[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]




                    OVERSIGHT OF THE PUBLIC COMPANY
                       ACCOUNTING OVERSIGHT BOARD

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                   GOVERNMENT SPONSORED ENTEREPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

                             JUNE 24, 2004

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-98


                    U.S. GOVERNMENT PRINTING OFFICE
96-165                      WASHINGTON : 2004
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSSELLA, New York              CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  DAVID SCOTT, Georgia
JEB HENSARLING, Texas                ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey            CHRIS BELL, Texas
TIM MURPHY, Pennsylvania              
GINNY BROWN-WAITE, Florida           BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director
  Subcommittee on Capital Markets, Insurance and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman  PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma             DENNIS MOORE, Kansas
EDWARD R. ROYCE, California          MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York               RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio                  KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona             JOSEPH CROWLEY, New York
JIM RYUN, Kansas                     STEVE ISRAEL, New York
VITO FOSSELLA, New York,             MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois               WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin                CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania      JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania        BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio              DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    June 24, 2004................................................     1
Appendix:
    June 24, 2004................................................    29

                               WITNESSES
                        Thursday, June 24, 2004

McDonough, William J., Chairman, Public Company Accounting 
  Oversight Board................................................     6

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    30
    Gillmor, Hon. Paul E.........................................    32
    Kanjorski, Hon. Paul E.......................................    33
    McDonough, William J. (with attachments).....................    34

              Additional Material Submitted for the Record

Oxley, Hon. Michael G.:
    Study prepared by the staff of the House Financial Services 
      Committee..................................................    82

