations
    in the USA, and I am sure you have seen them in Australia as well,
    where corporations have been reporting earnings and an excess of assets
    over liabilities using our current Generally Accepted Accounting
    Principles just before going bust. We now have the case where after the
    tragic events of September 11 some U.S. airlines are teetering on the
    brink of bankruptcy and the market prices of their aircraft have fallen
    into the cellar. Yet the historical cost of those aircraft continues on
    the airlines' balance sheets because, under the FASB's rule in
    Statement 121 and now Statement 144 of looking to the undiscounted
    future cash flows from the aircraft, the carrying amount of the
    aircraft is not impaired. What an awful rule. Historical cost of assets
    and representations as assets of FASB-approved junk such as goodwill,
    deferred income taxes and tax benefits of operating loss carry-
    forwards, and capitalized direct-response advertising costs have misled
    investors for years. I will have more on quality later.
        The second reason to adopt mark-to-market for all assets and
    liabilities is to go back to basics--to go back to first principles--
    and to simplify the accounting. First, we need a definition of assets
    that we can all understand. The FASB's definition of assets in
    paragraph 25 of its Concepts Statement 6 is as follows: ``Assets are
    probable future economic benefits obtained or controlled by a
    particular entity as a result of past transactions or events.'' That is
    followed by six paragraphs of about six hundred words explaining the
    definition. There are 330,000 members of the American Institute of
    Certified Public Accountants. It is my experience that a very large
    majority of those CPA's does not understand the FASB's definition of an
    asset. I have seen litigation involving alleged fraudulent financial
    statements because of improper asset and income recognition where both
    parties to the litigation and both of their expert witnesses, in their
    briefs and at trial, quoted the very same words from the FASB's
    Concepts Statements saying that a debit balance on the balance sheet
    was, or was not, a fit and proper asset under the FASB's definition.
    The judge has not yet decided the case even though 3 years have gone
    by.
        Not only do most practicing accountants not understand the FASB's
    language about assets, ordinary folk are mystified by that babble. The
    financial statements that are produced as a result of all of the FASB's
    rules, which now is a veritable mountain of rules, are impenetrable. Go
    to the Internet and look at the financial statements and related notes
    to the financial statements of U.S. companies in their annual reports.
    There are pages and pages of jargon, understandable to a few highly
    indoctrinated accountants but not most investors and other ordinary
    folk. This is not just my opinion. The new Chairman of the SEC, Mr.
    Harvey Pitt, is quoted in the November 5, 2001 issue of Business Week,
    at page 92, as saying that quarterly and annual reports are ``. . . not
    always capable of being deciphered by sophisticated experts, much less
    ordinary investors.''
        Using the FASB's definition of an asset, a thing that most of us
    call a truck is not that which is the asset. The asset is the economic
    benefit, whatever that is, that will arise from using the truck to haul
    lumber or coal or bread. Using the FASB's definition, the truck is an
    abstraction. I think that we should define assets by reference to real
    things, not abstractions. I think that we should define assets as
    follows: Cash, claims to cash, for example, accounts and notes
    receivable, and things that can be sold for cash, for example, a truck.
    I will bet this audience understands my definition of an asset.
        The FASB's definition of a liability in paragraph 35 of Concepts
    Statement 6 is as murky as its definition of an asset, to wit:
    ``Liabilities are probable future sacrifices of economic benefits
    arising from present obligations of a particular entity to transfer
    assets or provide services to other entities in the future as a result
    of past transactions or events.'' That paragraph is followed by five
    paragraphs of more than seven hundred words that explain the
    definition. Included in those five paragraphs is a sentence that says
    liabilities include, in addition to legal obligations, ``equitable or
    constructive obligations,'' but does not define what those are. Most
    accountants do not understand, at the margin, what the FASB's
    definition of a liability means, leading to great diversity in
    practice. In practice, if the management of a corporation says that it
    has a liability under a so-called restructuring plan, a liability may
    be, but need not be, booked. In practice, year-end bonuses to employees
    are sometimes, but not always, booked as liabilities as the year
    progresses even though there is no contractual obligation to pay the
    bonuses. We are seeing in 2001 that many U.S. corporations are not
    going to pay bonuses or are going to pay reduced amounts of bonuses.
    (See The Wall Street Journal, October 2, 2001, p. B1.) (I doubt that
    there is much disclosure in financial statements about those liability
    reversals.) In corporate acquisitions, liabilities are booked if the
    acquiring corporation declares that it will pay out cash for this or
    that even though there is no contractual requirement to pay cash; no
    liability is booked if the corporation makes no declaration.
    Consequently, liability recognition, and the amount thereof, is subject
    to great management discretion and abuse.
        I think that liabilities should be defined as follows: Cash
    outflows required by negotiable instruments, by contracts, by law or
    regulation, and by court-entered judgments and agreements with
    claimants. I will bet this audience understands my definition of
    liabilities. Nothing murky about it.
        The third reason to adopt mark-to-market for all balance sheet
    items is to stop--to stop dead in its tracks--earnings management.
    Earnings management is a scourge in the USA. The disease called
    earnings management is pandemic. I am not being shrill or alarmist when
    I say that I think that it threatens the very soul of financial
    reporting. What we get under our present reporting system is earnings
    as determined by management, not as determined by transactions and
    economic events and conditions that actually happened and that exist.
    Many people, indeed many accountants, are fond of saying that financial
    statements should portray economic reality. But, in fact, except for
    the financial statements of investment companies (mutual funds) and
    broker-dealers where all assets are marked-to-market every evening at
    the close of business, today's financial statements come nowhere close
    to achieving that goal because, except for stocks, and bonds in some
    cases, noncash assets are not marked-to-market.
        In the spring of 1998, a national business magazine in the USA--
    Forbes--had the following banner on its cover: ``Pick a Number, Any
    Number.'' That was followed by articles in the national press, such as
    USA Today, about ``Abracadabra Accounting,'' ``Hocus Pocus
    Accounting,'' and the like. The gist of these articles was that the
    accounting numbers were being managed or manipulated by corporations
    and certified as being okay by their external auditors. This national
    outrage moved Chairman Levitt of the SEC into action. On September 28,
    1998, Chairman Levitt gave a speech entitled ``The Numbers Game.''
    (That speech is available at www.sec.gov.) In that speech, he gave
    examples of ways that corporations are managing their earnings--big
    bath restructuring charges, creative acquisition accounting, cookie jar
    reserves, improper revenue recognition, and abuse of materiality. (I
    would point out that under our current accounting rules there are
    dozens of ways to manage earnings. Chairman Levitt gave only a few
    examples.) Chairman Levitt made numerous suggestions for improvement.
    The upshot of that speech was (1) the SEC's staff produced Staff
    Accounting Bulletins on restructuring charges, revenue recognition,
    materiality, and banks' loan loss allowances; (2) the New York Stock
    Exchange and the Nasdaq charged a blue-ribbon panel chaired by two
    prominent business leaders, Mr. Ira Millstein and Mr. John Whitehead,
    with making recommendations about corporate audit committees; and (3)
    the Public Oversight Board of the American Institute of CPA's charged
    the Panel on Audit Effectiveness chaired by Mr. Shaun O'Malley,
    formerly the CEO of PricewaterhouseCoopers, with making recommendations
    about improving the effectiveness of external audits.
        The Millstein and Whitehead Blue Ribbon Committee issued its report
    on February 8, 1999. (The report is available at www.nyse.com.) Among
    the Committee's recommendations are that: (1) there be a discussion
    between the audit committee and the external auditor about the quality
    of the company's accounting; and (2) that the audit committee represent
    in the company's annual report that, based on discussion with
    management and the external auditor, the company's financial statements
    are fairly presented in conformity with Generally Accepted Accounting
    Principles. The second recommendation attracted massive, negative
    comment from the corporate and legal communities. Commentators stated
    that audit committee members are not accountants and do not have the
    expertise to determine whether the company's financial statements
    conform to Generally Accepted Accounting Principles. When the SEC
    adopted its revised rules on audit committees on December 22, 1999 (See
    SEC Release No. 34.42266 at www.sec.gov.), the SEC did not adopt that
    recommendation. Instead, the SEC merely required that the audit
    committee state, in the annual report, that, after discussion with the
    external auditor, the audit committee ``. . . recommended to the Board
    of Directors that the audited financial statements be included in the
    Annual Report . . .,'' thereby implicitly acknowledging that members of
    audit committees do not know whether the financial statements comply
    with Generally Accepted Accounting Principles.
        The recommendation that the audit committee discuss with the
    external auditor the quality of the company's accounting has been acted
    on by the auditing profession in the USA. In December 1999, the AICPA's
    Auditing Standards Board issued Statement on Auditing Standards No. 90,
    ``Audit Committee Communications,'' which requires, as to public
    companies, that the auditor ``. . . discuss with the audit committee
    the auditor's judgments about the quality, not just the acceptability,
    of the company's accounting principles as applied in its financial
    reporting.'' I would like to be a fly on the wall when such discussions
    take place in the corporate boardroom. I can just imagine the auditor
    saying to his/her client, ``My firm has audited your financial
    statements. My firm is prepared to report without qualification that
    your financial statements have been prepared in conformity with
    Generally Accepted Accounting Principles, but my grade on the quality
    of your financial statements is C-.'' In my opinion, this requirement
    by the Auditing Standards Board is worse than a joke. It is farcical.
    The large auditing firms have hundreds, some thousands, of partners in
    the USA and still more worldwide. There are no objective standards by
    which the individual partner in San Francisco, Sydney, Seoul,
    Singapore, or Southhampton can make a judgment about the quality of a
    client's accounting. Following the Auditing Standards Board's rule,
    opinions about the quality of clients' accounting would be based on the
    idiosyncratic judgments of hundreds or thousands of individual
    partners. The practical upshot will be that every client's grade on
    quality will be an A. There are two reasons for that. First, given the
    highly competitive nature of the public accounting business, few if any
    audit partners are going to jeopardize a client relationship by telling
    the client that its accounting is not of high quality. The second
    reason is that the accounting rules under which financial statements
    are prepared allow the management to use its judgment in preparing
    those financial statements, and the auditor has no basis on which to
    make a different judgment except personal preference.\2\
    ---------------------------------------------------------------------------
        \2\ For an excellent discussion and analysis of why the presence of
    audit committees cannot and will not improve the quality and
    reliability of today's financial statements, see ``Are Audit Committees
    Red Herrings?'' by P. W. Wolnizer, Abacus, Vol. 31, No. 1, March 1995,
    pp. 45-66.
    ---------------------------------------------------------------------------
        The O'Malley Panel issued its 255 page report on August 31, 2000.
    (That report may be viewed at www.pobauditpanel.org.) The Panel's major
    recommendations are as follows:

              Auditors should perform some ``forensic-type'' procedures on
            every audit to enhance the prospects of detecting material
            financial statement fraud.
              The Auditing Standards Board should make auditing and quality
            control standards more specific and definitive . . .
              Audit firms should put more emphasis on the performance of
            high quality audits in communications from top management,
            performance evaluations, training, and compensation and
            promotion decisions.
              The Public Oversight Board (POB) of the AICPA, the AICPA, the
            SEC Practice Section (SECPS) of the AICPA, and the SEC should
            agree on a unified system of governance for the [auditing]
            profession under a strengthened Public Oversight Board that
            would oversee standard setting (for auditing, independence, and
            quality control), monitoring, discipline, and special reviews.
              The SECPS should strengthen the peer review process,
            including requiring annual reviews for the largest firms, and
            the POB should increase its oversight of those reviews.
              The SECPS should strengthen its disciplinary process.
              The audit committees should pre-approve nonaudit services
            that exceed a threshold amount . . .
              The International Federation of Accountants should establish
            an international self-regulatory system for the international
            auditing profession.

        As I understand it, the Auditing Standards Board and other AICPA
    entities are working on the Panel's recommendations. And I have no
    doubt that the SEC's staff is watching over their shoulders to make
    sure that all of the details are implemented to the SEC's staff 's
    satisfaction. Maybe the number of financial statement frauds that the
    SEC periodically has to investigate and address through enforcement
    actions will be reduced if more ``forensic-type'' audit work is done by
    external auditors as recommended by the Panel. But the earnings
    management game won't stop even if every one of the Panel's
    recommendations is implemented immediately. And the dismaying, surprise
    corporate collapses--such as HIH Insurance here in Australia--that
    happens about once a month won't stop even if every one of the Panel's
    recommendations is implemented immediately.
        There have been similar panels, committees, and even Royal
    Commissions in the past, all with more or less similar recommendations.
    We now have O'Malley. We had the Kirk Panel in the 1990's. We had
    Treadway about 15 years ago. We had the Cohen Commission in the late
    1970's. We had Metcalf. Canada had MacDonald. Great Britain had
    Cadbury. Australia has had similar committees, I am sure. In the
    1970's, we in the USA introduced peer reviews of audit firms.
    Concurring audit partner reviews also now are a requirement in the USA.
    We have the AICPA's Quality Control Inquiry Committee looking into
    external auditor performance when financial statements are restated. We
    have the AICPA's Public Oversight Board, breathing hard, looking over
    everyone's shoulder. All for naught. What we have is layers on top of
    layers on top of layers of regulation. After O'Malley, we no doubt will
    have another layer of regulation.
        We had the AICPA's Committee on Accounting Procedure writing the
    accounting rules from 1939 to 1959. That did not work and that
    committee was replaced by the AICPA's Accounting Principles Board,
    which wrote the accounting rules until 1973. In 1973, the Accounting
    Principles Board was replaced, with great hope and fanfare, by the
    Financial Accounting Standards Board.\3\ Things were supposed to get
    better. But nothing has changed. Earnings management continues to
    flower.
    ---------------------------------------------------------------------------
        \3\ I know. I was a Charter Member of the FASB. My wife and I were
    present at the FASB's inauguration dinner in the spring of 1973. Mr.
    Reginald Jones, the Chairman of General Electric, delivered the
    inaugural address. He held out great hope for the FASB.
    ---------------------------------------------------------------------------
        Corporations today continue to manipulate their earnings without
    objection from their external auditors. SEC Commissioner Hunt in a
    speech on October 26, 2001 discussed earnings management. (See
    www.sec.gov.) Business Week, in the July 23, 2001 issue on page 71
    reports, ``In today's financial climate, auditor's reports have about
    as much credibility as buy recommendations from Wall Street analysts.''
    The June 2001 issue of the Harvard Business Review has a 12 page
    article entitled ``The Earnings Game: Everyone Plays, Nobody Wins.'' On
    Friday night, October 19, 2001, on a TV program called ``Wall Street
    Week,'' I heard and saw a prominent Wall Street investment manager say
    something along the following lines: ``Corporations are writing off
    assets right and left in the quarter ended September 30, 2001.
    Comparative earnings statements in 2002 will be wonderful.'' His
    implication was that the write downs are arbitrary. The Levy Institute
    Forecasting Center, in a Special Research Report dated September 2001,
    describes in 23 pages of detail ``Two Decades of Overstated Corporate
    Earnings,'' which its Chairman, Mr. David Levy, previewed on TV on CNBC
    on October 24, 2001. Business Week, in the October 15, 2001 issue on
    pages 46 and 47, says: ``Brace yourself for what may be the ugliest
    quarter ever for corporate earnings. For years, companies used every
    trick in the book to make their results look better than they really
    were. Now many will be taking the opposite tack: Loading costs and
    charges onto their income statements in an all-out effort to make an
    already horrid year look even worse. To make next year's results look
    stronger companies may load losses into 2001 by: Slashing values of
    physical assets, which will cut depreciation charges in the future;
    overestimating likely bad debts, thus boosting future profits when
    customers pay up; and by charging impending restructuring costs
    immediately, so as to benefit if they are less than expected.''
        It is not just in Business Week and the Harvard Business Review. I
    see it in Forbes. I see it in Barron's. I read the earnings reports of
    corporations on their websites and in The Wall Street Journal, and I
    see the earnings management. It is going on in bright daylight, and not
    behind closed doors. Everyone on Wall Street knows it is going on. The
    Stock Exchanges know it is going on. The SEC knows it is going on.
    Every sell-side security analyst knows it is going on. Every
    institutional investor knows it is going on. But the individual
    investor who is not part of the Wall Street in-the-know crowd doesn't
    know it is going on. John and Jane Q. Public do not know it is going
    on. Maybe Members of Congress do not know it is going on. The external
    auditors cannot stop it. Even if the external auditors were U.S.
    Federal Government auditors, whose independence would be unquestionably
    pure, they could not stop it because the accounting rules allow for
    earnings management. External auditors have no ground on which to stand
    to stop it because of the way the accounting rules are constructed. The
    Stock Exchanges cannot stop it. Because the accounting rules allow for
    earnings management, the SEC cannot stop it through its Division of
    Corporation Finance, which reviews and clears registration statements
    and other filings by issuers of securities. The SEC's Office of Chief
    Accountant and Division of Enforcement cannot stop it because the
    accounting rules allow it. I could not stop it when I was Chief
    Accountant at the SEC.
        I have been in this business since August 1, 1957. I think that I
    have seen every side and dimension of this problem. In my opinion, the
    only way that earnings management will be stopped is as follows: The
    SEC, or the SEC and FASB, or the SEC and FASB and IASB, must change the
    accounting rules. The SEC must make deep and fundamental changes to the
    system. Unless and until the SEC requires that assets be reported at
    estimated selling prices, which of course means that only things that
    have a market price could be represented as assets, nothing will
    change. Unless and until the SEC requires that liabilities be reported
    at estimated settlement prices, nothing will change. Unless and until
    the SEC requires that reported asset and liability amounts be based on
    estimated selling and settlement prices and that external auditors get
    evidence about those selling and settlement prices from persons or
    entities outside the reporting enterprise, nothing will change.
        So long as management controls the numbers, nothing will change.
    For example, so long as management decides on the amount of inventory
    obsolescence, the amount of bad debts, or the amount of the warranty
    liability, nothing will change. So long as management decides on the
    assumed rate of return on pension plan assets, nothing will change. So
    long as management decides on the estimated useful lives and salvage
    values of capital assets without regard to the selling prices of those
    assets as determined by the marketplace, nothing will change. So long
    as management decides on what will be future, undiscounted cash flows
    from capital assets, and can change those numbers at will in
    determining whether the carrying amounts of capital assets are
    impaired, nothing will change. So long as management is allowed to
    recognize liabilities for restructuring the business whenever
    management wants to, and in an amount determined solely by management,
    nothing will change.
        The reported numbers for assets and liabilities must be such that
    they can be verified by external auditors (and by regulators and
    courts) by reference to sources outside the enterprise. By reference to
    competent evidence.\4\ The SEC must make deep and fundamental change to
    the system. Only by requiring that assets and liabilities have a
    reference point in the marketplace and that the amounts representing
    those assets and liabilities be verifiable by reference to sources,
    competent sources,\5\ outside the enterprise, will we be able to
    produce financial statements that include reliable numbers. As a
    practical matter, neither the FASB nor the IASB can accomplish such
    deep and fundamental change on its own. Or even together. Only the SEC
    can accomplish such change. And only if such change is made will the
    financial statements be of high quality.
    ---------------------------------------------------------------------------
        \4\ This style of auditing--obtaining competent evidence--is
    exactly what P. W. Wolnizer describes and recommends in his book
    Auditing as Independent Authentication, Sydney University Press, 1987.
        \5\ The SEC should require (a) disclosure, either by the reporting
    enterprise or the external auditor, of the names of the persons or
    entities that furnished the selling and settlement prices and (b) the
    consent of those persons or entities to the use and disclosure of their
    names.
    ---------------------------------------------------------------------------
        This idea that financial statements be of high quality, or that
    accounting standards be of high quality, has attracted a lot of
    attention recently. The term, ``high quality,'' is on everyone's lips.
    It is high sounding. The IASB's website says that the IASB, ``. . . is
    committed to developing, in the public interest, a single set of high
    quality, understandable and enforceable accounting standards that
    require transparent and comparable information in general purpose
    financial statements.'' The U.S. House of Representatives' Subcommittee
    on Capital Markets, Insurance and Government Sponsored Enterprises, on
    June 7, 2001, held a hearing on ``Promotion of International Capital
    Flows through Accounting Standards.'' Representatives Baker, Oxley,
    LaFalce, Kanjorski, and Mascara made ``Opening Statements.'' Mr. Paul
    Volcker, Chairman of the Trustees of the IASB, Mr. Philip Ameen, VP &
    Comptroller of General Electric, representing Financial Executives
    International, and Mr. Robert Elliott, a KPMG partner representing the
    AICPA, testified before the Subcommittee about international accounting
    standards. By my count, the U.S. Representatives, Mr. Volcker, Mr.
    Ameen, and Mr. Elliott, in their prepared remarks, used the term ``high
    quality'' no fewer than twenty-three times. Sometimes high quality
    standards, sometimes high quality financial statements, and sometimes
    high quality information. Mr. Lynn Turner, the SEC's Chief Accountant
    from mid-1998 to mid-2001, used the term frequently in his speeches
    when describing financial statements prepared under FASB standards and
    when he described what he hopes will result under IASB standards. But I
    cannot tell what it is that these people are describing. These people
    obviously are not describing what Chairman Levitt described in his
    September 1998 speech, what Commissioner Hunt described in his speech
    on October 26, 2001, and what Chairman Pitt meant when he said
    quarterly and annual reports are indecipherable by ordinary investors.
    These people obviously are not describing what I see in the Harvard
    Business Review, Business Week, Forbes, and Barron's about earnings
    management. To me, these people sound like my 7-year-old granddaughter
    who is wishing that Santa Claus will bring her a pony on Christmas
    morning.
        What is it that we want for investors when we say ``high quality
    financial statements'' or ``high quality information?'' I will tell you
    what I want. I want financial statement amounts (numbers) that are
    relevant and reliable. Historical costs of assets and historical
    proceeds of liabilities are not relevant to an investor for purpose of
    making an investment decision--or to any business person wanting to
    make a decision about an asset or a liability. Only current selling
    prices for assets and current settlement prices for liabilities are
    relevant. The only reliable measures of those prices are those that
    come from the marketplace, from persons or entities unrelated to the
    reporting enterprise. Selling prices of assets and settlement prices of
    liabilities can be verified by external auditors by reference to
    marketplace sources. If the SEC requires that assets and liabilities be
    measured, and be verified by external auditors, by reference to selling
    and settlement prices that exist in the marketplace, and requires
    disclosure of the names of persons or entities that furnished those
    prices, the resulting financial statements will be of high quality. And
    that standard, unlike what we have today, will be enforceable by
    external auditors, regulators, and ultimately the courts.
        There is a new Chairman, Mr. Harvey Pitt, and a new Chief
    Accountant, Mr. Robert Herdman, at the SEC. Mr. Pitt made a speech on
    October 22, 2001 (see www.sec.gov) before the governing council of the
    AICPA, wherein he spoke of ``. . . simplifying financial disclosures to
    make accounting statements useful to, and utilizable by, ordinary
    investors'' and that ``we [SEC] may need to reconsider whether our
    accounting principles provide a realistic picture of corporate
    performance.'' The SEC's press release on September 19, 2001 (see
    www.sec.gov) announcing Mr. Herdman's appointment as Chief Accountant
    says, ``Mr. Herdman will lead us [SEC] in revising and modernizing our
    accounting and financial disclosure system.'' Those words are
    promising. Maybe Mr. Pitt and Mr. Herdman will surprise investors with
    the equivalent of a pony on Christmas morning--that is, high quality
    financial statements.

