[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
____________________________________________________________________________
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            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\
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    \4\ PricewaterhouseCoopers has recently announced it would add 
three outside directors to its board, a definite step in the right 
direction.
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    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\
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    \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\
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    \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.
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    \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.
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    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\
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    \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.
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    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.
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    \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.
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    \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).
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    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 
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    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.
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    \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).
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    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\
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    \25\ Public Statement by SEC Chairman Harvey L. Pitt at the SEC 
Speakers Conference, Washington, DC, February 22, 2002.
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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.











































































































































































































































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