 
                    OVERSIGHT OF THE PUBLIC COMPANY
                       ACCOUNTING OVERSIGHT BOARD

                              ----------                              


                        Thursday, June 24, 2004

             U.S. House of Representatives,
    Subcommittee on Capital Markets, Insurance and,
                   Government Sponsored Enterprises
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:03 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Gillmor, Oxley (ex 
officio), Capito, Tiberi, Sherman, Inslee, Lucas, Clay, 
Matheson, Emanuel, Scott and Velazquez. Also present was 
Representative Maloney.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Capital Markets Subcommittee to order. Today, 
the committee meets for the purpose of reviewing the progress 
to date of the Public Company Accounting Oversight Board, 
created in an environment where the professional conduct of the 
accounting profession had been brought into significant 
question pursuant to relevant disclosures over the method by 
which public reporting had failed to meet professional 
standards.
    In the light of that environment, the creation of this 
board and the assignment of the new responsibilities identified 
was indeed a significant task for the participants to engage 
in. Over the course of the past months, the board has engaged 
in a number of significant steps, including the most recent 
action on June 18 requiring even higher standards of audit 
independence. I have found the actions of the board to date to 
be highly appropriate and very responsive to the express 
concerns, and certainly should be commended for the manner in 
which the identified conduct of concern has been addressed.
    More importantly, I think the actions taken extend to 
market participants and market observers a higher level of 
confidence than ever that the financial statements presented to 
those who are interested can be more likely relied on as being 
a true and accurate statement of financial condition of the 
corporation than ever before.
    It was of concern to me that in the course of the 
committee's work prior to the adoption of Sarbanes-Oxley, we 
actually had those in management appear before the committee 
who indicated that the preparation of a financial statement was 
a mutual endeavor which was the joint property of management 
and shareholder. The view had developed apparently that 
managing the statement to meet or beat earnings expectations 
was somehow in the shareholder's best interest, as opposed to 
giving a true and accurate condition of the corporation's 
actual condition. For these reasons, it was important to have 
individuals of the highest professional standing in order to 
bring about the necessary accountability. I am very pleased we 
have the Chairman of the Board, Mr. William McDonough here this 
morning to give us his insights into the steps taken and to 
identify any other areas that the Congress may need to address 
in light of the work engaged in.
    I commend him highly and the board for their great work in 
the midst of most difficult conditions, and have confidence 
that their efforts will give many benefits to a prosperous and 
growing marketplace. That is a goal which I am sure all of us 
are very pleased to see pursued.
    With that, I would recognize Mr. Emanuel who may have an 
opening statement.
    Mr. Emanuel. Mr. Chairman, thank you for holding this 
hearing today. I would also like to thank Chairman McDonough 
for taking the time to be with us, and for your leadership over 
the last 18 months, and most importantly, for restoring trust 
and accountability to the accounting profession and the 
financial markets, given the shaky last 2 1/2 years that have 
existed in the private sector.
    I would also like to thank the Chairman for calling a 
public roundtable on July 14 for auditors' independence. I wish 
it could have been July Fourth, which would have been more 
fitting for auditors' independence, but I do appreciate your 
doing that. Hopefully, Congress can be invited to participate 
in some capacity. This issue has been raised both in the public 
and private sector, dealing with auditors' independence and the 
issues associated with it. There has also been bipartisan 
legislation in both the House and Senate. Chairman Oxley and 
Chairman Baker must be somewhat tired of hearing me gripe about 
it.
    So I do think this is an issue that we need to deal with, 
and hopefully we can move on the legislation at some point, or 
if not, for a hearing or a markup, because in the last 6 months 
we have had an unprecedented suspension of one of the Big Four. 
It has never been done before, to my knowledge, and maybe you 
can shed some light on that, and continuing revelations just 
last week in The Wall Street Journal about one firm which has 
been offering advice to companies both on the tax side and on 
the auditing side that I think raises questions.
    What this is truly in my view not so much that they are 
doing something wrong. It is that they are operating in a zone 
with a flashing yellow light. It is neither a red light nor a 
green light. The consequences of the lack of that what we would 
call independence or separation of those functions, how does 
that spill out and affect the American people? According to the 
GAO, we face a $311 billion tax gap, much of it due to under-
reporting, some of it coming from either the corporate or high-
end sector where people are receiving tax advice based on 
unclear rules.
    I would hope that we in this committee can begin to deal 
with these issues. I would hope that the Board's July 14 
roundtable will mark the beginning of not just a public 
discussion, but a clearer focus on what actions we can take. It 
is one of the rare moments here that we have bipartisan 
agreement and bicameral agreement, and we need to deal with 
this. The consequences are at the end of the day when you have 
a $300 billion shortfall of under-reporting or not paying, is 
that that burden shifts to middle-class, working-class 
families. And nobody then believes the system is fair or that 
everybody is playing by the same set of rules. And the system, 
and we represent that system, loses confidence by the American 
people.
    So I look forward to your hearing today, asking questions 
on the subject, and your leadership on this very one particular 
point. Not only your last 18 months, but I hope the next 18 
months are as fruitful for the private sector as the first 18 
months.
    With that, I yield back.
    Chairman Baker. I thank the gentleman.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    Less than 1 year ago, this committee held a hearing 
entitled Accounting Under Sarbanes-Oxley: Are Financial 
Statements More Reliable? That was the first time that our 
distinguished witness, Chairman McDonough, appeared before 
Congress as Chairman of the Public Company Accounting Oversight 
Board.
    I am pleased to report that, due in no small part to his 
exemplary leadership and that of the other board members, the 
answer to the question we posed 9 months ago appears to be a 
resounding ``yes.''
    While the problems that led to the passage of the Sarbanes-
Oxley Act nearly 2 years ago have by no means disappeared, the 
Act's wide-ranging corporate reforms and the effective actions 
of the PCAOB have helped to restore the faith of America's 
investors.
    In his brief tenure, Chairman McDonough has transformed the 
board, the centerpiece of Sarbanes-Oxley, into a rigorous, 
effective and highly respected overseer of public accounting 
firms. The board has spread a little fear, and Chairman 
McDonough has hit the proper tough-but-fair tone, in my 
estimation. I have been reading your speeches. He has listened 