                                   ----------

        Postscript on December 9, 2001: After I presented this lecture, I
    received in the mail a brochure advertising a two-day course entitled
    ``How to Manage Earnings in Conformance with GAAP.'' ``This Intensive
    Two-day, Skill-based Workshop Features over 50 Illustrations,
    Applications and Case Studies to Make GAAP Work for Your Company or
    Client.'' ``Earn 16 Hours of A&A CPE Credit and CLE Credit.'' This
    course is sponsored by the National Center for Continuing Education,
    967 Briarcliff Drive, Tallahassee, Florida 32308, and costs $995. I
    rest my case about earnings management being a disease.
                                    *  *  *
        Walter P. Schuetze, now retired, was Chief Accountant to the
    Securities and Exchange Commission and Chief Accountant of the
    Commission's Division of Enforcement, a charter member of the Financial
    Accounting Standards Board, a member and chair of the Accounting
    Standards Executive Committee of the American Institute of Certified
    Public Accountants, and a practitioner of public accountancy with the
    firm of KPMG LLP.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                          WEDNESDAY, FEBRUARY 27, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:30 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        We were delayed because there was a vote, which has now
    been taken care of and, hopefully, we will have a stretch of
    time here.
        This morning, the Senate Committee on Banking, Housing, and
    Urban Affairs holds its fourth hearing on accounting and
    investor protection issues raised by the collapse of Enron and
    other public companies. Today, the Committee will consider
    numerous corporate governance issues raised by recent corporate
    difficulties.
        Issues raised by corporate governance that have received
    widespread attention include the independence of directors, the
    independence of audit committees, selection of public firms'
    external auditors, corporate loans to executives, restrictions
    on option sales, conflict of interest policies, and other
    matters.
        A recent article in the Financial Times stated that:
    ``Effective corporate governance is the only way that investors
    can protect themselves against executives who make mistakes and
    seek to cover them up. . . . It gives meaning to the
    shareholders' ownership of the company.'' In studying these
    issues, we need to keep in mind that any change to corporate
    governance practices should be made with an eye toward
    protecting the investing public.
        At our first hearing, we heard from five former Chairmen of
    the SEC, who made a number of recommendations on the corporate
    governance issue, and I am going to include that in the record
    and I may refer to some of them in the question period.
        The Chairman of the SEC, the current Chairman, Harvey Pitt,
    has asked both the New York Stock Exchange and the NASD ``to
    review their listing agreements, to see whether new obligations
    for corporate officers and directors can be articulated.''
        The Bush Administration is exploring ways to make it easier
    for the Government, it so reported, to punish corporate
    officers and directors accused of misleading shareholders.
        On February 13, the SEC announced a number of initiatives
    on corporate disclosures, including requiring more prompt
    reporting by companies of transactions by company insiders and
    the company securities, and improving public disclosure of
    trading activities by executive officers, directors, and
    beneficial owners of 10 percent of a company's stock.
        There have also been suggestions brought to our attention
    to require stock exchanges to toughen board and committee
    independence standards, to require a substantial majority of
    independent directors, to require stock exchanges to toughen
    their definitions of who qualifies as an independent director,
    and a mandate that the SEC require additional proxy disclosures
    regarding the role of the audit committee in approving both
    audit engagement and nonaudit consulting agreements with the
    audit firm.
        We are very pleased today to have two knowledgeable, able,
    and committed witnesses. Both are former members of the New
    York Stock Exchange and NASD's 1998 -1999 Blue Ribbon Committee
    on Improving the Effectiveness of Corporate Audit Committees.
    The Blue Ribbon Committee published a series of recommendations
    and guiding principles for best practices by audit committees.
        Our first witness is John Biggs, who is Chairman,
    President, and CEO of TIAA-CREF. He serves as an at-large
    trustee of the Financial Accounting Foundation, a trustee of
    the International Accounting Standards Committee, a member of
    the Public Oversight Board, and was a member of the Blue Ribbon
    Committee.
        And our other witness today is Ira Millstein, a Senior
    Partner of the law firm of Weil, Gotshal & Manges. In addition
    to his legal practice, Mr. Millstein is Chairman of the Board
    of Advisors of the International Institute for Corporate
    Governance at the Yale School of Management. He is a former
    Chairman of the OECD Business Sector Advisory Group on
    Corporate Governance, and was Co-Chair of the Blue Ribbon
    Committee to which I made reference.
        The other Co-Chair of the Blue Ribbon Committee, John
    Whitehead, former Deputy Secretary of State, was unable to join
    this panel because of a scheduling problem, but he will be with
    us on March 19. We will have the benefit of his testimony at
    that time.
        We very much are looking forward to hearing our two
    witnesses today and I want to express my appreciation and the
    appreciation of the Committee for their willingness to give
    considerably of their time, effort, and energy in order to be
    of assistance.
        Before I turn to the witnesses, I will turn to my
    colleagues.
        Senator Gramm.

                    STATEMENT OF SENATOR PHIL GRAMM

        Senator Gramm. Well, Mr. Chairman, let me thank you very
    much for the hearings that you are holding. I thought our
    hearing yesterday was outstanding and it really went a long way
    to focus on the whole debate about accounting standards and
    independence of standard setting boards.
        I am very pleased to have an opportunity to be here today.
    I would like to say to Mr. Biggs that three members of my
    family are investors in TIAA-CREF. As an old college professor,
    I invested in TIAA-CREF. My wife invested in TIAA-CREF. And I
    now force my number-one son, who is a new economist and college
    professor, to put 15 percent of his gross into TIAA-CREF.
        [Laughter.]
        I told him, if he will do that religiously, that he will
    some day be well off. And I want to thank you for the good job
    you do in turning school teachers into capitalists.
        Mr. Biggs. Thank you.
        [Laughter.]
        Senator Gramm. The American system lived out the only
    meaningful part of Karl Marx's dream, and that is that workers
    could own the means of production.
        This is a very important subject. I would have to say that,
    as I look at where we are and the whole question of corporate
    governance, I think someone today who had something to
    contribute in corporate governance would think a long time
    before going on a corporate board.
        There appear to be people who think that someone meeting
    four or six times a year is capable of auditing the books of a
    giant corporation.
        My own feeling is that we have to have a good balance here
    in improving system, but yet, not producing a system where no
    one who has any real ability will choose to serve on a
    corporate board.
        Since a year from now, I am going to be gainfully employed
    somewhere, this is something that I have thought through myself
    in terms of what are the benefits relative to the potential
    costs in being involved in corporate governance? And I think,
    as we go through the process, this is something we have to keep
    in mind. No matter what the rules are, if you do not have good
    people, you are not going to have an effective system.
        So, Mr. Chairman, this is very important business we are
    about here. I am glad that the jurisdiction of these areas is
    the jurisdiction of this Committee. I think the public and our
    great system of capital accumulation will benefit from that
    fact.
        Chairman Sarbanes. Thank you very much. In the cause of
    full disclosure, since my wife was a teacher, I should say that
    she has also invested in TIAA-CREF and persuaded me to do the
    same.
        Senator Miller.

                    COMMENTS OF SENATOR ZELL MILLER

        Senator Miller. This is important business, Mr. Chairman,
    and I thank you for holding these hearings and I thank these
    outstanding witnesses for being with us.
        I have no opening statement.
        Chairman Sarbanes. Thank you very much.
        Mr. Biggs, why don't we start with you? We will be happy to
    hear from you. Then we will turn to Mr. Millstein.

                       STATEMENT OF JOHN H. BIGGS

                      CHAIRMAN, PRESIDENT, AND CEO

               TEACHERS INSURANCE AND ANNUITY ASSOCIATION

             COLLEGE RETIREMENT EQUITIES FUND (TIAA- CREF)

        Mr. Biggs. Thank you, Mr. Chairman. I am honored that you
    have asked me to do this. I am also very uneasy about the
    obligations that my company has to the two of you.
        [Laughter.]
        In response to Senator Gramm, what has been extraordinary
    is the wealth that has been created by people putting in 15
    percent a year. At last count, we had 35,000 of our
    participants who are millionaires, and they are beginning to
    call in and ask us questions about something that they said
    that they did not think they would ever be subject to the
    estate tax. But all of a sudden, they do have estate tax
    problems and we had to create a trust company to serve their
    needs. It has been a wonderful experience.
        As you said, Senator, I have had a fair amount of
    experience with the oversight groups, the NASD, and most
    recently, the POB.
        The Enron collapse is still a mystery. We do not understand
    it fully. It is an extraordinary event and the number of
    questions that it raises is enormous.
        I am happy to report, again, in my TIAA-CREF role, that our
    analyst on Enron came to the conclusion last year in the spring
    and summer that he simply could not understand the company from
    what was reported. And he said, if we cannot understand it, we
    should not buy any of the stock. Unfortunately, we did have
    some of the stock because we have Index Funds and Enron had
    become one of the largest companies in the S&P 500, and so, we
    held stock there. But the fact that so many people thought they
    could understand that company through reading their financial
    statements and recommended it, raises real questions for all of
    us about the quality of the analysis, the ability of analysts
    to read accounting statements.
        I have three topics that I would like to focus on. First,
    the issue of the environment that may have created this. A lot
    of people said, well, there are all these issues as far as the
    accounting regulation and the oversight of the accountants. But
    what were the environmental factors?
        It seems to me one that was very powerful was the
    widespread overuse, in my view, of stock options. Sixty percent
    of Enron's employees had them. The focus on daily stock prices
    has become almost an epidemic, I think, in American business.
    And at least, I think we ought to expense those options because
    there are better ways to use stock in employee incentive plans.
        The second issue is some basic common sense regarding
    auditor independence. We have had some specific experience in
    my company which I would like to tell you about. But also, I
    thought a lot about how Congress might address this and I do
    have a suggestion, a recommendation to make to you.
        Finally, what I believe was a major topic yesterday--the
    need for a strong regulatory model for overseeing the
    accounting profession. And I know that you will be talking with
    Chuck Bowsher soon about the POB, but I can give you a
    businessman's perspective on that experience.
        First off, the stock options. I do not want to spend too
    much time on this. It is an issue that those of us in the
    investment world have been fairly heated about. The investment
    community sees it one way and the business community, the
    preparers of statements, see it differently. And there has been
    a long stand-off between us.
        The 1972 rules on stock options make them seem to be free.
    But that is limited to a very narrow kind of stock compensation
    award, the fixed-price stock option. There are many other award
    systems--those that involve incentives, hurdles, requirements--
    in which you cannot get the free treatment under the 1972
    rules, the rules in APB-25.
        Enron used options very extensively. Sixty percent of their
    employees had options. Obviously, their executives had a lot of
    them. There was enormous interest in the stock price.
        One of the more gross stories that came out was when the
    stock passed $50, there was a $100 bill put on every employee's
    desk. And it seems to me, if you want to really focus everybody
    on the daily value of the stock price, that is a good way to do
    it. But is that really a healthy corporate environment?
        Ironically, of course, there were years when there were no
    taxes paid by Enron because of the strange practice we have in
    this country that you can deduct the cost of the stock option
    when an employee exercises it, but you do not have to show it
    in the earnings statement to the shareholders.
        There was extraordinary lobbying, which I think is well
    known, and the very existence of the private sector standard
    setting was threatened, and the FASB and the SEC both
    capitulated finally in 1994 and didn't adopt a requirement that
    we believe was a reasonable one, with reasonable provisions. It
    should have been adopted.
        Arthur Levitt said publicly that he thought it was the
    greatest mistake made by the SEC during his tenure that they
    did not continue to fight for that.
        The FASB ruling gives a choice--you can either disclose it
    in a footnote or you can put it in the earnings statement.
        I am very proud of the fact that I am on the board of the
    one major company in the United States that has decided to use
    FAS 123, the option of expensing it, and that is the Boeing
    Corporation.
        I chair the Boeing Compensation Committee and we have a
    very strong stock award plan that I think is an optimal plan in
    many ways. It is a plan that we at TIAA-CREF have urged on
    companies regularly as an investor. Namely, it requires hurdles
    to be met before a stock option or a stock award becomes
    valuable.
        In the case of Boeing, very simply, we make a generous,
    restricted stock award to executives each year, and if the
    company does not have at least a 10 percent growth in value,
    compounded value over 5 years, the entire value is forfeited.
    If they have a 10 percent value, they get 25 percent of the
    award, and if they get up to a 15 percent annual growth rate,
    they can get as much as 125 percent of the award.
        Clearly, you do not pay huge amounts to executives when
    they have not had excellent performance. The current fixed-
    price stock option frequently ends up doing that. The kind of
    plan that Boeing wanted to develop is not often used since it
    would not qualify as a free option under the accounting rules.
        And I can tell you that, meeting after meeting, we have
    talked to companies and asked them to adopt some hurdle rates,
    some performance standard before they received huge pay-offs,
    and they all refuse to do it because of the accounting issues.
        Again, the accounting model is a 1972 model. And I think it
    is interesting that the date was 1972. It was in 1973 that the
    two Nobel winners formulated the Black-Scholes model.
        I can assure you that every high-tech executive in Silicon
    Valley has that model on his Palm Pilot and knows how to
    calculate the value of his own options. On the other hand, he
    would be very unwilling to see the Black-Scholes used to value
    his company's stock plan and put that cost into his expenses.
        Some of the side effects of this that I think are
    undesirable is that we have had explosive growth in the use of
    the fixed-priced stock option. It has distorted earnings
    statements. I think that there has been a dramatic decline in
    dividends paid by companies over the last decade, primarily
    because of this pervasive use of stock options.
        A dollar per share paid as a dividend when the stock goes
    ex-dividend, drops the stock price by a dollar. And if your
    compensation is largely determined by a stock option, which
    only depends on the price of the stock, you are not going to be
    in favor of paying out that kind of cash to the shareholders.
        In some companies, stock options have completely replaced
    pension plans. It was interesting when we challenged IBM on the
    way they were abandoning their defined benefit plan, the answer
    of the company was most of our competitors in the high-tech
    industry have no pension plan whatsoever. They rely entirely on
    fixed-price stock options, and so, why should IBM continue a
    very expensive form of the defined benefit form?
        I am not quite sure how Congress should deal with this
    issue. I think we at TIAA-CREF have always urged that we keep
    that standard setting, those technical issues, in the private
    sector with the FASB or with the International Accounting
    Standards Committee. Some expression of support from Congress
    might encourage the FASB to take up the issue.
        The Levin bill has an obvious plausibility. If an employee
    exercises an option and earns a million bucks off of it, and
    the company is allowed to deduct that from their taxable
    income, isn't it plausible that they would also deduct it from
    their earnings? And that bill seems to be based on that, and I
    find that as a pretty heavy way to go about getting this done.
    One would wish that we could do it through the accounting
    standards process.
        Let me turn to auditor independence.
        We have two practices at TIAA-CREF that we have been very
    pleased with and I would be happy to answer your questions
    about them. We are not sure when it started, but we think it
    was back in the 1950's, that we had a policy of rotating our
    auditor every 5 years. We have liberalized that to 7 years. I
    think 7 years is a reasonable number.
        During my Chairmanship, we have had two rotations and I
    would be glad to comment on what that experience has been like.
    It is not nearly as bad as many would make it out to be.
        The other policy was a simple, bright-line test that when
    we hire an auditor, the auditor does only auditing and nothing
    else. We do not use them for any other services. And it is
    extraordinary the number of services that an accounting firm
    can offer to you, from finding new housing for your employees
    when they move to another city, to doing stuff that might
    plausibly be connected with the audit. But it is a broad array.
        We just said that we are not going to have our auditor do
    any of those activities, including tax-planning work for the
    company. I know the accountants contest this view.
        Taxes are incredibly complex in companies. In ours
    particularly, where we are a combination of a life insurance
    company and a mutual fund complex and a trust company and so
    forth. The tax issues are complex. We want to use a separate
    consulting firm. It happens to be an accounting firm. We use
    them to do the tax work, and I value very highly having their
    name on the line that they believe our decisions are
    appropriate, not too aggressive, sensible tax provision for us
    to take because there are judgments involved and an
    understanding of the background.
        Then I have our auditors come in and do an independent
    second review of their competitor's work and tell me that it is
    okay, that they are comfortable with it.
        Frankly, I have a chance, and our chief financial officer,
    to probe at both of them on those important issues. But it has
    been a simple, clean system that has served us well. I
    testified before you in the fall of 2000 on this, on our
    experience.
        The companies and the auditors will be very much opposed to
    rotation. But I can vouch from our experience that it has not
    been a costly or difficult process to go through this.
        The SEC, in any event, requires rotation of the partners on
    a periodic basis, and when the partners rotate, it is certainly
    a good time to rotate the whole firm and bring in a new group.
        What we have found, very briefly, is it is an enormously
    energizing effect for us to have our financial people--and I
    get involved myself--in interviewing the people proposing to do
    the audit, in that they bring in their stars. We can get one of
    the best teams that have done the work at the Prudential or the
    Metropolitan Life or one of the other major financial
    institutions. It could be Fidelity or whoever. And they can
    bring in folks who have a new point of view, have a new
    understanding.
        I value very highly the services of an audit firm. They are
    the brightest group of people that can come in and really know
    all about your company and can answer the questions of the
    senior management in a way that nobody else can.
        I do not rely on the State examiners in the same way. They
    do not have the background. They do not have the talent of the
    auditors. You want the very best and brightest on your account.
    And if you rotate, you will get them because the firms coming
    in will compete with the quality of their people.
        I think rotation every 5 to 7 years is good corporate
    policy. We recommend it always to our portfolio companies that
    we invest in, but not many of them have adopted it.
        I was amused to see Kodak celebrating the 100th anniversary
    of their relationship with their auditor. And I thought, is 100
    years with the same auditor really a good thing? Is that
    anything you want to brag about? Maybe sometime in the 100
    years you might have gotten some new ideas with a different
    firm.
        Senator Gramm. If you are in business for 100 years, you
    want to brag about it.
        Mr. Biggs. That is true.
        [Laughter.]
        I would agree with that, Senator Gramm.
        I think about the Enron case and Arthur Andersen. Had
    Arthur Andersen in 1996 known that Peat Marwick was going to
    come in in 1997, there would have been a very different kind of
    relationship between them and Enron. Clearly, they would have
    wanted to have their work papers in order, all of the deals
    documented and well explained. They might well have challenged
    Enron's management in that early period where Enron was
    changing its accounting.
        The new firm coming in would do an outstanding peer review,
    on the spot, real time, of that previous auditor. We have been
    discouraged by the lack of effectiveness of the peer review
    mechanism that the POB has overseen for the accounting
    profession.
        It is not a bad system. Good people work on it. There have
    been improvements in accounting because of that peer review
    system. But it would not have anywhere near the bite that it
    would have if you had rotation and a new audit firm coming in,
    real life, on a firm.
        I would think that there is a very high probability that
    had rotation been in place at Enron with Arthur Andersen, you
    would not have had the accounting scandal that I think we now
    have, but instead, you would have had probably a challenged
    company. Maybe even Enron might have changed its business
    practices if you had had a tough questioning, challenging
    accounting relationship, which they did not have.
        I think that the other problems of the audit relationship
    are diminished enormously when you have rotation, in the sense
    that if you hired one of the partners from the audit firm, by
    the time the person is really in place and becomes the CFO of
    your company, you have a new audit firm.
        So, I do not think that you need to have as many rules and
    monitoring of that, which I think is very difficult and would
    trouble me in limiting the employment possibilities for
    auditors.
        We have an excellent, outstanding individual in our company
    that manages all of our investment accounting functions who was
    a manager at Deloitte & Touche. But we now have Ernst & Young
    as our auditor. And so, I do not see any problem of his being
    able to dictate to the young E&Y auditors what their views
    might be.
        There is also a kind of simple economic analysis. I believe
    that the Andersen people considered the Enron account as a
    perpetuity. It wasn't $55 million in fees in the next year.
    They assumed they were going to get $55 million every year
    going into the future. And if you discount that at some
    reasonable discount value, that relationship was somewhere
    between a half-billion and a billion-dollar asset to the Arthur
    Andersen firm. When that kind of money is involved, the
    pressure on the people who might lose the account if they stand
    up to management I think is just--you cannot expect human
    beings to cope with that kind of money.
        Rotation would just cut that whole effect off. I hope that
    is an action that will be taken by Congress. I think it
    requires Congressional action. I do not think the SEC could
    impose that. I do not think a self-regulatory organization
    could impose that because I think it affects the basic working
    of American business.
        I am very reluctant to impose more rules on American
    business. But in this case, the importance to the capital
    markets and the public interest in quality statements is so
    enormous, that I think that those considerations would offset
    the intrusion, the regulatory intrusion.
        My third point I will not spend a lot of time on. I have
    probably gone on too long already. But I think we need a strong
    regulatory model. I had the experience for just 9 months of
    working on the POB. I was persuaded, strong-armed into doing it
    by people saying it was my public duty to do so. It was very
    hard work. The agendas are very long, extremely complex,
    fascinating in many ways. There is nothing more interesting
    than studying the detail of a failed audit and getting the
    evidence of who lied to whom and what were the circumstances.
        I admit that sometimes 100 page documents which we received
    at each meeting went by quickly. But they were nevertheless
    time-consuming and demanding.
        I do not think we will ever get, putting myself aside, a
    better board of people than the POB had. Two individuals that
    you all are familiar with--Chuck Bowsher and Norm Augustin--
    were members of the committee. Mel Laird served for a number of
    years. I succeeded Paul O'Neill, who went out of retirement
    back into an active job. We had Don Kirk, who Chaired the FASB,
    and Aulana Peters had been a member of the SEC.
        I think it was a hard-working group. It was a smart group.
    But it was not welcomed by the accounting profession. Every
    time the POB tried to cause a change which was opposed, the
    opposition was made clear, finally to the point of absurdity
    when they simply said, we are not going to pay your expenses
    any longer, or pay for your staff. And at that point, the SEC
    had to intervene and say, you have to do it. That kept us
    alive.
        But it was clear that we did not have the authority. When
    there was a failed audit, we would ask for information and we
    were in effect begging for the accounting firms to comply, and
    if they had any real serious concerns, they simply wouldn't.
        Then if we did find somebody who had committed an
    outrageous audit, all we could do is recommend to the executive
    committee of the AICPA that they look into the matter and find
    out whether there had been ethical violations. They would then
    delay it until the litigation was over, which was usually about
    10 years later. By that time, we were well past any useful
    rule.
        I think you heard vigorous testimony yesterday from people
    saying we need a strong oversight board. And I concur with
    them. I have had discussions with a number of the former chief
    accountants and with former chairmen of the SEC, and I think
    that there is a general consensus that we need that, and so I
    do not think I need to go through and tell you about that.
        I do have one point, though, and I will end.
        The financing of it, I think, is very important. I served
    on the Financial Accounting Foundation that raises money to
    finance the FASB and appoints the members of the FASB. I am
    also serving with Paul Volcker on the International Accounting
    Standards Board's foundation. In each case, we have had to go
    to the American business community with a tin cup asking for
    money to support these.
        I have had I do not know how many discussions over the 5 or
    6 years that I have been doing this with people, and it is a
    very uneasy discussion because a key question is always there.
    In some cases, they are crude enough to ask, and say, well, how
    much influence will we have over what the FASB decides? But in
    other cases, you know the question is there, but the individual
    is smart enough not to ask it.
        I think if we can find some way to finance the new
    regulatory agency--I would hope also the FAF and maybe even the
    American share of the IASB, that you would find that it could
    be the stock exchanges could pay for it. They do not want to do
    it, of course. Or it could be a registration fee, some kind of
    fee allocated when stocks or bonds are issued--so that the
    users of the statements would actually pay.
        I have been dismayed, and I have a lot of personal
    experience in this, asking the investment community to pay for
    getting quality finance reporting. They simply won't do it.
    They free-ride on the system. We have to go to others in the
    business world to do it. There are some exceptions, I should
    say.
        Actually, TIAA-CREF was never asked and did not until I
    became involved, and we have become generous supporters because
    we know we are going to be in managing assets for 50 to 100
    years ahead just for the people who are signing up now. The
    long-run success of the capital markets in America and
    worldwide are vital to us.
        I could also make a speech about the importance of the
    quality international accounting standards effort because I
    think they will make it much easier for TIAA-CREF and others to
    acquire interests in companies in other countries.
        Enron notwithstanding, other countries are still so far
    behind the United States, that enormous progress needs to be
    made. And I think the IASB has a good chance of causing that.
        Thank you for letting me go on as long as I have on these
    points.
        Chairman Sarbanes. Thank you very much. It has been very
    helpful and we appreciate it.
        Mr. Millstein, we would be happy to hear from you now.