to practical implementation problems and has worked to ease 
them, provided it does not interfere with Sarbanes-Oxley or the 
PCAOB's mission. The PCAOB has been a vast improvement in 
accounting industry regulation.
    We will learn today about the inspection process that the 
board began during its startup year of 2003 and the auditing 
and professional practice standards that the board has both 
adopted and proposed. I would particularly like to commend 
Chairman McDonough for his accommodations on foreign firm 
inspections.
    I am pleased that the Securities and Exchange Commission 
recently approved the board's final internal control standard 
as required by Section 404 of the Act. The internal control 
requirement of the Act has been the focus of some criticism 
from sectors of the business community. My view is that these 
costs, although never pleasant, are offset by great benefits.
    In implementing the protections of Section 404 and, indeed, 
all of the Sarbanes-Oxley Act, it is essential that regulators 
seek to minimize the cost of compliance as much as possible, 
consistent with the Act's goals. The board has done exactly 
that, and we will learn more about that today. At the same 
time, we must keep the appropriate perspective. According to 
one report, there were 323 companies that restated their 
results last year. In 58 of those instances, the outgoing 
accounting firm reported problems related to internal control. 
Clearly, the need for strong internal control has not 
diminished.
    Equally important, I am pleased by reports of the positive 
effects of the internal controls requirements on public 
companies' business. General Electric's finance chief recently 
stated, ``We have seen value in the section 404 work. It helps 
build investors' trust and helps give them more confidence. We 
have gotten positive benefits from it.'' This is precisely the 
purpose of this requirement.
    There is much more work to be done, but I remain confident 
that Chairman McDonough and his colleagues will continue to 
ensure that financial statements are more reliable.
    Again, Mr. Chairman, welcome you back to the committee. It 
is good to see you again. We look forward to your testimony.
    I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 30 in the appendix.]
    Chairman Baker. I thank the Chairman.
    Are there further opening statements? Mr. Scott?
    Mr. Scott. Thank you very much, Mr. Chairman.
    I, too, want to welcome you, Chairman McDonough, to our 
hearing. I want to thank Chairman Baker and Ranking Member 
Kanjorski for holding this hearing today on the progress of the 
Public Company Accounting Oversight Board.
    This hearing is particularly timely, given that the board 
issued its first annual report last week. The Sarbanes-Oxley 
Act of 2002 was enacted to end self-regulation for the 
accounting profession. Historically, auditors were regulated by 
the American Institute of Certified Public Accountants. The 
board was created to serve as the regulator for auditors of 
public companies and set higher corporate standards for 
auditing.
    I am very much concerned about the issue of the inspections 
and I am very delighted and pleased to learn that the 
inspections, according to you, Mr. McDonough, will go beyond 
the traditional peer review and technical compliance, to look 
at firm culture and practices to ensure that compliance is 
encouraged. This is very, very important. You went on to 
further note that these limited inspections disclosed 
significant audit and accounting issues, and the need for 
enhanced standards, and you emphasized the importance of the 
information gained through individuals and auditing 
engagements.
    The board's new standard of guidelines for accountants was 
approved by the Securities and Exchange Commission on June 18. 
There have been some complaints by public companies about the 
costs of complying with these new standards and the clarity of 
guidance on complying with the new rules. While some resistance 
is expected to new regulations, I would like to better 
understand the depth of these concerns, especially on the 
compliance costs to small firms.
    I look forward to your testimony today, Chairman McDonough, 
to detail the progress from the board.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Ms. Velazquez.
    Ms. Velazquez. Thank you, Mr. Chairman.
    First, I want to thank Chairman Baker for holding this 
oversight hearing on the PCAOB. The committee's recent series 
of oversight hearings has illuminated many important issues 
with our nation's capital markets regulators, many of which 
would have not been addressed had we not undertaken these very 
hearings. So I am thankful that this committee has taken its 
oversight responsibilities seriously.
    I believe that the success of our capital markets is 
dependent on accurate and truthful information. Without such 
information, investors will not be able to make informed 
decisions. This is why Sarbanes-Oxley is so important, because 
it provides investors with greater confidence in the 
information they rely on.
    The investor population is more diverse today than ever, 
from union workers investing through pension plans to 
professionals investing through 401(k)s to retirees investing 
through IRAs. They all have money invested in public companies. 
For this new class of investors, who typically rely on 
professionals to guide their investment decisions, increased 
scrutiny of corporate audits is essential. It provides these 
investors with some additional comfort that there is someone 
watching the shop on their behalf.
    While Sarbanes-Oxley is in the process of bolstering audit 
requirements and providing increased scrutiny of corporate 
audits, I would like to raise one specific issue here today: 
the potential need for an alternative audit standard for 
smaller non-public companies. Although Sarbanes-Oxley was 
intended for public companies, it appears that many smaller, 
non-public companies may be adopting PCAOB standards. Often, 
the adoption of these enhanced standards is voluntary, but I 
have a concern that the adoption of the PCAOB standard may 
become a quasi-requirement for many non-public companies.
    In many of these cases, the adoption of the standards is 
not driven by a desire to protect the investing public, but 
rather to satisfy other private interests. In addition, the 
cost of obtaining a full PCAOB quality audit is quite 
significant, requiring both a substantial startup investment as 
well as considerable ongoing costs. In pursuing this one-size-
fits-all approach, I have great concerns that this will create 
an excessive burden for many smaller non-public companies, 
while at the same time doing little to benefit the investing 
public.
    These companies represent about half of the U.S. companies 
and are a major driver of economic growth in our communities. 
By unnecessarily diverting significant resources to PCAOB 
compliance, these smaller companies will be unable to expand 
their operations or hire new employees. As a result, we may be 
unnecessarily hindering growth at a time when we need more 
high-quality new jobs.
    I hope to learn more about this issue today and I look 
forward to hearing Chairman McDonough's perspective on this 
issue.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentlelady.
    Mr. Lucas, did you have a statement this morning?
    Mr. Lucas of Oklahoma. I am looking forward to the 
Chairman's testimony.
    Chairman Baker. Great statement.
    If there are no further opening statements, at this time I 
would like to recognize Mr. William J. McDonough, chairman of 
the Public Company Accounting Oversight Board. Welcome sir. 
Please proceed as you choose.