                     STATEMENT OF IRA M. MILLSTEIN

                CO-CHAIRMAN OF THE BLUE RIBBON COMMITTEE

                   ON IMPROVING THE EFFECTIVENESS OF

                       CORPORATE AUDIT COMMITTEES

              SENIOR PARTNER, WEIL, GOTSHAL & MANGES, LLP

        Mr. Millstein. Thank you, Mr. Chairman.
        I appreciate being invited here, and having the opportunity
    to think a little bit more about how to improve corporate
    governance. I have been fussing with corporate governance for
    about 20 years, teaching it in one way or another. And I would
    like to say how much I appreciate being here with Mr. John
    Biggs.
        TIAA-CREF is the outstanding corporate activist in the
    pension field. They have taken the leadership role in pushing
    for governance reform for many years. They are entitled to huge
    credit for leading capital market participants to focus on
    corporate governance. And John Biggs has helped me in a number
    of corporate governance reform efforts, both here in the United
    States and all over the world.
        I would just like to publicly thank TIAA-CREF for
    everything they do in this area.
        Unfortunately, in the process of preparing for today, I
    thought of a lot of things that are not in my statement and I
    would like to add them today and I am happy to have the
    opportunity.
        [Laughter.]
        What we are talking about, basically, is how do we get
    people to do the right thing?
        Anybody who does not understand what good corporate
    governance is, and what they should be doing, must be living on
    another planet. There are enough courses, lectures, books, good
    practice rules and so on, to fill a library about what is good
    corporate governance.
        And you have to scratch your head after all these years and
    say, why doesn't everybody just do it? Why are we talking about
    new regulations and new rules? I agree with Lynn Turner: We can
    have rules and rules and rules and rules. But unless people do
    what they are supposed to do, nothing is ever going to happen.
        For example, even GAAP--the wonderful GAAP--has so many
    gaps in it, it is a Swiss cheese. It is all about discretion.
    And the question is, how do we get people to use discretion
    appropriately? How do we get boards to act the way they ought
    to act? What do we have to do to make people realize that the
    integrity of this system is critical, and that each and every
    player--from board member to audit committee member to analyst
    to auditor--has a role to play in making the system work right?
        We do not have to teach them what they have to do. They
    know what they have to do. It is just ``Do the right thing.''
    Everybody knows that is the answer. So how do we get them to do
    it?
        I had practical experience with this issue when I Co-
    Chaired the Blue Ribbon Committee. I was asked by Arthur
    Levitt, the then-Chairman of the SEC, Frank Zarb, then head of
    the NASD, and Richard Grasso, head of the New York Stock
    Exchange, to get together a group of people and come up with
    some ideas about how to improve the functioning of audit
    committees.
        Chairman Arthur Levitt was worried about managed earnings
    and cookie jar reserves and all those nice things. I know
    Harvey Goldschmidt, then the SEC Counsel, was talking to you,
    Senator Gramm, about these things and trying to figure out what
    to do?
        Well, I was given the job of putting together a great
    group -- John Whitehead of Goldman Sachs; John Biggs of TIAA-
    CREF; Frank Borelli of Marsh & McLennan; Chuck Bowsher, the
    former Comptroller General; Dennis Dammerman of General
    Electric; Dick Grasso of the New York Stock Exchange; Frank
    Zarb from the NASD; Phil Laskawy and Jim Schiro from the
    accounting profession; and Bill Steer, from Pfizer.
        That was our very knowledgeable group. What did we do? We
    came up with a report. I really urge you to read it. Perhaps if
    more people read and understood it--and practiced what it
    preached--we would not be here today. The vast majority of our
    recommendations were implemented by the SEC and the listing
    bodies. But I don't know the facts and so I can't answer that
    question. What we recommended that audit committees do however
    seems to me to be capable of avoiding numerous types of
    problems, both for directors and investors.
        Look at Recommendation No. 9, for example. The reason that
    I mention it is that it has everything in it.
        We recommended that the audit committee disclose whether or
    not it had done the following things:
        Did management review the audited financial statements with
    the audit committee, including a discussion of the quality of
    accounting principles, as applied to significant judgments?
        Did the outside auditors discuss with the audit committee
    the outside auditor's judgment of the quality of those numbers?
        Did the members of the audit committee step aside and talk
    among themselves about whether or not all of these things had
    taken place?
        We recommended that audit committees disclose in the proxy
    statement, that it did all of these things and state that the
    numbers fairly present the performance of the company.
        Just assume that every audit committee in the United States
    did all this. Would we have these widespread problems today? I
    don't think so.
        The new audit committee requirements have only been in
    effect for about a year. And interestingly, we thought that a
    lot of these rules were being complied with, but recent events
    may raise questions about this.
        The issue is, how much further can we go in the world of
    corporate judgment and corporate governance than to tell people
    to report in the proxy statement whether or not they did these
    things.
        What Mr. [Steven] Harris prompted me to think about this
    morning is whether there is anything legislatively that could
    be close to cause audit committee members to take this even
    more seriously than they do.
        That is what we wanted to do--cause audit committees to
    study this and say, ``This is what we are really going to do.
    We will talk to the auditors about quality. We will talk to the
    internal auditor. We will talk to management. We will talk
    among ourselves and we will pay very close attention to this
    process.'' That is what we wanted to see happen.
        Now is a requirement that audit committees report in the
    proxy statement whether they did it enough to encourage them to
    do it? I would suggest that maybe we could take one step
    further and ask the audit committee not only to disclose
    whether they did it, but also disclose what they did and what
    conclusions they reached. That would be big, bright sunlight.
        The SEC, I think, is concerned as to whether or not it has
    the authority to do that without impinging in the corporate
    governance area a little further than they may have the right
    to.
        I would urge this Committee to consider whether or not it
    might be worth giving the Commission just a little more
    jurisdiction than it has at the moment, at least making it
    clear that it could take such a step and ask the audit
    committee to disclose not only whether they discussed these
    matters, but also what conclusions they reached.
        I know everybody will get very nervous, Senator Gramm, and
    cite this as another reason not to serve on an audit committee.
    I understand.
        By the way, the audit committees were not deserted because
    of our original recommendations; nor have D&O insurers refused
    to insure.
        But in order to encourage people on the audit committee to
    do this, and in order to encourage the Commission to just put a
    little more sunlight on the process and ask the audit committee
    to talk about what they did or what conclusions they reached,
    let's give them a safe harbor. Let's give them a safe harbor
    from litigation so that they won't get sued in State court
    proceedings.
        Legislation could provide that the only people who could
    proceed against an audit committee member for doing this--
    namely, talking about what they did--would be the SEC, and then
    for fraud. But eliminate State court proceedings and strike
    suits and all the rest, which is really what audit committee
    members worried about.
        Directors should not worry about the SEC. The SEC proceeds
    fairly, in my view, but directors are worried about strike
    suits and they are worried about the litigation that invariably
    follows in the State courts. So eliminate them.
        Congress has done that before. They have eliminated strike
    suits in those kinds of proceedings before. If you really want
    to throw sunlight on the process and motivate audit committee
    members to do their job, and talk about what they did, it seems
    to me that a safe harbor might do the trick.
        I would urge Congress to think about that because, as I
    say, what we are trying to do is to get people to do the right
    thing. And we may have to nudge them a little bit further than
    we have.
        The whether-or-not requirement, which is what the
    Commission uses now for disclosure, may not be enough. It is
    too easy to just say, yes, we did it. But it doesn't tell what
    the audit committee did. It just says that the committee went
    through a process. That may not be enough.
        What else could we do to move things along and get boards
    to upgrade the way they attack their problems?
        By the way, I have confidence in boards. I believe the only
    way we are going to solve this is to get boards to do what they
    are supposed to do in terms of monitoring their agents, the
    managers. That is what they are supposed to do.
        One of the problems I want to talk about, and I will deal
    with that very briefly, is the issue of compensation. I think
    the compensation packages that are being handed out now
    unfortunately motivate managers to go in the direction of
    pushing the numbers.
        I am talking about compensation directly related to stock
    price. When your compensation is directly related to stock
    price, and you can exercise your options during some snapshot
    in time when the price is high, you are motivated--you are only
    a human being--you are motivated to see that the price goes up
    so that you can exercise your option and cash out at the right
    time.
        There is nothing illegal about that. It is just what you
    are going to do. Now shouldn't we try to cure that because that
    may be one of the major pushes? But before I get to that, let's
    talk about some things which have not been done, surprisingly
    enough, and should be done now.
        Everyone has talked from the beginning about independent
    directors. Interestingly enough, there is no requirement that a
    board have a substantial majority or any majority of
    independent directors. There is no requirement anywhere.
        My recommendation is that, through listing standards and an
    SEC push, there be a requirement that every major board in the
    United States have a substantial majority of independent
    directors. Period.
        Everybody says it is the right thing to do. And in almost
    every book about good governance written, it says, ``You ought
    to have a majority of outside directors.'' But there is no
    requirement.
        Let's make it a requirement. Let's get a good definition of
    what independence is. We do not have a standard definition of
    what independence is. We have a definition that applies to
    audit committees, which came about as a result of the Blue
    Ribbon Committee report. But it only applies to audit
    committees. It doesn't apply to the rest of the board.
        We have seen in some of the current situations that, the
    concept of independence is a little mushy. Is a director who
    presides over a university that gets a substantial gift from
    the company independent? Does such a financial tie impinge on
    independence?
        We should have a good, solid debate about what independence
    is, and we should have the stock exchanges provide a listing
    requirement on director independence that applies, not just to
    audit committees, but to the majority of directors on the
    board, including those on compensation and nominating
    committees.
        Another item on the agenda which ought to be considered:
    Can the CEO properly lead the board? I never have believed that
    it was a possibility. In other words, can the CEO be the
    chairman at the same time? Bear in mind that the board has a
    completely different function than does management. Management
    manages and the board oversees.
        How can you oversee yourself ? If you are the chairman and
    the CEO, it is very hard for me to understand how you oversee
    yourself. So, I have always recommended, and a lot of other
    people have recommended, that we move toward separating the job
    of CEO and chairman and making the chairman an independent
    director.
        Now if you do not like the idea of taking the ``chairman''
    title away from the CEO, at least every board should have a
    leader of the independent directors who is an independent
    director; a leader who can lead the compensation talk, lead the
    nomination talk, lead the evaluation of the CEO talk.
        You should have someone other than the CEO evaluating the
    CEO, compensating the CEO, and recommending who the next
    directors will be. That ought to become a listing requirement
    as well. And there ought to be, again, a requirement, and here
    the SEC can step in, that every board have a conflict of
    interest policy and a code of ethics. No reason not to.
        Indeed, I wouldn't be opposed to the SEC or another body
    indicating the kinds of things that ought to go into a code of
    ethics and then have the SEC require disclosure on a comply-or-
    explain basis. Namely, if a board doesn't follow this voluntary
    suggestion, explain why. It seems to me that those are all
    things that would improve the performance of the board. An
    independent majority, a definition of independence, independent
    leadership, and more disclosure about ethics and the rest.
        Now that would be a way of getting people again to do the
    right thing. I believe if you have the right people on the
    board, properly defined, properly independent, they will do the
    right thing. I believe that. And if the SEC requires them to
    talk about what they did, it will help. Sunshine.
        Now as far as compensation is concerned, and that is where
    I am going to wind up, I think something needs to be done about
    the compensation area. And I realize that that is somewhat out
    of your jurisdiction. But I think, again, by regulation, or at
    least by SEC disclosure provisions, we could get something done
    there.
        One of the greatest experts in the compensation world, Fred
    Cook, has recommended that really and truly, you are never
    going to make long-term investors out of management as long as
    they are permitted to exercise their options during their
    tenure.
        I would like to read from a Fred Cook memo (pages) which is
    appended to my written statement. It says: ``If executives were
    expected, or required, to hold a significant portion of all the
    company stock they earn . . . and not diversify until after
    they retire, then they will regard themselves as owners and
    builders of long-term shareholder value instead of short-term
    value maximizers.''
        So think about it. If compensation committees really wanted
    to incentivize their managers by stock, good idea, they should
    hold their stock. They might even have options. There is
    nothing wrong with that.
        But why not require that although they vest right along,
    options cannot be exercised until the executive retires. It
    just seems to me that is a way of saying to the executive, we
    really want you to be a long-term person.
        There are other ways of doing that. People do not like to
    mess with the tax laws. The other way of doing it is to create
    a tax incentive for executives to hold onto their stock.
        In other words, you can exercise your stock options during
    your tenure. But if you hold onto it for a longer period of
    time--if you do not exercise it and you do not sell right
    away--you will get a tax break by holding onto it 3, 4, or 5
    years. We have used tax incentives before. There are ways of
    doing that. And it seems to me to be useful.
        Now if you do not want to change the tax laws, and I
    realize that this is not in your jurisdiction, how about again
    having the compensation committee explain a little bit more
    about the type of compensation arrangement it has adopted for
    its managers, and explain why they have decided not to require
    the executive to hold until after he retires.
        In other words, at least say to the compensation committee,
    if you are going to allow short-term exercises, explain why you
    are doing it. Or explain why you are not going further long-
    term.
        I think the SEC could, if we give it a little more elbow
    room in the compensation area, go to the point of having the
    compensation committee explain why it was doing something that
    clearly did motivate the manager to go short-term.
        It appears to me that those are clearly opportunities for
    improving corporate governance and improving the mechanisms by
    which people are compensated.
        Finally, on the professional advisor's side, again, I think
    there could be a governance mechanism to use there. And this is
    my last recommendation. I think there ought to be a presumption
    that auditing and consulting do not mix. And that presumption
    could be created by the SEC.
        I would not go for a bright-line rule that says, never,
    never, never. Never-evers always bother me a lot. It just seems
    to me that there may be occasions with a good reason to mix.
        But I like a presumption against a mix. And again, I would
    have the audit committee explain why it granted an exemption
    from that presumption in any particular case.
        So all of these suggestions are governance suggestions.
    They are all suggestions that are intended to improve the
    board, improve the audit committee, make it function better,
    put more sunlight on it, in the hope that the sunlight will
    help.
        Thank you very much.
        Chairman Sarbanes. Very good. Thank you very much, sir.
        Senator Gramm has another engagement, so I am going to
    yield to him to go ahead with his questioning, and then I will
    pick up after that.
        Senator Gramm. Thank you, Mr. Chairman. I want to thank
    both of you for presenting comprehensive testimony, and I think
    valuable testimony.
        First of all, I do not know that we need to provide tax
    incentives for people to hold stock longer. I think the problem
    we have today is dual taxation of dividends makes the holding
    of stock to earn by conventional means of dividends
    extraordinarily unattractive and that many of the concerns that
    you have raised are at least in part--I am not saying totally,
    but at least in part--a product of the tax code itself. Would
    you agree with that?
        Mr. Biggs. Absolutely. There are situations where it
    probably doesn't matter. As a pension plan, you take cash or
    stock appreciation as the same thing. And there are people that
    still live on the dividends and want them, but the double
    taxation seems extraordinarily unfair in that case. But then,
    that is another pressure on reducing dividends and we do not
    have big enough dividend payouts I think from companies because
    of the tax situation.
        Mr. Millstein. I agree.
        Senator Gramm. I have a little bit of concern about the
    dominance of outside directors. I can see that there are
    benefits in terms of proctoring behavior and granting
    transparency. But I think it is important as we look at this to
    look at cost and benefits, not just benefits.
        I think that there is something to me that at least
    concerns me, a nagging concern about having people running
    major companies in America that have little stake in that
    company.
        If you had a mandate that the majority of members of the
    board be outside members, so you have a company like Wal-Mart
    that 80 percent of it is owned by one family, and they are in
    essence, required to turn over the running of their company to
    people who are marginal owners, at best, I think we have to
    look at costs and benefits. And I would have to say that
    concerns me.
        In terms of not having the CEO in essence be the CEO in
    terms of the board, I can see checks and balances coming from
    it, but if the objective of the company, if the overall
    objective of the economy is to promote economic growth and
    let's say that by not allowing the CEO to be, in essence,
    chairman of the board, that you were able to, at the margin,
    affect behavior in terms of reporting. But in doing so, the
    cost is that you eliminate the kind of dynamic leadership that
    produces the economic growth to begin with.
        I would have to say that I have real concerns about that. I
    would just like, in the time I have, to give both of you an
    opportunity to respond to that.
        Mr. Millstein. This is a debate that has been going on a
    long time, as you well know. And I respect the other side of
    the debate very much because it is a very legitimate concern.
        I guess my difference is that I do not look upon the board
    as running the company, not at all. I have always tried to make
    it clear that the board has a totally different function. It
    does not run the company. It does not audit the company. It is
    the overseer of the company.
        You might operate on the assumption, and I think it is
    true, that the managers are really agents. They are agents for
    the shareholders. And any agent has to be supervised.
        I see the board's only role as hiring the managers,
    supervising them, watching them, overseeing them, providing
    incentives and making sure that they operate in the interests
    of the shareholders and not themselves. That is the job of the
    board.
        I think Wal-Mart is an exception, obviously. And the bulk
    of the Fortune 500 is diversely owned by thousands and
    thousands of individual shareholders and funds and so on, who
    do not have time to run the businesses of the companies. If
    Wal-Mart's owners run the business, that is fine. I think that
    is great.
        Senator Gramm. Do they want people who are not
    substantially owners running it?
        Mr. Millstein. They are not running it. Let me say that----
        Senator Gramm. My experience with corporate governance is
    more centered around boards of regents of universities.
        Mr. Millstein. That is different.
        Senator Gramm. Well, I don't know. You have a lot more
    experience in this area than I do. I think board members that I
    have talked to think--they certainly think they run the
    University of Texas and the University of Georgia and Texas
    A&M.
        Now, I often think they get too involved. But when you have
    the power to hire and fire the CEO, when you have the power to
    set compensation, maybe you are not supposed to be running it,
    but you can come pretty darn close to running it, it seems to
    me. And I just raise the concern.