  STATEMENT OF WILLIAM J. MCDONOUGH, CHAIRMAN, PUBLIC COMPANY 
                   ACCOUNTING OVERSIGHT BOARD

    Mr. McDonough. Thank you.
    Chairman Baker, Chairman Oxley, members of the 
subcommittee, I am pleased to appear before you today, and I 
want to thank the members of the subcommittee and the entire 
House Financial Services Committee for your strong bipartisan 
support of the Public Company Accounting Oversight Board. We 
benefit greatly from your wisdom and encouragement.
    With the landmark Sarbanes-Oxley Act of 2002, Congress took 
a giant step toward restoring investor confidence in financial 
reporting and in the auditing of public companies. No one 
should doubt that it is the faith of investors that fuels the 
growth and competitiveness of our economy, not the freedom of 
corporate managers from public regulation and oversight. The 
Sarbanes-Oxley Act sets out the blueprint for rebuilding 
investors' faith.
    Over the last 18 months, we have turned the Sarbanes-Oxley 
blueprint into an operating organization. Today, the PCAOB is 
well on its way to maintaining a continuous program of auditor 
oversight, to quote from the statute, ``in order to protect the 
interests of investors and further the public interest in the 
preparation of informative, accurate and independent audit 
reports.'' Registration of public accounting firms that audit 
public companies is the foundation of the board's authority. 
Since October 22, 2003, it has been illegal for any U.S. public 
accounting firm to prepare, issue or play a substantial role in 
an audit report on the financial statements of a U.S. public 
company unless the firm is registered with the board. As of 
July 19, the same restriction will apply to non-U.S. firms. As 
of yesterday, we have registered 1,003 U.S. and non-U.S. public 
accounting firms that audit or may wish to audit U.S. public 
companies, and we continue to receive registration 
applications.
    Once a firm is registered, it is subject to board 
inspections. The Act and the board's rules require annual 
inspections of the firms that audit more than 100 public 
companies. Smaller firms that have at least one public company 
client will be inspected every three years. Although regular 
inspections began this year, we launched limited procedure 
inspections of the Big Four firms in 2003. We recently made our 
draft reports on those limited procedures available to the Big 
Four firms.
    Even with limited inspections, we learned a great deal 
about quality control in the largest firms. In numerous 
interviews, we heard audit partners and staff express their 
perceptions of a renewed focus on audit quality. We have seen 
some evidence of this renewed focus in firm policies generally, 
and in internal firm communications about those policies. Even 
so, we alerted the firms to quality control concerns and we 
will continue to look hard at whether the firms' conduct 
mirrors their words.
    We also learned that there is tremendous wisdom and value 
in the Act's requirement that we review selected audit 
engagements. Although we reviewed only a small number of 
engagements in 2003, we identified significant audit and 
accounting issues. As we examine more engagements in the 
future, we expect the prospect of scrutiny to alter the 
relative risks and rewards to individual engagement partners 
who might otherwise consider short-cutting audit steps or 
bending to pressures to please clients.
    Our inspections also provide valuable information about the 
need for enhanced standards. In reviewing audit engagements in 
2003, we became concerned that auditors may place insufficient 
emphasis on the importance of thorough documentation of audit 
work. The Act expressly required us to adopt an auditing 
standard on documentation and we were able to use what we had 
learned about existing documentation practices to develop the 
new standard.
    Situations will inevitably arise in which standard setting 
and inspections are inadequate tools for addressing auditing 
problems. When we find serious violations of PCAOB standards or 
the securities laws, we will use our authority under the act to 
investigate and, as appropriate, to seek disciplinary sanctions 
against the firms and auditors under our jurisdiction. Those 
sanctions include monetary penalties and even revoking a firm's 
registration, thus preventing it from auditing public 
companies.
    We will continue to push forward step-by-step toward the 
world envisioned in the Act. It is a world in which public 
accounting firms are strong, reliable businesses that compete 
based on virtue. It is a world in which the investing public 
has enough confidence in the fairness of our capital markets 
and in the auditors who stand in their place, to invest their 
and their children's futures in those markets. And it is a 
world in which U.S. companies have access to rich capital 
markets funded by those investors to grow new businesses, to 
develop new products, and to hire new employees to design and 
produce those products.
    Mr. Chairman, thank you for the opportunity to describe our 
progress towards this goal. I will be happy to answer any 
questions.
    [The prepared statement of William J. McDonough can be 
found on page 34 in the appendix.]
    Chairman Baker. Thank you, sir. Once again, I express my 
appreciation for what appears to be a very well done job over 
the past 18 months.
    I would be interested in your view with regard to the 
effect of the new standards, the accountability that is now 
required with regard to a corporation's ability to attract 
capital or investors. Do you see any measurable improvement, 
any measurable concern as a result of the implementation of the 
standards? There was the view at the outset by some that this 
would simply raise the cost to the corporations without any 
measurable benefit. Perhaps a better way to say it, from a 
cost-benefit analysis, forgetting for the moment the concerns 
raised by inappropriate conduct, in real business dollars has 
this been a net gain for corporate America or is it a net 
expense?
    Mr. McDonough. I would say thus far it is a net gain. 