        Mr. Biggs, let me ask you, as an investor, if you have any
    of those concerns?
        Mr. Biggs. First off, I am Chairman and CEO, and so, I
    violate the principle. And so maybe I am not that fair,
    unbiased, on that subject.
        I think it is hard to tell whether there is a difference
    between the American practice on that versus the British
    practice, which largely separates them. I don't have any
    particular feeling about that. Frankly, I think having a single
    leader of an institution has enormous value. I have actually
    worked in a case where I was a CEO and there was another person
    that was chairman, and I was lucky enough to get a person who
    understood exactly what oversight means rather than
    micromanagement.
        If you have a separate, independent chairman of the board
    and the CEO has to do some very unpopular things, unpleasant
    things in a company where he knows there is going to be
    opposition, you have a real danger that people will try to end-
    run the CEO and go to the chairman of the board. So, I think
    there is that downside.
        On the minority interest, I guess I come at it as an
    investor with perhaps a different point of view. If I were a
    member of the Walton family, I think I might see it otherwise.
    But we have been burned often enough, particularly in foreign
    investing, where we go in as minority shareholders and somebody
    exploits their position as a strong family ownership.
    Particularly governments are the worst offenders. We have had
    troubles with the French government on several investments.
        The way I usually express it is, the price you pay for
    going public and getting those minority shareholders in, is
    that you have to give them the protections that the
    shareholders should have. And companies might want to think
    longer about going public because they do give up enormous
    control when a family owns a company, if they bring in that
    outside shareholder money.
        Chairman Sarbanes. That is important. I just want to
    interject for a second. I think that we have to start thinking
    about corporate governance with a sharp distinction between
    when you go public and get listed on an exchange and then
    people can buy in and institutional investors buy you and
    everything else, and when that is not the case. And the rules
    that apply in one arena may not be appropriate for the other
    arena.
        Therefore, when people go public, you have to understand
    that they are shifting the way they work. Now a lot of these
    go-go high-tech companies, they pump it up and then they go
    public, they cash it out, but none of the different way of
    operating and thinking that I think ought to come with going
    public.
        I am not necessarily signing off to everything that you
    suggested, but I think that idea has a lot to be said for it.
        Senator Gramm. Mr. Chairman, let me say that, obviously,
    when you go public, you take on a tremendous range of things
    you have to do, and you should. The question is, how far should
    that go?
        With a corporate entity, at least at the margins,
    theoretically, over time, the shareholders have the power to
    fire the management. But if the majority of the board is made
    up of outside board members, it seems to me that what we have
    to do, we have to have a system where you have checks and
    balances. But in the end, economic growth comes from wise and
    effective risk-taking and from strong leadership.
        I have a concern when we are talking about, we pay
    corporate executives extraordinary amounts of money--some
    people resent it. I do not. People who have the skills to make
    decisions where honest-to-God fortunes are made and lost, and
    they can do it successfully, they help people like me who own
    part of TIAA-CREF. But I am just concerned about this movement
    that takes away the entrepreneurship and resolves everything
    into a committee process.
        Now, I think you can certainly overdue it. Obviously, one
    of the things we have to do is look at accounting, look at
    checks and balances and have some strengthening.
        But I think when you get to the point that you are
    requiring that the majority of board members be outsiders, if
    you got to the point where the CEO could not be effectively
    chairman of the board, all based on the assumption that board
    members really understand their role, which is oversight and
    checks and balances, not to run the company--if Senator Corzine
    were my chief executive and I were on the board, who works for
    who? Or is it whom? Whatever.
        [Laughter.]
        Anyway, the point is, if I am an investor, I want somebody
    who is responsible and who is in charge and who is talented,
    and I would be very concerned about investing my money where
    the majority--and I think outside board members are important,
    critically important. But the idea that they should be the
    majority, I do not know. That makes me nervous.
        Mr. Millstein. Do I have time for one more comment?
        I don't know. I think that it depends on where you come
    from, Senator. I have been bouncing around 50-odd board rooms
    in my career and what I have seen--maybe I have seen all the
    wrong ones--but when all the power is located in one place, you
    have a dangerous situation.
        If you do not have somebody with real checks and balances
    on the CEO, you can have a real problem. If you do not have a
    board that is really looking at what is going on, you have too
    much power in one place. You really have to have that agent
    under control.
        TIAA-CREF and CalPERS and I were in Russia recently talking
    to the oligarchs about their marvelous corporate governance
    system. They had it all right. They have a board. They have
    people on it. But the money disappeared. Why did the money
    disappear? Nobody was watching it. The CEO and the board were
    all buddies. Everybody's fooling around. They said, well, we
    have a board of directors. Look at this. Here they are. They
    are all sitting here.
        And I said, well, where's the money?
        Senator Gramm. Yes, but I do not think that is the issue we
    are talking about here.
        Mr. Millstein. The issue we are talking about is really
    controlling what happens when too much power is located in one
    place. There is nothing more complicated about corporate
    governance.
        Senator Gramm. Do not forget, we are the beneficiaries and
    victims of our experience. But what about where not enough
    power is located in one place?
        Mr. Millstein. Balance.
        Senator Gramm. What about when you have bureaucracies and
    people cannot make decisions? I think it cuts both ways. All I
    am saying is, we have to look at not just the benefits of all
    the things we do in terms of oversight, redundancy,
    transparency, all those things. We have to look at the cost. I
    am speaking in theoretical terms, obviously.
        Mr. Biggs. There really has to be a balance, it seems to
    me. You have an engine of growth and leadership and driving and
    making a company go. You have to preserve that. If you hem it
    in with too much bureaucracy and limitations, you can destroy
    that. On the other hand, when something goes wrong, as does
    happen, then you really look closely at that other side of this
    issue, which is what were the oversight mechanisms and so
    forth, that were in place there.
        I would hope that we can get the balance right. But,
    Senator Gramm, I hear you. On the stock options, for instance,
    the last thing I want to do is eliminate stock compensation.
    Most people say if you expense it, that everybody will stop
    giving it, using stock as awards, and I think that is just
    nonsense.
        I think stock compensation, if it is properly constructed--
    in the case of our Boeing plan, they have at least a 5 year
    perspective because it does not count until the end of 5 years.
    They do not have to wait till retirement, but they cannot cash
    out 6 months or 2 years later.
        But if you can get those kinds of plans, and get the right
    balance between long-term objectives and stock, I think it can
    work. I think you keep the engine, the real genius of American
    capitalism still fully empowered.
        Senator Gramm. Thank you, Mr. Chairman. You have been very
    generous.
        Chairman Sarbanes. I am going to yield to Senator Miller
    now. I just want to make this observation on the executive
    compensation issue we have been discussing.
        On February 24, the Los Angeles Times reported that, ``In
    1995, 41 percent of a typical chief executive's total pay was
    in the form of conventional salary or cash. The CEO collected
    slightly more, 42 percent, in long-term incentives, primarily
    stock options. By last year, chief executives were collecting
    65 percent of their pay in long-term incentives, while salary
    plunged to 18 percent.''
        I just want to throw that into the mix here.
        Senator Miller.
        Senator Miller. Thank you, Mr. Chairman. And thank both of
    you for this very interesting and enlightening testimony.
        I want to continue, as you put it, on this debate that has
    been going on for a long time. I listened to you talking about
    the pushes and the nudges and the sunshine. What is the role of
    Congress in providing those pushes and nudges and sunshine?
    Should Congress be legislating in the corporate governance
    area?
        Mr. Millstein. No. I did not suggest that. That is the last
    thing that I would suggest. I love the Congress, but stay out
    of corporate governance.
        [Laughter.]
        Most of us in the field are not in favor of Federal
    chartering or any of those things, and that is not what I am
    talking about.
        What I was talking about was giving the Commission a little
    more discretion to inch into the governance area. They are
    chary about it. The Commission is chary about inching into it
    because they have been slapped on the wrist several times, once
    in the Supreme Court, about getting into the area of corporate
    governance. And they are supposedly not the corporate nanny.
    They are simply a disclosure mechanism. All I am suggesting is
    that in the disclosure area, they be permitted to get more into
    what people are disclosing than just that they are disclosing
    it.
        In other words, at the moment, all the Commission says is,
    tell us what your process is. I am suggesting that maybe the
    Commission be permitted to go a little further and say, why did
    you make that decision? What did you decide? In order to do
    that, I am not saying that Congress should do that. I said the
    Commission should do that. The Commission should police it and
    directors ought to get a safe harbor and not be subject to suit
    when they talk more about what they do.
        I suppose what I am saying is, I just think it would be a
    good idea if directors talked a little bit more to the
    shareholders and the markets about what they had just done. Why
    did they adopt this compensation system? Did they really think
    that it was going to be long-term?
        And instead of having written boilerplate statements which
    say, yes, I talked about it, here's what we talked about. Not
    in all the details, but these are the conclusions we reached.
        Why do I think that would be good? It is more sunlight and
    if they have to explain what they did to the shareholders,
    things I think would be a little better. But do not put them in
    a position of being sued for having done that.
        I do not want directors to feel, well, we do not want to
    talk about it because if we do, we are going to get sued. I
    would say, give them a safe harbor and give them an exclusion.
    But let them talk a little bit more about what they have done.
    I think it would help.
        Senator Miller. Thank you.
        Mr. Biggs, do you have any thoughts on pushing and nudging?
        Mr. Biggs. I certainly agree that I do not think Congress
    needs to get into the corporate governance arena in an explicit
    way. We certainly need your help. Also, it seems to me, as I
    said, I think that the accounting standards ought to stay in
    the private sector to every extent that we can make that
    possible.
        I think you should be encouraged by the progress that we
    have made in the private sector in pushing better corporate
    governance.
        Ira's been at this longer than I have, but I think we have
    made real progress in the last 20 years, 10 years, 5 years. I
    have been thrilled with what we have accomplished with the
    audit committee work. I think we really have made some
    improvements, and I believe the system is working. For example,
    the proxy method. We file a fair number of proxy resolutions.
    We have effected a lot of change.
        One example--we went after a form of poison pill that
    seemed extraordinarily obnoxious called the Dead Hand Poison
    Pill, which meant that if someone came in and elected a new
    board, and threw out the old board, the new board could not get
    rid of the poison pill, which was a clever legal device for
    making it absolutely impossible to force out a board.
        We went after companies, and it took us about 2 years. The
    real secret was finally getting to the law firms and saying,
    stop writing this in, because we would go to CEO's and say, you
    have this horrible provision. And they would say, I had no
    idea. We just stuck that in because that was the standard form.
        I think the system is working pretty well. When Enron
    happened, you say, well, where is your system? How good is it?
    But I think if you look across the board, we have really made
    progress on corporate governance.
        Senator Miller. Another quick question and maybe you can
    give me a brief answer. This is along the lines of the audit
    committee and also, independent directors. Yesterday, Mr.
    Sutton went so far as to recommend that the audit committee
    ought to be made up entirely of independent directors. What do
    you think about that?
        Mr. Millstein. It is required. The stock exchange listing
    requirements today say that the audit committee has to be all
    independent directors. My feeling would be it would be a good
    idea to have the nominating committee and the compensation
    committee have the same requirements.
        Mr. Biggs. I think that it is pretty standard now among
    companies that really worry about good corporate governance,
    that they do that.
        Senator Miller. Thank you.
        Chairman Sarbanes. Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman. I feel like I
    arrived in the last third of a movie, so I am a little out of
    context.
        [Laughter.]
        First of all, I want to compliment the witnesses on their
    superior work throughout the years to try to enhance the
    quality of corporate governance and transparency of what goes
    on in corporate America to the benefit of the quality of our
    financial markets and the depth and breadth.
        Their testimony, some of which I have read, and some that I
    am still studying--I apologize if I am not square on and I ask
    for your forbearance.
        Let me ask on this independence issue, and I do not know
    how much you have done on this independent director. But I do
    not understand and I would wonder from your own experience, why
    one thinks that would compromise entrepreneurship.
        Challenging questions can lead to entrepreneurship. And I
    would wonder if you have tangible examples or situations, done
    any study of where you have broad board independence in the
    success of the underlying companies?
        Mr. Millstein. I do have a few. I believe that independence
    promotes entrepreneurship, not destroys it, because the
    independent board can remove a nonperforming manager a lot
    faster than if the manager's family is running the board.
        My view has always been that the independent board members
    can more easily act on behalf of the shareholders to get rid of
    a nonperforming management fast and replace it with a good
    management. That is really their basic job in life, to hire and
    monitor, compensate, and then get rid of managers. That is the
    job of the board. Not to run the company, but to make sure that
    the board has the single best management that it can possibly
    get, and then get rid of that management if it is not working.
    And if that doesn't promote entrepreneurship, I do not know
    what does.
        Mr. Biggs. Two points. One answer, and I think there has
    been a silly series of studies done by economists, usually
    young assistant professors, trying to show correlations between
    performance and some aspect of a board structure.
        I think some of those studies have shown that boards that
    have independent directors do not perform as well. And I think
    that those studies are just nonsense. I just do not think that
    is a measurable effect, for example, pick some one attribute of
    a board and then try to see if it produces good or bad
    performance. I do not think that is the level you were really
    raising the question about, Senator Corzine.
        I think a good, probing, independent board can be very
    effective in prodding entrepreneurship, challenging management.
    I do not see any reason why it cannot.
        I think, though, that if it becomes too bureaucratic, it
    can certainly drag a company down. But I do not think many
    boards have done that, in my experience. I think the ones that
    have been independent and questioning of senior management have
    gotten good results by just doing that.
        Senator Corzine. With regard to the correlation of
    independent boards and some of the issues we see--by the way, I
    think the Enron issue if overblown relative to other
    fundamental problems that we see with regard to corporate
    governance and accounting and other issues. It is an important
    issue because there are people who have been hurt by the
    process.
        But the restatements that we have seen by companies leads
    one to wonder whether investment decisions have been taken on
    proper information historically, or whether anyone is held
    accountable after the fact. We haven't seen many corporate
    executives giving up their bonuses that were formulated on
    earnings that were then restated.
        Is there any information that you all are aware of whether
    there has been boards of great independence in those cases
    where you have had performance reported and performance real,
    relative to those companies that have gone through the
    restatement process?
        Mr. Biggs. The short answer is, I do not know of any formal
    analysis of that. There is a fair amount of anecdotal
    information. There may be a correlation between the
    aggressiveness of the SEC at any point of time and the amount
    of restatements that is required. If the SEC is really pressing
    companies on that issue, it could make a difference in that
    there is that pressure. But that doesn't explain the high
    number of restatements that we have had in the last 5 years.
        Senator Corzine. What do you attribute this restatement to?
        Mr. Biggs. We talked earlier about the stock option
    mentality, which is surprisingly short-term. People invest and
    there is acute interest in where the stock price is. The market
    is the market, so you cannot argue with it. But the response of
    missing earnings by a penny can be brutal. Usually, the view is
    if it missed by a penny, then, clearly, they did not have a
    cookie jar that had any cookies in it, or they would have taken
    them out.
        So that tells you something about the accounting. And that
    kind of cynical view in the analyst community and in the
    controllers of companies preparing the statements leads to the
    kind of thing where you push the envelope and then you have to
    go back and restate when somebody finally blows the whistle on
    you.
        It could be the internal process of the company that can
    blow the whistle. Other times, it may be the SEC finally that
    challenges.
        I have served on the Public Oversight Board and I get the
    privilege of reading the investigation of the bad audits. It is
    usually a CEO who lied to his auditor and forced the revenue
    numbers in some way. I thought there were going to be devious,
    complex accounting issues involved, and it is not. It is a guy
    who stuffs the product line or whatever, has side deals with
    companies to buy huge amounts, and then he gets caught. And you
    end up either with a restatement or the company can go under in
    that event.
        Senator Corzine. I presume that is why you feel strongly
    about corporate governance.
        Mr. Biggs. Yes.
        Senator Corzine. If you are going to have a check and
    balance on that, then you therefore need those outside
    questioners of CEO's and senior management.
        Mr. Biggs. Yes. One example--I think, somehow, somebody has
    to take the rule--the external auditor shouldn't also be the
    internal auditor.
        Senator Corzine. Right.
        Mr. Biggs. That was something that they did at Andersen--
    well, that Andersen condoned that I found astonishing. But
    there are many people that feel that is not an inappropriate
    practice.
        Senator Corzine. I see my time is up.
        Chairman Sarbanes. Do you want to continue?
        Senator Corzine. I wonder if Mr. Millstein has any comment
    on the restatements.
        Mr. Millstein. I subscribe. I think he has it right.
        Senator Corzine. Thank you.
        Chairman Sarbanes. I want to ask some basic questions and
    get your response. Why should the accounting standards be set
    by a private body?
        Mr. Biggs. I think that they are very complicated issues,
    for one. That does not mean that the Government could not
    handle a complicated issue, of course. But that there are so
    many economic interests that are being affected by the
    decisions, that if it becomes a political issue where people
    are really just asserting a basic economic interest that they
    have, you will not get good results.
        One of the important things in accounting principle setting
    it seems to me is the word progress, that we need to move
    continuously to get better. And that progress is always
    bitterly opposed.
        Chairman Sarbanes. I am going to be a devil's advocate
    here, but I want to explore this a little bit.
        Suppose you had a division of accounting standards in the
    SEC. Now that division, presumably, could develop the level of
    competence and expertise to understand the issues because,
    granted, that they are very complicated issues. That is why
    people come along and they say, well, the Congress certainly
    shouldn't legislate accounting standards because the Congress
    cannot begin to understand the complexity of the issues.
        Although we had a former chief accountant of the SEC
    yesterday who said that Congress ought to set mark-to-market as
    a standard, establish it by the Congress. What are the
    arguments against that?
        Mr. Biggs. I would argue that--a specific issue that might
    be a good one to use--I think substantial progress was made
    when we required companies to put on their books the cost of
    benefits that are promised employees after retirement.
        If you told people that you were going to provide medical
    care for their lifetime after they retire, you ought to have a
    liability on your books for that and you ought to expense it in
    an appropriate way. That was bitterly opposed by a number of
    companies that claimed it would cause them to be in effect
    bankrupt. So it was very controversial. But it was proposed by
    the FASB as a position.
        I think General Motors had a huge liability that they had
    to put up at that time.
        It was proposed by the FASB with a good process. There was
    no reason that you could not have a good process within a
    division of the SEC as well. And it was vented. There was a
    driving force to get that rule implemented. We did, and I
    think, overall, it has been good for the country and good for
    capital markets and we now have those liabilities on the books
    of companies.
        Would a division of the SEC have ever done that? Would they
    have wanted to take on an issue that was that deep and
    controversial and involved so many companies? I think it is
    unlikely. I think having it in the private sector with board
    members of the FASB who are totally independent gave you a
    chance that they would do that.
        And there will be issues coming up in the future. I do not
    know what they will be. The most recent one was of course
    derivatives and how to account for derivatives, an incredibly
    complex subject, but one on which I would think a Government
    agency would have been smart to say, I am going to duck this
    one and not take it on. Whereas, the FASB did feel it was
    important. It was an issue that had to be dealt with.
        Chairman Sarbanes. Mr. Millstein, do you have a view on
    this?
        Mr. Millstein. Yes, I do. Just formed, because I hadn't
    thought a lot about it.
        Chairman Sarbanes. You have had enough experience, that
    your just-formed-view is better than most people's. So please
    go ahead.
        [Laughter.]
        Mr. Millstein. The SEC approves listing requirements. The
    SEC can turn to the NYSE and Nasdaq and say, ``We think you
    should consider some listing requirements in this area,'' as
    they did in our case with audit committee independence and
    chartering. The SRO's do it, and it comes back to the SEC for
    approval.
        Now it seems to me you could have the same system with
    respect to accounting standards. I wouldn't be uncomfortable
    with that.
        I would like the listing standards to be prepared by a
    private body. They are the ones who know best. I do not think
    it is necessary to have the Government hire thousands of
    experts to come up with accounting standards. But having come
    up with accounting standards through, and even auditing
    standards, by the way, which are just as important as
    accounting standards, I would find it perfectly appropriate for
    Congress to give the SEC the authority to approve, just as they
    do in listing. At least somebody in Government would be taking
    a look at what just happened.
        Mr. Biggs. The SEC has the authority to set accounting
    standards now, but has delegated it to the FASB. And the
    European Commission is doing the same thing. They have the
    authority to actually do the standards.
        The SEC now, under the 1934 Act, can----
        Mr. Millstein. I think they should take it back.
        Chairman Sarbanes. Well, it came out clearly yesterday in
    the panel that the SEC actually has authority to do a number of
    things. They haven't done them.
        Mr. Millstein. That is correct.
        Chairman Sarbanes. Now why haven't they done them? Well,
    there are a lot of pressures at work, not the least of which
    are pressures from the Congress. The pressures are different
    right now, but the pressures were 180 degrees in the other
    direction not very long ago, as a general proposition.
        I take it you both feel strongly that if the standards are
    going to be done by a private body, that the funding for that
    private body should be in some manner automatic and assured, so
    that the body setting the standards, many of which are
    potentially controversial, or at least will be opposed by
    significant elements in industry who see some advantageous
    route that they have managed to scout out being close off to
    them.
        So, we have to have a funding mechanism that is automatic.
    I like some automatic fee arrangement or something that
    provides the budget for these standard setting boards. Isn't
    that the case?
        Mr. Biggs. Absolutely. I think you are absolutely right.
    Given the controversial nature, we need that. The irony is that
    we saw it actually happen, when the POB took an unpopular
    position with the accounting profession, AICPA said, we are not
    going to give you any money to pay your staff.
        When you have that kind of power----
        Chairman Sarbanes. We had Paul Volcker here and he had the
    situation where he went to Enron to get money for the
    International Accounting Standards Board. And then Enron
    internally circulated a memo from one of their executives to
    another saying, well, if we make a significant contribution
    here, will this give us influence over the standards that this
    board is going to set? It was a direct connection.
        I am going to yield to Senator Corzine, who has a few
    questions. But let me ask this, if you have just a moment, Jon.
        Mr. Biggs, I want to make sure I understand what you do
    with your audit firm. As I understand it, your auditor does no
    other work but audit. Is that correct?
        Mr. Biggs. That is right.
        Chairman Sarbanes. No consulting work of any sort?
        Mr. Biggs. No.
        Chairman Sarbanes. Including tax consulting because they
    are constantly arguing that they have to do the tax consulting.
        Mr. Biggs. We do not permit that.
        Chairman Sarbanes. And you change your auditor
    periodically?
        Mr. Biggs. Practically, it is every 7 years at this point.
        Chairman Sarbanes. Now is that not more expensive for you?
    The argument is made that through these kinds of separations,
    that it will cost the companies significantly more money.
        Mr. Biggs. It is imperceptible to me. Theoretically, I
    think one would think it would be more expensive because you
    are bringing in a new firm that has to get involved with a new
    company--but when we look at the fee schedule that we pay the
    old auditors, I cannot see any change when we move from one to
    another. I mean, the fees have gone up because our company has
    grown substantially. But the growth in the fees has been
    related to the company's growth and complexity, not due to
    rotation.
        I do not believe there is any costs to the company. In our
    cost, we have not been able to see it.
        Now, I think a very huge, complex company, a General
    Electric or Boeing, would be almost bound to incur some extra
    costs. But I think those costs are offset by very significant
    benefits. I do not mean just benefits to the public and the
    independence, but benefits to the company in bringing in a new
    team.
        Chairman Sarbanes. What do you say to the argument that we
    hear that if we just do auditing, we are not going to be able
    to get the best and the brightest because the best and the
    brightest want to do these innovative, imaginative work
    challenges that they get if they are consulting? And so, the
    ability to do consulting along with auditing means that we are
    going to get a higher talent person into our accounting firms.
    What is your view of that argument?
        Mr. Biggs. First off, the position we always had as a
    company is you just did not do your consulting on your audit
    clients. Instead of giving the Big 5 pretty even distribution,
    you had 80 percent of the market to go do your consulting work,
    do it with them and not where the independence issue was
    raised.
        I just do not buy that argument. What seems to me
    remarkable is, I think the best and brightest accountants were
    going into auditing back in the 1950's and 1960's and they are
    not doing it now. And yet, this has been a period when
    consulting has exploded in size--and they did not have any
    consulting. Nobody knew about computers back in the 1950's and
    1960's. They have started learning, and that is when the
    accountants got into that business.
        But they were able to attract good people to auditing when
    it was a respected, honorable field and not competing with the
    firms with all the other business activities.
        We have seen a real decline in people taking accounting and
    the best and brightest aren't doing it in business schools.
    Part of that is the decline in the respect paid to the audit
    function. It is viewed more and more as a commodity. The CEO's
    do not take the senior partner as seriously as they used to.
    And there has been a general decline in the prestige of that
    function.
        I am not an accountant or an auditor, but I was the chief
    accountant of a company at one time. I think accounting is a
    fascinating field in its own right, with enormous complexity,
    intellectual demand, intellectually interesting, and people
    will be attracted to the profession and they do not have to
    have computing and a lot of other things thrown in as actual
    enticement.
        Chairman Sarbanes. I regret that Senator Enzi, who is our
    only accountant in the Senate, is not here because that would
    be music to his ears, what you just said about accounting. We
    will make sure that the transcript of that gets to him.
        Mr. Millstein.
        Mr. Millstein. I think there is a likelihood that what John
    would like to see happen will happen. The audit function is, by
    virtue of what we are doing here today and what you are doing
    in all the hearings that are taking place, is going to get up
    in the eyes of everybody.
        I think a lot of the companies with whom I deal are
    beginning to look at their auditors a little differently. Now
    that, I hope, will lead to the point where they can charge
    more. If they can charge more, they can pay more. And in
    today's society, that will attract people into the auditing
    profession.
        It is a very respectable and important profession. The
    auditor now is just as critical as the lawyer or anybody else
    representing or working for the company. I think all of these
    hearings are extremely useful in putting the emphasis back on
    the significance of that independent auditor and what he or she
    means to the system.
        I think if we get that into our heads and are willing to
    pay for it, then auditing will become an attractive profession
    again.
        Unfortunately, many professionals were attracted to the
    consulting business, where they could charge anything. And many
    good people moved over to consulting because it was so well
    paid.
        Well, I think the consultants are not doing well at the
    moment, at least from what I have heard around the track.
    Consulting is just not doing as well. So maybe some of them are
    going to drift back to auditing, where they belonged in the
    first place. But let's make it an important thing and worth
    paying for, and people will go back to doing it again.
        Chairman Sarbanes. Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman. I am going to go
    a little parochial.
        There is a merger going on in and around New Jersey with
    Comcast and AT&T. One of the provisions of the merger
    agreement, the companies are asking for a provision that would
    ban for 3 years the electing of new directors. I wonder if
    either of you have trouble with that. What are your thoughts
    about those kinds of corporate governance positions?
        Mr. Millstein knows this more from his legal work--is this
    something that is typical in mergers or is this unique to this
    situation? Is it symptomatic of how the whole process has
    been--I do not know about perverted--but diverted from the
    interests of shareholders?
        Mr. Millstein. Well, let me say, I really would not like to
    talk about Comcast and AT&T. But, in general, the problem I
    think is sometimes people do that in order to preserve the
    management structure they are putting into place. In other
    words, the two companies get together and they decide X is
    going to be the chairman and Y is going to be the next
    chairman, and they want to be sure that the succession takes
    place the way it should. So what you do is you put the
    directors in concrete for 3 years and that makes everything
    wonderful.
        Do I think that is always a good idea? No, I do not. But it
    is one way of guaranteeing succession in management when you
    have a merger like this. People are going to do it.
        Senator Corzine. These are the kinds of things, though,
    that, if we had independence with regard to boards, you could
    actually have some difference of view, or at least challenge of
    those kinds of things.
        Mr. Millstein. That is right. And I think that this is one
    of the reasons why I promote the idea of independence on the
    board. It is troublesome to me to see directors locked in by
    some agreement for some period of time. Indeed, I am not sure
    you can do it.
        Senator Corzine. By the way, I was not looking for an
    opinion about the particulars of the situation.
        Mr. Millstein. I understand. Just the principle.
        Senator Corzine. You could ask also about super-voting
    rights and other issues that lead to deterioration of the
    independence.
        Mr. Millstein. Mr. Biggs and CalPERS and TIAA-CREF fight
    this every day of the week, quite properly.
        Mr. Biggs. All the extreme anti-takeover protections.
        Senator Corzine. I would suggest that sometimes, some of
    these things, while we would love to stay out of the Congress
    participating in this process, you may never get a resolution
    of some of those issues if you limit it only to the regulatory
    structure. I am unclear whether that can be done.
        Mr. Biggs. No.
        Senator Corzine. There are some things that go over a line
    of breaking down corporate democracy.
        Mr. Biggs. It is hard to imagine what people are going to
    come up with.
        Senator Corzine. Right. I have to ask one question, Mr.
    Biggs.
        Chairman Sarbanes. Sure.
        Senator Corzine. How do you feel about diversification in
    portfolios?
        Mr. Biggs. I have just written a very nice piece to all of
    our participants saying, obviously, TIAA-CREF cannot have
    concentrations in any company. I think that is one where we are
    going to have to keep a balance because we have had a long
    history in our country of encouraging stock ownership.
        I am very uneasy, though, when people jam it into a 401(k)
    plan. I agree with your view that that is a tax-benefited plan.
    There ought to be some limitations on using that. On the other
    hand, Congress has changed the Internal Revenue Code, so that
    companies are now encouraged to put the stock in there because
    then the dividends can be changed around so that the dividends
    are deductible. So, we are getting different messages from
    Washington on that. And the tax message is one that people
    really hear very loud and clear.
        I was frankly shocked when I saw how many marquee names in
    American business have more than a majority of their 401(k)
    accumulations, in their own company stock. I think that it is a
    problem. I have a hard time balancing it against, the history
    that goes back to the 1950's where we encouraged ESOP's with
    tax benefits. We encouraged stock ownership. Owning stock in
    your own company became as American as homeownership.
        Senator Corzine. Well, you can be encouraging of
    participation in American economic system through stock
    ownership and even in your own company in certain ways. But
    whether you do it for retirement plans is one issue and whether
    you do it in compensation is obviously a whole other issue.
        Mr. Biggs. Right.
        Senator Corzine. And everything is an issue of degree.
        Mr. Biggs. Yes. Every company I have been involved with has
    been very, very careful about having too much stock in the
    pension portion. It could be the defined benefit plan funding
    it if the plan was overfunded. But there are ERISA limitations.
        Senator Corzine. There is a 10 percent limit in defined
    benefit programs.
        Mr. Biggs. Right.
        Senator Corzine. Thank you.
        Chairman Sarbanes. I want to ask some very specific
    questions that arose from the testimony of others.
        Former SEC Chairman Breeden, in his testimony, raised
    concerns about the practice of corporations making large loans
    to executives without the knowledge or approval of
    shareholders. He recommended that corporations be required to
    disclose in proxies all company loans to executives, specifying
    the amounts of the loans and balances to be repaid. He also
    recommended requiring that shareholders ratify any loans to
    executives above a certain level. I would be interested in your
    views on these suggestions.
        Mr. Biggs. I very strongly agree with that view. In fact,
    the whole issue of executive compensation of extraordinary
    amounts being buried in contracts between the executives has
    been a theme that we massed for some time. We think there is a
    lot of abuse in the use of SERP's--Supplemental Employment
    Retirement Plans--where there are extraordinary benefits paid.
        The former Bank of America chairman before NationsBank took
    over, had a contract that provided a pension that turned out to
    be worth $60 million. But it was never disclosed. Shareholders
    could not see that. We had no way to know that that existed.
        I think transparency on executive compensation is
    critically important. And the SEC knows our views on that
    because we spent a lot of time going to see them to say that we
    want all that information in the proxy.
        Mr. Millstein. I agree. I would go further and say that any
    transactions between the executive and the company should be a
    subject of disclosure. I just think that the shareholders ought
    to know everything that is going on between the executive and
    the company in the way of special transaction. I also think
    that shareholder ratification of major compensation plans
    should probably be required.
        But I don't know that I would require them to ratify every
    single thing that happens. I don't want to see the world slowed
    down to that extent. It seems to me that basic compensation
    packages should be subject to shareholder ratification. And any
    transaction should be disclosed. That should be an open book.
        Chairman Sarbanes. We know that in Enron's case and other
    cases of other companies, insiders sold their shares within
    months of the company's bankruptcies.
        Now leaving aside what may be available to you under the
    bankruptcy law to reclaim that money, some of which does not
    have much punch to it, do you feel that we need stronger
    penalties or remedies on insiders in this regard, including
    making it easier to make them disgorge their profits?
        Mr. Millstein. I think the insider trading laws are so
    arcane, that I do not think we are going to solve anything
    immediately. I cannot see what new law would do that would
    improve anything. I really don't.
        I think under the bankruptcy laws, there can be efforts to
    try to recoup if it has been done right immediately in the zone
    of bankruptcy, or if it is insider trading, you go after them
    for insider trading. But, Senator, I do not know how to draw
    the line any finer.
        Chairman Sarbanes. Okay. Now if we are going to make
    systemic or structural changes on the accounting issues, the
    standards and their implementation, what should that structure
    be?
        The Public Oversight Board is all resigning. We are going
    to hear from Chuck Bowsher.
        Mr. Biggs. Right.
        Chairman Sarbanes. What is your model that we can use here
    to try to get a structure that seems to work better? First of
    all, I do not think you would argue that the current structure
    works very well, the tin cup analogy, in and of itself. I think
    that the Public Oversight Board did not have the kind of
    authorities or powers that one would assume ought to be in a
    body of that sort. Do you have any view of what the structure
    ought to be if you were drawing a model?
        Mr. Biggs. Frankly, I think a lot of the----
        Chairman Sarbanes. Because that is something we may do.
    That is something that the Congress could get into place and
    then say, now you go do your business, instead of us trying
    somehow to do the business each step of the way.
        Mr. Biggs. Well, I think the SEC has proposed a regulatory
    model, which is not bad. I believe the view of Chairman Pitt
    was that he could move quickly and get that done without
    Congressional action. And he thought the Congressional action
    might come rather slowly.
        But my view is that the board has to have much more
    authority than we had at the POB. It has to be able to
    investigate and be able to go in and get information and then
    have privilege of that information so that it cannot be called
    up in litigation.
        I think the licensing of accountants needs to be addressed
    in a Federal regulatory board. We have all the State licensing
    of all the accountants and yet, when they are doing an SEC-
    regulated audit, it seems to me that that ought to have a
    strong Federal control over the individuals permitted to do it.
        Now, we have put together the most crazy quilt combination
    of institutions. It took me the first 3 or 4 months on the POB
    just to get straight all the initials, the acronyms, of all the
    different organizations from the different accounting standards
    groups, either auditing standards, accounting standards, the
    investigative groups, who had authority, the peer review
    mechanisms, and so on.
        But I think that it would take Congressional authority to
    give proper authority, some self-regulatory organization. I
    thought you had a lot of ideas presented yesterday about the
    specifics of it, which I am not really qualified to suggest.
        Chairman Sarbanes. Mr. Millstein, do you have anything to
    add?
        Mr. Millstein. I agree. I think you need a regulatory body.
    I do not think self-regulation works that well. And peer
    pressure I do not think works that well.
        In our business, the law business, we have the courts, who
    keep a pretty good eye on us. And if there's going to be
    disbarment or something like that, we have some place to go to
    make it happen.
        Chairman Sarbanes. Right.
        Mr. Millstein. I think there ought to be some equivalent of
    that in the accounting profession. We are held to pretty high
    standards, but we have somebody keeping an eye on us, which is
    the courts.
        Chairman Sarbanes. Well, gentlemen, thank you very much.
    You have been very, very helpful and we really appreciate your
    testimony and the work that went into it. Hopefully, we will be
    able to continue to consult with you as we move ahead in trying
    to frame a response here.
        Mr. Millstein. Thank you.
        Mr. Biggs. Thank you.
        Mr. Millstein. We would be happy to do that.
        Chairman Sarbanes. Thank you very much.
        The hearing is adjourned.
        [Whereupon, at 12:20 p.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]