However, we did try to put into the internal control standard, 
our auditing standard number two, as much cost-benefit thinking 
as we possibly could. I must admit that we stretched the 
statute as much as we thought the statute could be stretched in 
order to do that.
    We think that is particularly important because of the 
concerns that Congresswoman Velazquez mentioned earlier, and 
that is the effect on small-and medium-size companies. If you 
look at a large company, as Chairman Oxley mentioned, the 
excellent remark from General Electric, they invested I think 
they said about $30 million, which is not a great deal of money 
for General Electric, in 404 implementation and they thought it 
was money well-spent. In the case of large firms, first of all, 
they should have had good internal control standards, and if 
they did not and they have new expense to put in the internal 
control standards, what it tells us is they should have done it 
in the past. I do not have much sympathy for the large firms in 
this regard.
    There is a requirement, of course, that they document the 
internal controls. I always though, in my days of being a chief 
financial officer, if you have internal controls, you ought to 
document them in any regard, but in some cases they actually 
had the controls, but had not documented them very well. That 
is a new expense. There is no question that the attestation by 
the auditor of the adequacy of internal controls is a new 
expense, one that I think is justified.
    When you get to small-and medium-size companies, I think 
what has to be used and what we try to push very hard is that 
both the issuers themselves and private companies, for that 
matter, have to use good judgment. I think one of the greatest 
things in God's work in creating human beings is the giving of 
judgment. A small-or medium-size company simply does not need 
the bells and whistles on internal controls that General 
Electric needs. It would be very ill-advised and a terrible 
waste of money for them to have all those bells and whistles. 
So we expect them to look at the nature of their business, how 
complicated it is, how difficult are the internal controls, to 
make sure that they have the level of internal control that 
they really need.
    Then we also expect the audit firms to use their judgment 
to say, given the reality of this firm, do the internal 
controls set up by management actually meet the test of good 
judgment? If the answer to that is yes, then in our inspections 
I will expect our inspectors to say, if the firm used good 
judgment, if the company used good judgment, whether or not our 
inspector would have done it exactly that way is not important.
    The important thing is, did the company and the audit firm 
use good judgment? If the answer to that is yes, we should 
bless it, because we do not want to have unnecessary expense. I 
believe vehemently and have for years, small-and medium-size 
companies are the guts of the American economy. They are the 
net creators of new jobs. We do not want, and especially I do 
not want, because of my long record on this issue, to have 
anything that PCAOB does step in the way of growth of the 
American economy.
    Chairman Baker. Thank you. I have time just to get one more 
question in here.
    I note that you have made an observation with regard to 
executive compensation, and reasonableness. I recently had a 
document published by some organization that not single-line 
businesses, but complex, sophisticated financial organizations, 
that the average salary, not benefits, was $12 million a year 
and the average value of stock held in the institution which 
they managed was $800 million. I do not want to call it 
disturbing, but I was surprised by the numbers. These are 
averages. These are not the extremes.
    Is there a better way to have disclosure of compensation 
packages so shareholders can make the appropriate judgments? I 
am not second-guessing anyone. I am certain there are 
individuals worth those dollars. I just think that if you are 
in an environment where the company may be losing money, that 
might be one area where one would want to focus some attention. 
Do you have views on that?
    Mr. McDonough. Mr. Chairman, I have probably reached the 
point of being notorious for having views on the subject of 
executive compensation. The first time I spoke on the matter 
was in the sanctuary of Trinity Church at the foot of Wall 
Street on the first anniversary of 9-11, and have been speaking 
about it ever since. Why do I think it is important? I think it 
is important because the nature of this greatest of all 
countries is the belief that we are all in it together; that if 
you were born in humble circumstances, I was, that you have 
full opportunity to participate in the American Dream.
    I think that everybody probably thinks from your district, 
I hope that every kid in the district thinks that he could be 
your successor some day. I think that a lot of people think 
they can be President of the United States. But I am really 
worried about whether people think that they can get to the top 
rungs of business because of this very high pay, as to whether 
it is becoming a closed club. I think the nature of the 
American society works much better in the old days; in 1980, 
the average Fortune 500 CEO made 40 times more than the average 
person who worked for him or her. That sounds pretty 
reasonable. Now, by 2000, it was between 400 and 500 times, and 
last year I believe that same study said it was about 530 
times.
    There is no economic theory on God's planet that can 
justify that. It was a breakthrough of greed in the 1990s, 
which is understandable because it looked as if we had the 
great economic miracle. I do not think that there is a way 
that, and I think your remarks suggested it, that we can figure 
out how to legislate a control over it or how the SEC or 
anybody else can figure out how to do it.
    I think what it comes down to is the common sense, never 
mind good judgment, of the people running these major 
companies. As I have suggested publicly, if the CEOs do not 
have enough sense, well then their boards of directors should 
decide they probably need a new CEO. Somebody with such lousy 
judgment probably should be replaced anyway.
    So I do think that on a firm-by-firm basis, the private 
sector has to, and I spend a lot of time trying to encourage 
them to take over the responsibility for doing the right thing. 
Disclosure I think is very important, but if what is being 
disclosed with all the detail that one can imagine is excessive 
and inappropriate greed, well, it will make it more obvious. 
But I think mainly what we need to do is to correct a problem 
that I think is really a difficulty for our society that simply 
must be overcome.
    Chairman Baker. Thank you, Mr. Chairman.
    Mr. Emanuel.
    Mr. Emanuel. Thank you, Mr. Chairman.
    Chairman McDonough, some Fortune 500 companies have 
complained about the costs associated with Sarbanes-Oxley. 
Could you compare the compliance costs associated with 
Sarbanes-Oxley to some of the Fortune 500 compensation packages 
for CEOs?
    Mr. McDonough. I suppose an easy remark, Congressman 
Emanuel, would be that in most cases the cost of implementation 
of Sarbanes-Oxley is less than the pay to the CEO.
    That is an interesting comparison. I think, as I mentioned 
earlier, in the case of large companies, it is very clear that 
the Congress of the United States, 97 to nothing in the Senate, 
three negative votes in the House of Representatives, decided 
that the American private sector had to be run in a somewhat 
different way, a bill which I applauded at the time and now am 
spending a lot of my life trying to implement.
    I think that the money in large companies that is spent for 
a reasonable implementation of the Sarbanes-Oxley requirements, 
especially the internal controls, is fully and unquestionably 
justified. I do have the belief, as I mentioned earlier, when 
you get to small-and medium-size companies, we ought to size 
the thing properly.
    Mr. Emanuel. Let me go back to the issue of auditor 
independence. I do believe what we have is not a right and 
wrong. We have a flashing yellow light and people are unsure of 
the terrain, the people being those in the financial services 
industry and financial services advice industry to boards and 
to management, top management.
    Since four major accounting firms basically audit close to 
80 percent of the public companies, if we do not act here in 
Congress and set some clear guidelines, which is why I think we 
do need to act, how do those on the regulatory side deal with 
the fact that four companies monitor, audit and offer financial 
advice to nearly 80 percent of the public companies, and 
without enacting measures or penalizing wrongdoers in ways that 
would harm the financial markets?
    Mr. McDonough. Congressman, I think we have to distinguish 
between some of the things that we are reading about in the 
papers about the large firms, which are things that they did in 
the past I spent a lot of time talking with the leadership of 
the four firms, and if there are any people in this world who 
want to get that behind them, it is they.
    Mr. Emanuel. I would agree with that.
    Mr. McDonough. Let's say now looking forward, what our 
responsibility is . As you know, it is limited to the 
activities of the accounting firms in dealing with their audit 
clients. I think the area in which you are particularly 
interested is the area of tax, which is what our July 14 
roundtable is about is auditor independence as it refers to tax 
advice. What I have been telling the leadership of the Big Four 
is that what they have to do is to restore the faith of the 
American people in the accounting profession as a profession 
and in their firms in particular. The American people do not 
make a whit of distinction between the audit practice of the 
firms and the rest of the firm. For the American people, it is 
one thing, one firm.
    Therefore, I have been very strongly and very vehemently 
suggesting to them that even though I do not have the legal 
capability to tell them what they can do for their non-audit 
clients, if they are doing anything that is sort of towards the 
creative end of just where the IRS might let somebody get away 
with it, it is an extraordinarily ill-advised thing for them to 
be doing because they will destroy any possibility of restoring 
the faith of the American people. So I think the good judgment 
of the people running the firms, if they swing into gear and 
carry out that which I think they should in their own best 
interest, then I would have to leave it up to you and the 
Congress as to whether you need legislation or not.
    Mr. Emanuel. Let me follow up on that last point. Is it 
your view then, that we should be patient here, and see how the 
market handles this, both from a regulatory and legislative 
perspective? Or should we begin to do something from the 
legislative side that sets clearer rules of the road?
    Mr. McDonough. That is a question that comes very close to 
one's personal philosophy, so I will have to share mine with 
you. I think that the Congress and those of us who are created 
by the Congress have the responsibility to serve the best 
interests of the American people and that comes first. We have 
loaded the private sector with an awful lot of new things to 
do, like internal controls. We have loaded on the accounting 
firms a new era of oversight, of very penetrating inspections 
by the PCAOB people.
    That would lead me to believe as a generalization that it 
would be wise to let see how it is working out, and especially 
since I am seeing in the leadership of the private sector 
generally, except on the compensation issue, and in the 
leadership of the accounting profession, a view that they 
really did get the message of Sarbanes-Oxley.
    If that is true, one might, at least my philosophy would be 
to let's give it some time and see if it works. If it does not, 
it is rather what we say to the accounting profession, you will 
either restore the faith of the American people voluntarily or 
we will make you do it. It is going to work a lot better if it 
is done voluntarily.