                      PREPARED STATEMENT OF JOHN H. BIGGS

                          Chairman, President, and CEO
                   Teachers Insurance and Annuity Association
                  College Retirement Equities Fund [TIAA-CREF]
                               February 27, 2002

        Mr. Chairman and Members of the Senate Banking Committee, I am
    honored that you asked me to testify today on the important issues of
    corporate governance raised by the Enron collapse.
        My name is John Biggs and I am Chairman, President, and CEO of
    TIAA-CREF, the system providing pensions and other financial products
    to the education and research community. We manage about $280 billion
    in assets through TIAA, a New York licensed insurance company, and
    CREF, the country's first variable annuity plan. Our company also
    offers to the general public life insurance products, trust services,
    mutual funds, and college tuition savings plans. As the CEO of TIAA-
    CREF, I am proud to report that our stock analysts covering the energy
    business could never understand how Enron could make enough money to
    cover its obligations--so our active portfolio held less than the
    benchmark level, resulting in relatively favorable results for our
    participants. We did unfortunately hold positions in our Index Funds
    since Enron once held a prominent position in the S&P 500.
        My other experience relevant to your deliberations is as an
    independent public sector participant in financial regulation. I served
    for 2 years as a Governor of the NASD and some 5 years as a Trustee of
    the Financial Accounting Foundation, which funds the Financial
    Accounting Standards Board, or FASB, and appoints its members. I now
    serve as a Trustee of the Foundation supporting in a similar way the
    new International Accounting Standards Board (IASB). I was also a
    member of the Blue Ribbon Committee on Improving the Effectiveness of
    Audit Committees. And currently, I continue as one of the five
    trustees, all of us independent, of the Public Oversight Board. As you
    know, this Board will go out of business on March 31 of this year. I am
    not an accountant but did start my career as an actuary and earned a
    Ph.D. in economics along the way.
        The Enron collapse and the intense interest the public and the
    Congress have taken raises a number of questions. I will focus on three
    primary areas where I believe America's corporate governance must be
    strengthened--and I will suggest ways in which the Congress might bring
    this about.
        The three changes we have needed for some time and that bear
    directly on the circumstances of Enron are these: (1) a means of
    dealing with the widespread overuse and abuse of fixed-price stock
    options; (2) the need for some basic common sense regarding auditor
    independence; and (3) the need for a strong regulatory model to oversee
    the accounting profession.
    Overuse and Abuse of Stock Options
        Several accounting professionals have attempted to lay the problems
    of Enron's accounting on the FASB. I believe they are seriously
    mistaken. In fact, during the late 1980's and early 1990's the FASB was
    aware of the very issues that Enron eventually faced. Among other
    things, the FASB addressed the absurd policy of accounting for stock
    options by which they appear to be ``free'' even though they form a
    central feature of executive compensation plans and obviously have very
    substantial costs.
        Enron used such options extensively, covering all their management
    employees and granting large awards to their senior executives. Sixty
    percent of Enron's employees had options. The cost of these options was
    never reported in Enron's earnings statements although the exercise
    gains were so great that in several years Enron paid no taxes.
        The IRS allows as a deduction for compensation expense the
    difference between the option price and the stock's price when it is
    exercised (for most employee stock options). But in reports to
    shareholders that difference, or any other amount, has never been shown
    as an expense. Through its long, tedious, but open process the FASB
    explored all theoretical aspects of stock options. It put out tentative
    proposals, conducted exhaustive hearings so that all participants could
    comment, and heard arguments pro and con. The process took several
    years.
        Many critics now say that the FASB is too slow, but at other times
    critics have said it was too fast, especially when the issue was an
    unpopular one such as stock compensation or derivatives. The final
    proposal would have required a charge to expense for stock options
    given to employees as compensation. After extensive lobbying of
    Congress by companies and auditing firms, and following legislative
    threats to the existence of private sector standard setting, the FASB
    and the SEC capitulated. Arthur Levitt has publicly stated that he
    believes this was the greatest mistake made by the SEC during his
    Chairmanship.
        In capitulating, the FASB published a rule in 1995, known as
    Financial Accounting Standard 123, that offers the choice of expense
    recognition or disclosure in footnotes. If disclosure is chosen, the
    income statement will show expense for options only under certain
    circumstances required by the Accounting Principles Board (the
    predecessor to the FASB) in its Opinion No. 25 (1972). The FASB said
    the following in FAS 123, a statement with which I completely agree:
    ``The Board chose a disclosure-based solution for stock-based employee
    compensation to bring closure to the divisive debate on this issue--not
    because it believes that solution is the best way to improve financial
    accounting and reporting.'' (Paragraph 62) So in other words,
    disclosure in footnotes is inappropriate reporting to shareholders of
    the costs of operations.
        As you might expect, most corporations prefer to use the obsolete
    accounting model of 1972 which treats the fixed-price stock option as
    ``free'' and treats performance options as potentially very expensive.
    Significantly, most companies use virtually no other form of stock
    award than the fixed at-the-money option. Note that the Black-Scholes
    option-pricing model was created a year later, in 1973, and forms the
    basis for understanding financial transactions involving uncertainty. I
    can assure you that high-tech executives in Silicon Valley use the
    Black-Scholes model to value their own options. Most companies also use
    Black-Scholes to communicate total compensation to employees. Those
    same executives know that having to show the results of that
    calculation to shareholders would reduce or even eliminate the earnings
    of their companies.
        I serve as a Director of the Boeing Company, which is the only
    major U.S. company to adopt the FAS 123 expense, in order to report to
    its shareholders the true cost of its stock compensation plan. Boeing's
    executive compensation plan is based heavily on tough performance tests
    which are prohibitively expensive under the 1972 accounting model used
    by all other companies. For the record, Boeing adopted its plan and FAS
    123 in 1996, before I became a Director.
        I might mention a further example of the strong-arm tactics of U.S.
    corporations. Last year the Financial Executives International issued a
    press release threatening to withdraw funding for the newly formed
    International Accounting Standards Board if the Board dared to study
    the issue of accounting for stock-based compensation. The use of
    options and stock as employee compensation is a growing phenomenon
    overseas, with little or no accounting guidance in place. I am happy to
    say that both Paul Volcker, Chairman of the Foundation supporting the
    IASB, and Sir David Tweedie, Chairman of the IASB, are standing their
    ground, and the project is proceeding.
        The use of questionable accounting methods--for stock options has
    several negative results:
        (1) Explosive growth in the use of stock options since 1995--huge,
    indeed, incredible awards to CEO's and in some companies awards to
    every employee. For several years, this practice has been a major
    concern addressed by TIAA-CREF's corporate governance program.
        (2) The serious distortion of earnings statements so that some
    companies report large earnings at the same time that no taxes are
    paid. This is because of peculiar accounting that results in fixed-
    price stock options as zero ``cost'' in public income statements while
    allowing the employee gain to be shown as a ``cost'' for the tax
    return.
        (3) Unprecedented focus on the stock price by all the employees of
    the company, to the point where serious ethical dilemmas are posed for
    employees. When excessive stress is placed on company accountants and
    their auditors, malfeasance may result. Business ethics experts wonder
    if potential ``whistleblowers'' are intimidated by their colleagues' or
    their own concern for their stock options.
        (4) The dramatic decline in dividends is a direct result of so much
    recent attention to stock options. A dollar per share paid to a
    shareholder as a dividend reduces the stock price by a dollar. Can
    anyone wonder why corporate managers find many reasons to justify a
    reduction or elimination of the dividend?
        (5) In many companies, stock options have replaced pension plans
    entirely. When we protested the action of IBM in abandoning its defined
    benefit plan, the company responded by pointing out that its
    competitors in the technology world had no pensions whatsoever.
        (6) There has been an almost exclusive use of the fixed-price stock
    option in employee compensation plans. More desirable stock
    compensation plans could be devised that would better align management
    and shareholder interests. Such plans are effectively prohibited by the
    1972 rules because they require that management show an expense for
    them. For example, a plan that requires performance better than the
    general market performance is not considered a ``fixed-price option''
    and results in truly onerous accounting treatment under 1972 rules.
    FASB Statement 123 provides sensible expense accounting for performance
    plans.
        I have long been a strong advocate for the principle that the
    private sector (for example, FASB or GASB [the Governmental Accounting
    Standards Board] or IASB) should set accounting standards. Congress,
    through the political process, should not enter into such technical
    issues, but it should demand a fair and open process. I stand by that
    view. Some expression of support by your Committee, or by the full
    Senate or House of Representatives--the form of which you understand
    better than I--might make it possible for the IASB to study the issue,
    and for the FASB to reopen the question.
        I believe that history would see this action as an extraordinary
    benefit coming out of the many lessons to be learned from Enron.
    Auditor Independence
        My company has two very important provisions in its Audit Committee
    Charter. (1) Our auditors may not do any work for TIAA-CREF other than
    what is directly related to the audit function (this exclusionary rule
    also applies to our tax work); and (2) rotation of the auditor is
    considered after a 5 to 10 year period. The first rule was heatedly
    contested by our auditors at the time we imposed it; our current
    auditors knew the rule when they began working for us in 1997 and now
    accept it. We have had two auditor rotations since I have been
    Chairman, and each has been not only successful but also highly
    energizing for our financial management work.
        I testified before your Committee in the fall of 2000 in favor of
    the SEC proposal to move partially to our first rule on independence. I
    was startled by the vehement opposition from several accounting firms
    and especially from their trade association. I thought much of their
    testimony was deeply suspect, especially the claims that few companies
    used their auditors for other work and that, when they did, it was a
    minor use. The facts revealed since the SEC required disclosure reveal
    the truth to be very different.
        At TIAA-CREF, we are currently considering shareholder resolutions
    to be filed with several companies on auditor independence. We are
    particularly concerned about the following relationships between
    companies and their audit firms: (1) Have they used the same audit firm
    for a very long time, say 20 to 30 years? (2) Does the audit firm have
    a high ratio of nonaudit fees to audit fees? and (3) Is the Chief
    Financial Officer, the Chief Accounting Officer, or any other financial
    manager a former employee of the audit firm?
        We will ask the Audit Committee members to report on, and sign
    their names to, a statement that they have considered the
    circumstances, including competitive bids from other audit firms, and
    that they believe their audit firm is independent and represents the
    shareholders and not management. We will also ask for a rationale for
    that belief.
        I am astonished at the number of companies my colleagues have
    identified that have all three relationships with their auditors. This
    is not to say that such companies have produced inappropriate financial
    reports. In reality, I believe most corporations have the right ``tone
    at the top.'' It is well-known in these companies that the CEO and CFO
    simply will not condone inappropriate accounting. Nevertheless, when
    that tone is wrong, as it appears to have been at Enron, the auditor
    will have to exhibit extraordinary strength to stand up to management
    and say, ``you cannot do this.'' Such auditors do exist, of course, but
    investors cannot count on their luck to be represented by such an
    auditor.
        Of course, Arthur Andersen's relationship with Enron was
    ``embedded'' to say the least. But it went even further. Enron
    management proposed to Arthur Andersen, and Andersen's senior
    leadership agreed, to replace Enron's internal auditors with Andersen
    personnel. Enron outsourced its internal audit function to its external
    auditor, Arthur Andersen. Shouldn't warning bells have gone off at
    either Andersen's head office, or at the Enron Board, that this was an
    inherent conflict? In the last couple of months, the major accounting
    firms and the AICPA have said that firms should not provide internal
    audit services to audit clients and financial systems design services.
        Finally, and perhaps most significantly, Arthur Andersen appears to
    have played the role of both tax counsel and investment banker to
    Enron, devising the questionable tax and off balance sheet strategies
    that ultimately imploded, but which the independent auditor--Arthur
    Andersen--was supposed to review. Again, where was the ``tone at the
    top'' at Andersen? Didn't anyone in Chicago say this was going too far?
    Were the millions in additional fees for such ``high value'' services,
    and ``high margins,'' too tempting to resist?
        There seems to me a widespread lack of sensitivity to conflicts for
    auditors that must be addressed. And there need to be more examples of
    lucrative opportunities turned down than there are.
        I applaud the recent changes made by the accounting profession on
    limiting the types of nonauditor work. Several of the firms saw the
    public need to do this in 2000 when the SEC proposed limitations. The
    others have grudgingly assented, arguing, to my astonishment, that the
    Andersen-Enron relationships had no independence problem.
        A far more powerful antidote to this blindness to conflicts of
    interest would be to require auditor rotation every 5 to 7 years. Such
    a requirement will be fiercely opposed by the accountants and the
    companies, who will see only additional costs of having to make such
    changes. But I can vouch from my experience that the costs can be
    managed and that there are many positive benefits. Even if the cost-
    benefit ratio were unfavorable, which I doubt, isn't such a simple
    solution worthwhile, given the importance to our capital markets of
    confidence in financial reports?
        Consider the advantages of rotation for issues of independence that
    concern us.
        First, rotation reduces dramatically the financial incentives for
    the audit firms to placate management. If the audit firm has a kind of
    virtual perpetuity of millions in fees every year (from whatever
    source), the present value of that relationship is enormous: In the
    Enron case, probably over a half-billion dollars, given that total fees
    paid to Arthur Andersen for fiscal year 2000 were $52 million. That
    amount could be even higher if one considers the potential growth in
    ``cross sold'' services. On the other hand, if the audit firm has a
    limited term, the present value is cut by two-thirds or more. And in
    the final year of a 5 year term it has little value. Economic
    incentives are important, especially to accountants trained to
    understand them. Rotation would help contain financial incentives to
    manageable levels.
        When overseen by the Public Oversight Board, peer reviews have been
    useful in improving quality controls in audit firms. Typically, they
    are conducted carefully by serious professionals, and they have been
    expensive. But peer reviews are a weak self-regulatory tool, and they
    appear to be universally criticized as inadequate.
        Consider the peer review aspects of mandatory rotation. Had
    rotation been in effect at Enron in 1996, and Arthur Andersen had known
    that a new auditor would be appointed for 1997, and that the new
    auditor would do an exhaustive review of the former audit work papers,
    it is likely that Arthur Andersen would have assured that transactions
    and documentation were fully transparent. A thorough ``real-time'' peer
    review would be truly effective. A strongly constituted, independent,
    and authorized regulatory board to oversee the auditing profession
    might also ask for a brief, signed peer review report from the new
    auditor. None of this would be costly unless there were troubles, as
    there were at Enron.
        Clearly, had Enron been required to rotate its auditors every 5 to
    7 years, it is unlikely that misleading financial reporting would have
    continued or that the Board's Audit Committee would have been kept in
    the dark, as they claim they were. It is also conceivable that, if they
    had been confronted by a group of different noncompliant auditors,
    senior management might have hesitated to engage in some of the
    financial manipulation they appear to have carried out. Honest
    financial reporting from the beginning also would likely have resulted
    in more reasonable stock valuations.
        Rotation, furthermore, reduces the problem of cross-selling other
    services and is likely to eliminate the revolving door that allows
    former auditors to become the top financial officers of the audited
    company. For example, by the time the former KPMG partner becomes CFO,
    the new auditor might be PricewaterhouseCoopers, Deloitte & Touche, and
    so on.
        I believe rotation of auditors will not become a practice without
    explicit action by Congress. I strongly urge this Committee to consider
    the benefits such a change would make in the U.S. financial world.
    A Strong Regulatory Model
        The Public Oversight Board (POB) on which I have served for the
    past several months, attempted to oversee a bewildering array of
    monitoring groups. One was the Quality Control Inquiry Committee (QCIC)
    that reviews auditor performance in contested audits (for example,
    where a lawsuit had been filed). A second was the Peer Review Board
    that participates in inter-firm peer reviews.
        There were others as well. The POB oversaw the Professional Ethics
    Executive Committee (PEEC) that reviews members' actions in all types
    of ethical issues. It oversaw the Auditing Standard Board (ASB) and the
    SEC Practice Section (SECPS). Finally, the POB had the opportunity to
    raise questions with the FASB if accounting standards seemed in need of
    repair.
        Being a nonaccountant and an independent director, I found the POB
    very hard work, especially for a sitting CEO. The other four members
    were retired, and I succeeded Paul O'Neill who, as you know, moved from
    retirement to a very active position. What was often most frustrating
    was our lack of authority if we found something that we thought should
    be changed. While the major firms and the AICPA were outwardly
    cooperative when the SEC demanded action, they were unwilling to change
    in response to any significant POB initiative. At one point, the AICPA
    threatened to withhold funding from the POB, but was finally forced by
    the SEC into an unwilling marriage, documented by a new charter that
    gave us assurance of being able to pay our staff. No one will really
    miss us after March 31.
        In short, we need something better for a regulatory body. Elements
    of Chairman Harvey Pitt's proposal certainly move in the right
    direction, but I believe the proposed entity needs more authority. And
    that authority can come only from Congress.
        The investigative authority of a new accounting regulatory body
    needs to be clear-cut and not simply a derivative of the SEC.
    Accounting firms must know that they cannot refuse to open their books
    or prevent their staff from cooperating with this new agency. Of
    course, it must have the ability to keep the information gathered out
    of the hands of the litigating lawyers. And it must have the authority
    to discipline firms and individuals without the delays of an AICPA
    investigating process.
        The new agency must have licensing authority, beyond that of the
    States, for individuals who will practice at the SEC bar. It should
    have authority, I believe, to approve or to disapprove business
    affiliations of licensed practitioners--for example, is it appropriate
    for American Express or for H&R Block to become major players in
    providing audit services? Should accounting firms with an SEC audit
    practice be allowed to go into all the major financial businesses that
    the Big 5 have now entered?
        The new agency should also have a reliable funding source that does
    not come from the accounting profession on a voluntary basis. Nor
    should it come from the business community through the ``tin-cup''
    process now used by the Financial Accounting Foundation and the
    Foundation for the International Accounting Standards Board.
        Concerning this point, I have served on fund-raising committees for
    both the FASB and the IASB. I can assure you that voluntary giving to
    support the regulation of the auditing profession will not work.
    Raising money for a much more benign purpose--for instance,
    establishing accounting principles in the private sector--has been a
    very tough sell. Those of us asking for the money feel compromised. The
    unspoken question is this: ``If I give, will I have more influence on
    FASB decisions?'' The investment community has largely refused to
    support either the FASB or the IASB, with a very few exceptions to that
    rule. The usual contributors are those with a strong sense of community
    interest--the major banks, investment banking concerns, and several
    large global businesses.
        We should devise instead a fee on stock market transactions, or
    registrations, or some other financial activity that will be devoted to
    paying for auditing oversight, the work of the Financial Accounting
    Foundation, and perhaps even the American share of the IASB's needs.
        Given the welcome demise of the POB, the ball is squarely in the
    court of Congress and the SEC to define a strong regulatory body. It
    should have real teeth, adequate funding (without membership fees from
    the very institutions the new body will regulate), and a fair chance of
    bringing a new ethic and culture to a profession that needs to change.
        It is my hope that we will succeed in these three areas: First,
    that we can make companies provide transparent accounting for stock
    options; second, that we can assure greater independence of auditing
    through auditor rotation; and third, that a strong regulatory body can
    be created. If these goals are reached, I believe we may look back on
    Enron as being a short-term financial tragedy for its employees and the
    holders of its securities, but a major long-run benefit for U.S.
    capital markets.
        Thank you for giving me time to express my views on these important
    matters.