    Chairman Baker. I thank the gentleman.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    I want to explore a little bit with you, first of all, I 
totally concur with your statement about stretching the statute 
to accommodate as best we can the small-and medium-size 
company. That clearly is an issue. It is one that comes up 
quite a bit in my conversations with CEOs and CFOs. I applaud 
your foresight and ability to do that within the bounds of the 
statute. I think it is critically important.
    It is also true that in the cost area for Section 404 that 
we look at some interesting numbers. The average salary of a 
Fortune 500 CEO in 2004 was $6.6 million. Richard Scrushy, the 
former CEO of HealthSouth, his bonus in 1 year alone was more 
than $10 million, about 10 times what it would cost for a 
company of that size to comply with the act. So I think when we 
put it into that perspective, clearly we did some things right. 
I want to applaud you and your colleagues there on the board 
for recognizing that. I think it is clearly important.
    Also, is it not true that once the internal controls are 
set up, that is what incurs the most expense in my view of 
things. That is, once you have to set up the infrastructure 
essentially for compliance, which assuming it is done correctly 
and approved by you and the SEC, will be ongoing. So isn't it 
true, Mr. Chairman, that a lot of those costs are a one-shot 
cost?
    Mr. McDonough. Mr. Chairman, setting up the controls is a 
one-time cost. I think, however, that the issuers themselves, 
the companies themselves will have to be very careful to keep 
an eye on whether their internal controls, which may have been 
perfectly wonderful in the year 2004. Perhaps with new 
information technology or whatever comes along, you might want 
to modernize them in 2007.
    When I was Chief Executive Officer of the Federal Reserve 
Bank of New York, we put in the COSO implementation of internal 
controls. After about 3 years, I found that my people were 
getting a little relaxed, so I upped the ante and made the 
internal controls tougher. I think a CEO might want to do that. 
The auditor also will have to take a look and make sure that 
the internal controls have not changed, the application of 
them. So although the first year expense will be considerably 
higher, the expense on an ongoing basis will be higher than it 
was in 2003.
    Mr. Oxley. I accept that. I understand that. Let me also 
commend you on using what lawyers would call the ``reasonable 
man test,'' because ultimately that really is critically 
important that we allow some judgment here, and that we do not 
get ourselves so boxed in on compliance that we lose sight of 
the goals that we are trying to accomplish. So I applaud you 
for that attitude.
    There will be some people in some quarters, as you know, 
that will be more than willing to second-guess and to say that 
you need even more strict controls and that you have to go 
literally by the letter. Obviously, it just does not work under 
those conditions. So I really thank you for your judgment in 
that area.
    One of the things that I think concerns me and others, with 
the demise of Arthur Anderson, we are really down to the final 
four in terms of a national accounting industry. Does that give 
you some pause in terms of the lack, or at least apparent lack 
of competition out there? Do you see anything in the future 
that would maybe provide that some of these companies actually, 
and it has been suggested in some quarters, that they split 
into different parts, or perhaps the large regional accounting 
firms kind of stepping up and becoming national firms? What are 
your views on that?
    Mr. McDonough. Mr. Chairman, I think that it is the single 
most difficult issue in public policy in this area. The GAO was 
required by Sarbanes-Oxley to do a study of concentration in 
the accounting profession. It came to the conclusion, to just 
slightly oversimplify, that we have four firms; that the idea 
of growing a number five of anything like comparable size out 
of one of the regional firms would look pretty tough to do. 
Therefore, one is left with the notion of what do you do about 
the Big Four.
    One of the things that came to my mind immediately is you 
may remember that I was probably the most vocal person at the 
Federal Reserve on the notion that there was no such thing as a 
bank too big to fail, largely because I think as soon as you 
say a bank is too big to fail, you have de facto nationalized 
it. We can also not say that it is absolutely essential to the 
American people that each of the Big Four survive if, heaven 
knows I hope it does not happen, if one of the Big Four should 
so mismanage itself that it does not deserve to survive.
    Now, my conversations with the leadership of the Big Four 
make me think that is a very remote likelihood, but we have to 
make sure, and I have made very clear to the leadership of the 
Big Four, both individually and collectively, that their future 
depends on them, not the PCAOB. What I am not sure anybody can 
figure out is, if the Big Four either voluntarily or somebody 
pushing them, divided into the Big X, would the Big X be on 
average better and therefore the public interest is served? Or 
on average less good and therefore the public interest is 
disserved, if there is such a word? I do not know the answer to 
that question and I am not sure anybody does. It is an 
immensely important question and I think we have to keep 
figuring out what the real answer to it is, but as of now I do 
not know that anybody knows the answer to that.
    Mr. Oxley. Thank you. If I could just take 1 more minute, 
Mr. Chairman, I wanted to just weigh into this executive 
compensation issue, only to raise the issue. I do not think 
anyone is proposing that government try to manipulate or to 
change the current system, is that correct? I mean, in a direct 
way, we are not going to pass a law to deal with executive 
compensation.
    Mr. McDonough. I must admit, Mr. Chairman, that I, in my 
sermons to the CEO corps, hold out that if they do not do it 
voluntarily and the American people continue to be very upset 