                     PREPARED STATEMENT OF IRA M. MILLSTEIN

           Co-Chairman of the Blue Ribbon Committee on Improving the
                  Effectiveness of Corporate Audit Committees
                  Senior Partner, Weil, Gotshal & Manges, LLP
                               February 27, 2002

        Chairman Sarbanes, Ranking Member Gramm, and Members of the
    Committee: I am pleased to appear before you in my capacity as the Co-
    Chairman of the Blue Ribbon Committee on Improving the Effectiveness of
    Corporate Audit Committees (Committee on Audit Committee
    Effectiveness). This Committee was convened in 1998 by the New York
    Stock Exchange (NYSE) and the National Association of Securities
    Dealers (NASD) at the request of Securities and Exchange Commission
    Chairman Arthur Levitt. The Report that we issued in 1999 addressed
    concerns that are closely related to the concerns about the integrity
    of financial reporting, the audit and accounting profession and
    corporate governance that are at the heart of this hearing.
        At the outset, be advised that I am a Senior Partner in the
    international law firm of Weil, Gotshal & Manges, LLP. Several months
    ago, in the fall of 2001, my firm was hired to counsel Enron in its
    bankruptcy restructuring. The firm was not regular counsel to Enron
    previously. I am not actively engaged on the Enron matter, although my
    partners have consulted with me from time to time on certain corporate
    governance issues relating to the bankruptcy. I have no knowledge of
    the events leading up to the bankruptcy filing other than what has
    appeared in the media. In addition, over the years my firm has
    represented Arthur Andersen in litigation and other matters unrelated
    to Enron. I have no knowledge of Andersen's relationship to Enron,
    other than what has appeared in the media.
        My testimony today as the Co-Chairman of the Committee on Audit
    Committee Effectiveness does not necessarily reflect the views of Weil,
    Gotshal & Manges, LLP or any of my partners. I have not consulted any
    client in regard to this testimony, and therefore it does not reflect
    the views of Enron, Andersen, or any other client of my firm.
        You have asked that I provide recommendations for legislative and
    for regulatory responses to what appears to be an increasing incidence
    of high-profile financial reporting and governance failures in recent
    years. Throughout my career I have counselled corporate boards,
    managers and investors on various corporate governance and regulatory
    matters and have studied closely our system of corporate governance
    regulation. (In addition, I have taught graduate business school
    courses on corporate governance at Yale, Harvard, and Columbia.) Over
    this period, one element has remained constant: Our market system is
    not static; it is dynamic--constantly changing. Our corporate
    governance system continuously adjusts and improves in response to
    failures, whether through voluntary adjustment of board practice, new
    listing rule requirements, amendments to SEC disclosure rules, or
    various related pieces of legislation, for example, in the area of tax
    incentives. These high-profile corporate governance failures should not
    be interpreted, therefore, as failures of capitalism or capital
    markets. Rather, these failures should be viewed as cause for further
    adjustments and corrections to our corporate governance system. Such
    adjustments should focus on the factors that are key to the problems
    emerging in today's corporate environment: Management incentives, true
    independence and diligence on the part of corporate directors--who are
    charged with monitoring managers--and the professionalism of those upon
    whose advice directors need to rely in carrying out their role. These
    events present a challenge for all of us to avoid overreacting, and to
    limit our interventions to fine-tuning a system that usually works
    well.

    The Current Problem
        I will focus today on what I consider the core of the current
    problem: The incentives and disincentives that can drive managers and
    boards and those who advise them to push to the limit, and sometimes
    beyond, the numbers that are meant to reflect the company's financial
    performance and health. We should seek incentives and disincentives
    that are more carefully attuned to the pressures in the current
    environment.
        I wish we could solve today's problems by urging all participants
    in our market system, and particularly in our corporate governance
    system, to act moderately and prudently, fairly and ethically. If all
    did so, corrective action would not be necessary. As Oliver Wendell
    Holmes recognized, however, humans cannot be expected to act
    moderately, prudently, morally and ethically at all times.\1\ He noted
    that law and regulation generally, therefore, must address, by
    providing countervailing incentives and disincentives, the prospect
    that self-interest may lead persons to act ``badly.'' This applies to
    the corporate governance regulation as well. Self-interest--which a
    market system relies heavily upon--can interfere with the moral,
    ethical, and legal obligations of directors and managers to protect and
    enhance the assets of the corporation that are committed to their care
    by, and for the benefit of, others.
    ---------------------------------------------------------------------------
        \1\ Oliver Wendell Holmes, ``The Path of the Law,'' in The Path of
    the Law and its Influence: The Legacy of Oliver Wendell Holmes, Jr.,
    333, at 335 (Steven J. Burton, ed., 2000).
    ---------------------------------------------------------------------------
        An effective system of corporate governance must strive to channel
    the self-interest of managers, directors, and the advisors upon whom
    they rely into alignment with the corporate, shareholder, and public
    interest.
        In just the last decade, management has faced increased market
    pressures for short-term stock price performance and corresponding
    pressures to satisfy market expectations on a quarterly basis. This,
    coupled with increasing grants to senior executives of stock options
    and other incentives that are focused on short-term stock appreciation,
    may have created incentives that tipped the balance toward the
    promotion of self-interest rather than the protection and promotion of
    long-term shareholder value. As one of the country's leading
    compensation experts noted recently:

              It is . . . possible that stock option grants have become so
            large at top management levels that they encourage high risks
            to reap high rewards. Perhaps the power of incentives to
            motivate is not linear. If stock options are good, are more
            stock options better? Once stock option grants have become
            sufficient in amount to provide the right balance between
            operational and market incentives, whatever that amount is,
            what is the purpose in granting more? Is it merely wasteful, or
            is it possible that it goes beyond waste to create perverse
            incentives that destabilize a company? \2\
    ---------------------------------------------------------------------------
        \2\ Frederick W. Cook & Co., Inc. Memorandum re: The Implications
    of ``Enron'' for Executive and Director Compensation at 2 (February 6,
    2002) (``Frederick W. Cook Memorandum''). (A copy is attached as
    Exhibit A.)

        These concerns are magnified when the integrity of the independent
    auditors, financial and investment advisors and analysts, and lawyers
    upon whom directors, managers, and the public rely for a fair picture
    of the company's performance and prospects, may also be skewed by self-
    interest.
        In a general sense, these are not new concerns. The key issue in
    corporate governance regulation throughout the history of the joint-
    stock corporation, as recognized by Adam Smith in 1776, reiterated by
    Adolph Berle and Gardiner Means in 1932,\3\ and repeated by numerous
    observers since, has focused on the ``agency problem'': It is a given
    that directors and managers are fallible human beings (like all of us).
    Therefore, they may not always subordinate their self-interests to the
    interests of those on whose behalf they are acting. And this is true of
    auditors, analysts, and lawyers as well. This ``agency problem'' should
    be periodically reassessed to account for the circumstances of each
    era.
    ---------------------------------------------------------------------------
        \3\ Adam Smith, An Inquiry into the Nature and Causes of the Wealth
    of Nations, Vol. II at 264-65 (E. Canaan edition, 1776); Adolph Berle &
    Gardiner Means, The Modern Corporation and Private Property, at 123
    (1932).
    ---------------------------------------------------------------------------
        Over the past decade and a half, these issues have gained
    considerable attention as they relate to publicly-traded corporations.
    In particular, added emphasis was given to the importance of board
    composition, as well as to increased transparency about corporate
    governance processes and structures. With respect to board composition,
    the theory is that a board of directors comprised of a majority of
    knowledgeable individuals who are not members of management and who
    lack business or family ties to management will be more likely to
    provide effective oversight of the managers, and circumscribe the
    ``agency problem.''
        A number of recommended corporate governance best practice
    guidelines have issued from various sources.\4\ In addition, the tax
    code now provides tax incentives for certain performance-based
    compensation decisions when made by a committee of outside
    directors.\5\ Notably, within the past 2 years, listing rules of the
    NYSE, AMEX, and Nasdaq were amended to require that every listed
    company have an audit committee comprised of at least three independent
    members.\6\ At the same time, SEC disclosure requirements were amended
    to require a significant amount of disclosure by audit committees,
    including disclosures about audit committee consideration of auditor
    independence.
    ---------------------------------------------------------------------------
        \4\ See National Association of Corporate Director (NACD), Report
    of the NACD Commission on Director Professionalism (1996, reissued
    2001); The Business Roundtable, Statement on Corporrate Governance
    (1997); American Federation of Labor and Congress of Industrial
    Organizations (AFL -CIO), Investing in Our Future: AFL -CIO Proxy
    Voting Guidelines (1997); California Public Employees; Retirement
    System (CalPERS), U.S. Corporate Governance --Core Principles &
    Guidelines (April 13, 1998); Teachers Insurance and Annuity
    Association-College Retirement Equities Fund (TIAA-CREF), TIAA-CREF
    Policy Statement on Corporate Governance (2000); Counsel of
    Institutional Investors, Core Policies, General Principles, Positions &
    Explanatory Notes (2001). See also Organisation for Economic
    Cooperation and Development (OECD) Ad Hoc Task Force on Corporate
    Governance, OECD Principles of Corporate Governance (May 1999),
    available at www.oecd.org/daf/governance/principles.htm (setting forth
    international principles of corporate governance).
        \5\ I.R.C. Sec. 162(m).
        \6\ See Order Approving Proposed Rule Change by the NYSE, Exchange
    Act Release No. 42233, File No. SR-NYSE-99-39; Order Approving Proposed
    Rule Change by the AMEX, Exchange Act Release No. 42232, File No. SR-
    Amex-99-38; Order Approving Proposed Rule Change by the NASD, Exchange
    Act Release No. 42331, File No. SR-NASD-99-48.
    ---------------------------------------------------------------------------
        We have had only 1 year of experience under the new listing and SEC
    rules, so it may be premature to determine whether these improvements
    have had the intended impact. Nonetheless, we should now dig down and
    address root causes of the problems that have arisen.
        One matter that requires attention is, as noted above, the possible
    over-reliance on compensation devices for managers and directors that
    are unduly linked to short-term stock market price performance. This
    link may cause managers and directors to focus too heavily on their own
    self-interest in short-term stock appreciation. As long as the
    investing public focuses on short-term stock price performance rather
    than long-term growth--and this is not something that will readily
    change (and analysts and bankers play a role here)--we cannot expect
    corporate managers to be fully resistant to market pressures. This
    pressure is exacerbated when managers receive compensation that
    permits, and even induces, taking advantage of short-term rises in
    stock price.
        The markets tend to pressure managers to ``make the numbers,'' and
    self-interest compounds the problem. The boards and regulators need to
    keep this in mind. They can and should focus on creating countervailing
    incentives. This same concern extends to those advisors whom directors
    must rely on to carry out their crucial oversight role.
        Another leading compensation expert predicts that boards are
    learning that heavily concentrating compensation on short-term market
    priced incentives, rather than on ``real'' economic performance, is not
    good for the business--and that boards will self-correct:

              Re-balancing executive pay will be a major theme, as
            companies seek to reduce their reliance on the stock market and
            realign their compensation programs to pay for ``real''
            strategic and financial performance. There will be a new
            appreciation that successfully growing and running a business
            are of greatest value to shareholders in the long run, even if
            those efforts are not reflected in short-term stock price
            movement. This realization will result in some shift of
            compensation dollars from options to long-term incentives and
            to full-value stock grants earned on a performance basis.\7\
    ---------------------------------------------------------------------------
        \7\ Pearl Meyer & Partners Memorandum re: Executive Pay Trends:
    Looking Forward and Back at 2 (February 2002) (Pearl Meyer Memorandum)
    (A copy is attached as Exhibit B).

        Even if this prediction about the developing trend in management
    compensation is accurate, in today's environment many may question
    whether this change will be broadly enough felt to deter future
    corporate governance failures without a push from regulators and/or
    legislators.

    The Central Role of the Board in Controlling the ``Agency Problem''
        The board is the focal point of our corporate governance system.
    Pursuant to State statutes, it is elected by and accountable to the
    shareholders, and is charged generally with directing the affairs of
    the corporation.\8\ The board fulfills its role by delegating
    managerial authority to the managers, which it hires, monitors
    incentivizes (compensates) and replaces when necessary. The board also
    is charged with oversight of the company's financial reporting and
    legal compliance. To do all this, it can--and must--reasonably rely on
    advice from professionals. Under our system, while management is
    responsible for maintaining the corporation's financial records and
    completing its financial reports, it is the outside auditors who
    provide assurance that the financial reports comply with generally
    accepted standards. The board selects the outside auditors and is
    charged with ensuring auditor independence necessary for attaining that
    assurance. The board also has available the advice of legal counsel to
    help assess the company's disclosure and other compliance obligations.
    ---------------------------------------------------------------------------
        \8\ See e.g., Del. Gen. Corp. Law Sec. 141 (CSC 2002).
    ---------------------------------------------------------------------------
        The board is not positioned to (and hence does not) manage, audit,
    practice law or render advice on the short- and long-term reactions of
    the market. Rather, it delegates to management, and then monitors the
    management and performance of the company, all on behalf of
    shareholders and the company.\9\ In so doing, the board is entitled to
    reasonably rely on information and advice provided by managers,
    auditors, lawyers, bankers, and others.
    ---------------------------------------------------------------------------
        \9\ See American Law Institute, Principles of Corporate Governance:
    Analysis and Recommendations Sec. 3.02 (1994).
    ---------------------------------------------------------------------------
        However, the board faces constraints in its monitoring ability that
    it must take into account related to pragmatics, capacity and context:

     Managers need flexibility to take the reasonable risks that
        are at the heart of entrepreneurialism; directors who constantly
        second-guess management's reasonable business judgments risk
        stifling management performance.
     Boards are comprised, increasingly, of directors who are not
        members of management, with good reason. However, this means that,
        as stated above, boards must place considerable reliance on
        managers for information about company affairs and performance and,
        therefore, there will always be some risk of both intentional
        malfeasance and unintentional failure going undetected at the board
        level for some period. This highlights the legal and practical
        importance of the reports that management (and professional
        advisors) make to boards. In the investigations now going on,
        sufficient attention should be given to this and to the
        consequences of inaccurate or misleading reports to directors.
     Much of what impacts company performance and can effect
        manager incentives may be outside the board's control, including
        the market's short-term focus and occasional ``irrational
        exuberance.''
    The Committee on Audit Committee Effectiveness and Ensuing Reforms
        Throughout the mid to late 1990's, the SEC expressed increasing
    concern about the integrity of financial reporting by publicly-traded
    corporations, fueled by a perception that corporate managers faced ever
    increasing pressures to match or exceed market analysts' expectations.
    The expressed concern was that this pressure would lead to increased
    corporate efforts to ``manage'' earnings--to push the boundaries of the
    Generally Accepted Accounting Principles in preparing the company's
    financial reports, and thereby obscure the true condition of the
    company. In 1998, the SEC encouraged the NYSE and NASD to convene a
    private-sector Committee on Audit Committee Effectiveness to study the
    issues and make recommendations for encouraging greater financial
    reporting oversight by audit committees. I had the honor of Co-Chairing
    the committee with John Whitehead. (A copy of our Report and
    Recommendations [the Report], which includes a full list of committee
    members, is attached as Exhibit C.) Our Report contained 10
    recommendations, focusing on:

     Strengthening the independence of the audit committee.
     Improving audit committee operations.
     Improving mechanisms for discussion and for accountability
        among the audit committee, the outside auditors and management.

        Our premise was that if boards and their auditors accepted a clear
    delineation of responsibilities for financial reports and the reporting
    process, and then acted diligently, the problem would self-correct. Our
    recommendations aimed to support a culture of integrity and
    independence. Soon after the Report was released, the vast majority of
    our recommendations were adopted. (They are attached hereto as Exhibit
    D.)
        Audit committees of large publicly-traded corporations appear to be
    abiding by the new rules. To the extent that corporate culture has been
    resistant to change at some companies, the current widespread concerns
    about auditor independence and the quality of financial reporting
    combined with media attention and the fear of shareholder litigation
    and reputational effect, are likely to shock audit committees into
    action. It may be premature to determine whether these improvements
    have yet had the intended impact. Nonetheless, it is appropriate to
    take a hard look at whether additional legislation, SEC regulation or
    listing rules could strengthen independence, provide more appropriate
    incentives and thereby help to restore investor confidence.
        Significant legislative initiatives are already underway--at last
    count, Westlaw listed over fifty pieces of Enron-related
    legislation.\10\ In addition, the SEC has proposed certain disclosure-
    related reforms and is considering others. Recently, it asked the NYSE
    and NASD to review corporate governance listing requirements.\11\ The
    suggestions that follow incorporate and build upon a number of
    suggestions advanced by others that I believe bear consideration.
    ---------------------------------------------------------------------------
        \10\ A complete list of proposed legislation is available from the
    Enron-bills database found at http://www.westlaw.com, searching the
    terms ``House'' or ``Senate.''
        \11\ See Press Release, Securities and Exchange Commission, Pitt
    Seeks Review of Corporate Governance, Conduct Codes (February 13,
    2002), available at http://www.sec.gov/news/press/ 2002-23.txt.
    ---------------------------------------------------------------------------
    Board Independence
        Further and more serious consideration needs to be given to the
    issue of board independence, including the issue of independent board
    leadership. Providing objective judgment as to managerial performance,
    compensation, incentives, and all other oversight matters is at the
    heart of what boards are supposed to do. Best practice recommends that,
    to ensure objective judgment in assessing management, boards of listed
    companies be comprised primarily of outside directors who in form and
    substance--relationships, attitude, and perspective--are independent of
    management.\12\ Attitude and perspective cannot be regulated, but
    conditions can be set to reduce the possibility that certain
    relationships between managers and directors will taint objectivity,
    and other conditions can be set to create an environment in which the
    right attitude and perspective is promoted. Other than the listing
    rules pertaining to audit committees (and certain tax incentives
    applicable to compensation committee decisions \13\), there is today no
    mandate regarding board independence and no widely applied definition
    of independence.
    ---------------------------------------------------------------------------
        \12\ See supra note 4.
        \13\ I.R.C. Sec. 162(m).
    ---------------------------------------------------------------------------
        As to the issue of board leadership, we need to reconsider whether
    a corporate executive can adequately serve the board leadership
    function while heading up the management team that the board is charged
    with monitoring and incentivizing. Generally, managers disfavor
    separating the Chairman and CEO titles. In the United States, the
    expectation among CEO's is that the culmination of a successful career
    includes the title of ``Chairman and CEO.'' (Note, however, that this
    was the expectation in the U.K. as well, until the Cadbury Code--and
    now the Combined Code--recommended that two individuals hold the
    positions. Disclosure of the degree of compliance with these Codes was
    mandated by the listing rules of the London Stock Exchange. In the past
    decade, the practice of combining the titles--and related
    expectations--have changed significantly in the U.K., due solely to the
    pressure of this disclosure requirement.) Leading the board and leading
    the company are two very distinct and important jobs. Certain aspects
    of the board's leadership role--those concerned with leading the review
    of management performance, including compensation, and potential
    management transactions with the corporation--present a conflict of
    interest that makes it difficult, if not impossible, for a company
    executive to fulfill that role. Therefore:

     Boards of publicly-traded corporations should be required
        (through listing standards) to include a majority--I would call for
        a substantial majority--of the ``independent'' directors under a
        strict definition of independence (ideally the same definition that
        applies to the audit committee, albeit with some refinement as
        described below).\14\
    ---------------------------------------------------------------------------
        \14\ The SEC has asked the listing bodies to review corporate
    governance requirements. Press Release, Securities and Exchange
    Commission, Pitt Seeks Review of Corporate Governance, Conduct Codes
    (February 13, 2002), available at http://www.sec.gov/news/press/2002-
    23.txt. See also The Fall of Enron: How Could It Have Happened? Hearing
    Before the Senate Committee on Governmental Affairs, 107th Congress
    (2002) [hereinafter Governmental Affairs Hearings] (Statement of Arthur
    Levitt, Jr., former Chairman of the Securities and Exchange Commission
    (1993-2000) ), available at http://www.senate.gov/~gov__ affairs/
    012402levitt.htm (``[S]tock exchanges, as a listing condition, should
    require at least a majority of the directors on company boards to meet
    a strict definition of independence.) The current independence
    definitions applicable to the audit committees of listed companies can
    be found in the sources listed in Note 6.
    ---------------------------------------------------------------------------
     The definition of director independence provided in the
        listing rules (for audit committee purposes) should be reviewed to
        determine whether it adequately addresses all the relationships
        that may reasonably be expected to reduce independence. In
        particular, this review should consider relationships between
        directors and charities and educational institutions that receive
        significant grants from the corporation, and any consulting or
        other fee arrangements (other than regular compensation, within a
        usual range, for serving as a director) between directors and the
        corporation.\15\
    ---------------------------------------------------------------------------
        \15\ Id.
    ---------------------------------------------------------------------------
     Boards of publicly-traded corporations should be required
        (through listing standards) to constitute a compensation committee
        (much as they are currently required to have an audit committee)
        with entirely independent directors, using the strict definition of
        independence.
     Boards of publicly-traded corporations should be encouraged
        through SEC disclosure requirements (or even required through
        listing requirements) to separate the position of CEO from that of
        board leadership. Board leadership should be provided by a
        nonexecutive director; one who is independent in all aspects. I
        would urge that this independent leadership be formalized in the
        position of Chairman, but title can be left to each board to
        decide.
     As a matter of best practice, independent directors and
        independent board committees--including the audit committee and
        ideally the compensation and nominating/governance committees--
        should play a larger role in setting the ``tone at the top.'' They
        should bear responsibility for company culture vis-a-vis financial
        reporting and ``making the numbers,'' compensation and incentive
        decisions, management stockholding and trading policies, and
        policies concerning management transactions involving conflicts of
        interest.
     Although, the tone at the top cannot be mandated, the boards
        of listed companies should be required or encouraged (through SEC
        disclosure and listing requirements) to adopt, regularly review and
        disclose a corporate code of conduct that addresses conflicts of
        interest and management and director stockholding and trading
        policies. Clearly, the board should be responsible for overseeing
        its implementation and its actions taken by boards to implement
        these policies should be disclosed, including any exceptions
        granted under the policies and the reasons therefore.
     It may be time to consider whether boards should be encouraged
        to rely on a small full time staff or regularly use outside
        advisors for support. Board work, for larger corporations, requires
        significant information, time and attention. For the board as a
        collective group of individuals who convene on a part-time basis to
        fulfill all that we expect may require more support than
        traditionally has been available. It may be fruitful for some staff
        resources to be explicitly devoted to supporting the work of the
        board. We should consider ways to encourage boards, or the
        independent directors as a group, to have available some staff and
        counsel resources of their own, distinct from staff and counsel
        hired by management, especially where potential conflicts with the
        interests of management are apparent (for example, audit and
        compensation).

        Changes along the lines outlined above would encourage boards to be
    more vigilant and diligent in protecting shareholder value and in
    devising the best means to deal with the risk that self-interest will
    diverge from the corporate, shareholder and public interest.
        In considering these and similar measures, one should keep in mind
    the variety within the universe of publicly-held companies in the
    United States, not to mention the tremendous variety among companies in
    the rest of the world who compete in what is rapidly becoming one
    global capital market. In a market economy, variety and diversity can
    be a source of strength. We should be careful that any norms that are
    established be flexible enough to accommodate this diversity.
    Experience with corporate governance listing standards in the United
    Kingdom and Canada, suggest that often a ``comply or explain'' regimen
    is sufficient to induce widespread adoption of recommended practices
    without undue restriction on diversity.\16\ Specifically, under such a
    system, a company is required to publicly disclose whether it follows
    the normative, yet voluntary, standard and to explain the reasons for
    any noncompliance. This allows flexibility while still asserting
    reasonable pressure for compliance. It also provides investors
    significant amounts of information about the governance of companies,
    which can be used for investment and voting decisions. It may be time
    to consider what should be embedded in mandatory listing requirements
    and what should be encouraged through flexible ``comply or explain''
    disclosure requirements. But more yet may be needed.
    ---------------------------------------------------------------------------
        \16\ See London Stock Exchange Committee on Corporate Governance,
    The Combined Code: Principles of Good Governance and Code of Best
    Practice (July 1998), available at www.ecgn.org; Toronto Stock Exchange
    Committee on Corporate Governance in Canada, ``Where Were The
    Directors?'': Guidelines For Improved Corporate Governance in Canada
    (Dey Report) (December 1994), available at www.ecgn.org.
    ---------------------------------------------------------------------------
    Compensation Issues --The Core
        The growing practice of compensating managers with stock and stock
    option grants, which managers are then allowed to sell or exercise
    within a relatively short period of time --and during their tenure at
    the company-- can, as noted above, create inappropriately short-term
    and stock-price focused incentives, and thereby exacerbate the agency
    problem in the context of a short-term oriented market. Performance
    compensation based on a snapshot of stock market performance at a
    single point in time chosen by the manager may not provide incentives
    for the kind of management activity that is ``good'' for the company
    and shareholders as a whole in the long run.
        Over the past decade, companies have turned increasingly to stock-
    based compensation both as a form of pay-for-performance and as a means
    of aligning the self-interests of managers with the interests of
    shareholders. Indeed, I was among those who urged stock compensation as
    a method of aligning the interests of management (and directors) with
    shareholder interests. However, when managers are compensated with
    significant stock awards or stock options and are allowed to trade in
    that stock in the short-term (subject only to insider trading
    restrictions), their self-interest in relatively short-term stock
    market fluctuations may conflict with their need to focus on both the
    long-term viability of the company and improvements in its long-term
    profitability. In particular, the focus on stock-based compensation,
    without conditions linking stock awards to realization by managers of
    long-term performance goals, may have put in place incentives that
    promote managerial self- interest to diverge from the corporate,
    shareholder and public interest. In some cases, such compensation may
    have crowded out other more traditional means of compensation that
    supported a longer term view, thereby producing an imbalance in
    incentive compensation that is especially counterproductive.
        In 1996, Yale economist Paul W. MacAvoy and I co-authored a paper
    entitled ``The Board of Directors in the American Corporate Form as the
    Instrument for More Effective Governance.'' \17\ (A copy is attached as
    Exhibit E.) In it, we discussed the use of stock in pay-for-performance
    schemes and, in particular, the inappropriate incentives that linking
    such schemes solely to short-term movements in stock price might
    create. We said:
    ---------------------------------------------------------------------------
        \17\ Paul W. MacAvoy & Ira M. Millstein, ``The Board of Directors
    in the American Corporate Form as the Instrument for More Effective
    Governance,'' in The David Hume Institute: The First Decade (1996).

              Stock [based compensation] plans should be further refined to
            motivate the managers to achieve longer term growth and to
            sharpen their concern for the value added from improved
            strategies. Stock grants can be programmatic, but with sales
            restrictions, or even postponement of sales until retirement,
            so as to focus incentives on the long term.\18\
    ---------------------------------------------------------------------------
        \18\ Id at 7.

        Directors should seriously rethink stock-based compensation that
    creates short-term incentives to raise stock price rather than long-
    term incentives to improve performance and enhance value appreciation.
    It is with these concerns in mind that I recommend the following for
    ---------------------------------------------------------------------------
    consideration:

     Pay-for-performance programs should be linked to measures of
        profitability or economic value added rather than short-term
        changes in stock market valuation. In any event, they should be
        designed to consider company performance relative to peer group
        performance, and not simply generalized stock market performance.
        Although I have some reservations about the use of the tax laws to
        further corporate governance policy, consideration could be given
        to creating a stricter definition of what constitutes ``performance
        based'' compensation for purposes of Section 162(m) of the Internal
        Revenue Code.
     Mechanisms should be developed to encourage executives and
        directors to hold stock they receive, whether in the form of stock
        grants or stock options, for a significant period of time. Ideally,
        companies should restrict or discourage sale of company stock
        during a director's tenure and require or encourage significant
        holding periods for executives.\19\ (Of course, some flexibility
        may be required for special circumstances, for example, for start-
        ups that lack sufficient cash to pay executives what they are
        worth.) Again, while tax solutions pose concerns, consideration
        could be given to creating tax incentives designed to encourage
        executives to hold stock. Such incentives could include, for
        example, gradually reducing over some period of years the tax rate
        for grants of stock or exercise of options from the rate applicable
        to ordinary income to the most favorable rate for long-term capital
        gains. Alternatively, tax incentives could be created to encourage
        companies to contractually restrict the ability to transfer stock
        in grants of stock and stock options.
    ---------------------------------------------------------------------------
        \19\ Holding restrictions could apply to all stock received, or
    just apply to a high percentage (80 to 90 percent). See Cook, supra
    note 2, at 4 (discussing retention ratios in the context of company
    ownership guidelines or policies).
    ---------------------------------------------------------------------------
     Prompt disclosure of all transactions in the company's stock
        by corporate executives and directors should be required.\20\ At
        the very minimum, the current rules that allow for once-a-year
        disclosure of sales of stock back to the company should be
        eliminated.
    ---------------------------------------------------------------------------
        \20\ See Accounting and Investor Protection Issues Raised by Enron
    and Other Public Companies: Oversight Hearing Before the Senate
    Committee on Banking, Housing, and Urban Affairs, 107th Congress (2002)
    [hereinafter Banking, Housing, and Urban Affairs Hearings] (statement
    of Richard C. Breeden, former Chairman, Securities and Exchange
    Commission (1989-1993) ), available at http://banking.senate.gov/
    02__02hrg/021202/breeden.htm (suggesting that disclosure of all stock
    transactions by senior corporate executives be sped up); see also
    Legislative Solutions to Problems Raised by Events Relating to Enron
    Corporation Hearing Before the House Subcommittee on Capital Markets,
    Ins. and Gov't Sponsored Enter., 107th Congress (2002) (Statement of
    Harvey L. Pitt, Chairman, Securities and Exchange Commission),
    available at http://www.sec.gov/news/testimony/020402tshlp.htm (``One
    area of possible legislation already identified is the need to require
    corporate insiders to make public their trading activities more quickly
    than current law requires.'').
    ---------------------------------------------------------------------------
     The directors should be compensated fairly for the time
        necessary to fulfill their responsibilities. As a matter of best
        practice, however, stock options should be avoided altogether--
        especially those exercisable within a short period. ``The
        motivation of directors are and should be different from those of
        management. Directors are not strategic partners with management in
        creating value for shareholders; they are guardians of
        shareholders' interests.'' \21\ And directors should be discouraged
        from selling stock in the company during their tenure.
    ---------------------------------------------------------------------------
        \21\ Cook, supra note 2, at 6.

        These recommendations may seem a bit draconian, given what became
    the widely accepted compensation trend in the 1990's. However, before
    the widespread use of such compensation devices, U.S. corporations and
    the economy succeeded--and with considerable might--by compensating
    high-performing managers with salaries, bonuses, and some long-term
    stock opportunities.
    Conflicts of Interest
        Transactions between the corporation and its managers, directors or
    large shareholders are rife with potential conflicts of interest. Most
    large publicly-traded corporations have codes of conduct for addressing
    such conflicts that recognize that some conflicts are inevitable. While
    that may be so, the corporate culture should view transactions that
    involve conflicts--especially with members of senior management or
    directors--as highly suspect, and to be avoided if at all possible.
    Therefore, as alluded to above:

     The boards of publicly-traded companies should be required or
        be encouraged to adopt, regularly review and disclose a corporate
        code of conduct that addresses conflicts of interest, and
        management and director stockholding and trading policies. The
        actions taken by boards in implementing these policies should also
        be reported on, including disclosure of any exceptions granted
        under these policies and the reasons for the exceptions.
     SEC's rules should be amended to mandate prompt disclosure of
        transactions between the corporation (or its affiliates) and
        members of senior management, directors, or controlling
        shareholders.\22\
    ---------------------------------------------------------------------------
        \22\ See Press Release, Securities and Exchange Commission, SEC To
    Propose New Corporate Disclosure Rules (February 13, 2002), available
    at http://www/sec/gov/news/press/2002.22.txt (announcing that the SEC
    will propose rules that will ``provide accelerated reporting by
    companies of transactions by company insiders in company securities
    including transactions with the company'').
    ---------------------------------------------------------------------------
    Professional Advisors
        To obtain a fair picture of corporate performance and prospects,
    the shareholding public relies on managers and directors, as well as on
    auditors, analysts, and those who advise the company, all of who are
    susceptible to self-interest. Appropriate incentives and disincentives
    are required to protect against self-interest from overcoming the
    professional responsibilities of auditors, analysts, and lawyers.
        Obtaining the appropriate balance in the relationship between the
    board, the auditor and management is key to audit integrity and both
    the auditors' and the board's ability to perform the role expected.
    Significant efforts to improve auditor independence were recently
    undertaken by the SEC, and it is not yet clear whether the intended
    outcome is being fully realized. In particular, as noted above, it is
    only within the last year that audit committees have been required to
    both determine and report on auditor independence. Nonetheless,
    numerous recommendations for additional reforms have already been
    floated. They range from bright line prohibitions, for example,
    absolute limitations on the provision of nonaudit services to audit
    clients and requirements for auditor rotation, to more judgment based
    approaches.\23\ While the bright line approaches are attractive because
    of the certainty they create, careful consideration needs to be given
    to the potential for unintended consequences.
    ---------------------------------------------------------------------------
        \23\ See Banking, Housing, and Urban Affairs Hearings, supra note
    20 (Statement of Richard C. Breeden) (``One means of insulating the
    audit firms from the pressure of keeping the audit engagement would be
    to provide for mandatory limits on audit engagements to a specified
    period of time, such as 5-7 years.''); Governmental Affairs Hearings,
    supra note 14 (Statement of Arthur Levitt, Jr.) (``I also propose that
    serious consideration be given to requiring companies to change their
    audit firm--not just the partners--every 5 -7 years to ensure that
    fresh and skeptical eyes are always looking at the numbers.'');
    Banking, Housing, and Urban Affairs Hearings, supra note 20 (Statement
    of Harold M. Williams, former Chairman, Securities and Exchange
    Commission (1977-1981) ), available at http://banking.senate.gov/
    02__02hrg/021202/williams.htm (``I would urge the [Securities Exchange]
    Commission to consider a requirement that a public company retain its
    auditor for a fixed term . . .''); Harrison J. Goldin, Editorial,
    Auditor Term Limits, N.Y. Times, February 1, 2002, at A25; Banking,
    Housing, and Urban
    Affairs Hearings, supra note 20 (Statement of Roderick M. Hills, former
    Chairman, Securities and Exchange Commission (1975 -1977) ), available
    at http://banking.senate.gov/02__02hrg/021202/hills.htm (stating that
    the ``ultimate weakness'' of the financial reporting system is that it
    ``suffers from too many rules'' and should instead allow auditors to
    make their own judgments ``drawn from a conceptual framework'').

     Consider whether instead of asking the audit committee simply
        to review the possibility of conflicting relationships after the
        fact, it might be preferable to ask the audit committee to start
        with the decided presumption that audit and consulting do not mix.
        (The industry is already considering eliminating the mix,
        voluntarily.) Then leave it to the audit committee to decide on
        creating an exception when it deems an exception necessary and
    ---------------------------------------------------------------------------
        desirable for the company and its shareholders.

        Analysts and investment bankers also have potential conflicts of
    interest. The NASD has proposed changes to the rules for addressing
    conflicts of interest that arise when analysts are employees of
    investment banking or other firms having business relationships with,
    or who themselves own securities of, the company involved. Among other
    things, the proposal would mandate increased disclosure of conflicts in
    analyst reports and prohibit the investment banking arm from
    supervising or controlling research analysts or approving analyst
    reports. It would also prohibit approval of analyst reports by the
    subject company, prohibit a link between analyst compensation and
    specific investment banking transactions, and require disclosure in
    analyst reports if analyst compensation is based in part on investment
    banking revenues.\24\ Some observers may prefer bright line
    prohibitions against analyst coverage of any stock in which the analyst
    has an ownership interest or in which the analysts' firm is engaged in
    a transaction.
    ---------------------------------------------------------------------------
        \24\ National Ass'n Sec. Dealers, Inc., Proposed Rule Regarding
    Research Analyst Conflicts of Interest, File No. SR-NASD-2002-21, filed
    with Securities and Exchange Commission, February 7, 2002, available at
    www.nasdr.com/analyst__ guide.htm; see also S. 1895, 107th Congress
    (2002).
    ---------------------------------------------------------------------------
        I would be remiss if I did not discuss lawyers and their self-
    interests. Lawyers play a critical role in both supporting the
    governance efforts of boards and assisting managers to structure
    transactions while abiding by legal requirements. A classic dilemma is
    posed, however. Lawyers often identify with the management team and
    view themselves as strategic partners in achieving the client's
    business goals. And they may well perceive that the more effective they
    are in helping to achieve management's goals, the more likely it is
    that they will receive additional business. Yet lawyers also are
    expected to provide professional judgment and to counsel management
    about the legal boundaries and, in particular, to view their clients as
    more than just management, and to include the corporation and its
    shareholders. I would urge the American Bar Association to review the
    ethical conduct rules and, in particular:

     Consider whether ethical conduct rules give lawyers sufficient
        guidance in balancing these roles.
     Consider encouraging a set line of reporting for in-house
        counsel to bring to the board concerns not otherwise acted on by
        management.

        I support SEC Chairman Pitt's recent call for both lawyers and
    accountants to ``move away from wooden, rigid, literalism,'' and
    ``adopt a bias in favor of the needs of the investing public.'' \25\
    ---------------------------------------------------------------------------
        \25\ Public Statement by SEC Chairman Harvey L. Pitt at the SEC
    Speakers Conference, Washington, DC, February 22, 2002.
    ---------------------------------------------------------------------------
    Conclusion
        My suggestions can be boiled down simply to this: Diligent
    independent directors, properly led, informed and assisted, can
    circumscribe the agency problems. If managers are not overly motivated
    by options to seek short-term market price appreciation, they should be
    less likely to--consciously or unconsciously--push the numbers, push
    their auditor, and push the analysts. (Other compensation means are
    available to handsomely reward managers for true performance
    successes.) If auditors, analysts, and lawyers remove the conflicts
    that stand in the way of the true professionalism the public expects,
    they are more likely to resist.
        As I said at the outset, the great strength of our system is its
    ability to correct--sometimes by self-correction, sometimes with
    assistance from the SRO's, the SEC, the legislative bodies both State
    and Federal, and the courts. If self-correction by the private sector
    will not suffice (and in many respects it does not appear likely to
    fully address the current concerns), then look to the listing bodies
    and their contractual power to bind listed companies, together with
    greater SEC disclosure requirements. When that won't suffice, look to
    legislative solutions. We must remember, however, as recently well-put
    by the Financial Times, that ``no set of regulations, no matter how
    detailed, can outmanoeuvre a really determined manipulator. . . .''
    \26\ The great conundrum is that notwithstanding all our efforts for
    corrections, ultimately, to considerable degree, we are left to rely on
    the integrity of individuals.
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        \26\ ``Reforms to Restore Confidence in Business,'' Financial
    Times, February 19, 2002, at 14.