about it, that legislation would have to be considered. I must 
admit that I am stepping into the province of the Congress of 
the United States when I do that, but I think there has to be 
at least hanging out the possibility that if they do not do it 
voluntarily, the Congress might try to figure out a way to do 
it for them.
    Mr. Oxley. What is your view that with the changes taking 
place in the boardroom with more emphasis on independent 
directors and the like, won't that in and of itself have a 
mitigating affect on executive compensation? Won't that at 
least be partly solved in the marketplace?
    Mr. McDonough. It should be. There is no doubt in my mind 
that independent directors, members of compensation committees, 
should take on the responsibility of getting executive 
compensation back to a more rational level and one which would 
be more acceptable to the people of the United States. I hope 
very much that will happen. I think you and I both know the 
kinds of people who serve on those compensation committees. 
They are people of good character and I sincerely hope that 
they will carry out their responsibilities.
    Mr. Oxley. I am somewhat encouraged by that. You are even 
starting to see that in major league sports today, a kind of a 
leavening of that. I would hope at some point we could get to a 
point where some banjo-hitting utility infielder does not 
necessarily make $2.5 million a year, but I digress.
    [Laughter.]
    I do think it is an issue worth going after. Mr. Chairman, 
I would ask unanimous consent, we had a study done by the 
committee on the compliance costs for Section 404, based on 
revenue of various corporations. I think it really is a quite 
extraordinary study, where it says the average salary of a 
Fortune 500 CEO in 2004 was $6.6 million and the average cost 
of compliance for domestic companies is $1.92 million. So it is 
a very interesting statistic and I would ask unanimous consent 
that the study be made part of the record.
    Chairman Baker. Certainly, without objection.
    [The following information can be found on page 82 in the 
appendix.]
    Mr. Oxley. Again, Mr. Chairman, thank you for your 
appearance again. It is always good to have you here, and most 
enlightening testimony.
    I yield back.
    Chairman Baker. Thank you, Mr. Chairman.
    Mr. Scott.
    Mr. Scott. Thank you very much, Mr. Chairman.
    Chairman McDonough, it seems to me that one of the most 
effective tools that you have at restoring investor confidence 
is within the periodic inspections. Could you share with us how 
that is working, particularly what success it has had in 
detecting fraud, and making sure that there is compliance in 
terms of professional auditing standards? That is the first 
part of my question.
    The second one is, is the board making adequate progress in 
terms of addressing the concerns of foreign regulators in terms 
of overlapping areas of compliance?
    Mr. McDonough. I think we are making good progress on both 
of them. The nature of our inspection is we go into a firm and 
the main thing is that we start by looking at what we call the 
tone at the top. Do the people who run the institution 
understand what their requirements are under the Sarbanes-Oxley 
Act and the fact that the American people, I always remind them 
it is the American people as represented by the Congress, have 
decided that their profession needed an outside overseer in the 
PCAOB.
    We want to make sure that they understand that audit is 
their most important product. We get into their relative 
compensation of partners. We want to see that the good audit 
partners get well rewarded and not, for example, that the 
people who are very good at bringing in new business get most 
of the additional compensation. We also talk with everybody 
involved in the firm, especially down to the kids that they 
hired in the last few years, because we have to assume that the 
people running the firm would really have to be pretty 
dimwitted if they did not tell us what we want to hear and what 
the law says. But that does not do a whole lot of good unless 
they get that message really understood by all the people who 
work for them. So we look into that.
    Then we look into their individual engagements. The amount 
that we looked into in the case we did, just the Big Four, as 
you know, and we looked at 16 engagements for each of the 
firms. That is a very, very small sample and one has to be 
careful that you do not draw too many conclusions from that 
small a sample, but we think we have some pretty good ideas.
    The inspections that we are doing this year will be much 
more detailed. In the case of the Big Four, we will be looking 
at about 5 percent of their engagements, and the biggest firm 
has about 3,600 engagements. So 5 percent is a pretty important 
statistical sample. In the case of the next lot of firms, we 
will be looking at about 15 percent. We look at a combination 
of what looks like high-risk clients, very complicated 
companies, for example, and then we do a statistical sample so 
we pick up the rest, a random sample.
    When we get to the smaller accounting firms, as we get in 
there, we will have to figure out, we are doing those 
inspections now, and some of them will probably think, we 
better look at pretty much all of their engagements because we 
are not really sure how good they are. On the other hand, with 
others that really seem to be very, very well organized and 
really very good, and we look at one or two engagements and 
say, wow, they are terrific, well then it would not be wise to 
spend their time and money and our time and the public's money 
to do it further. I think that this will be a very effective 
tool to restore confidence.
    On the second part of your question----
    Mr. Scott. Before you leave that part about the periodic 
inspections, are there notices given to the firms? Is there 
leeway time or is it a surprise inspection?
    Mr. McDonough. We give them a very small amount of notice 
because it is better if you see them as they really are.
    Mr. Scott. When you say small amount of notice, how long?
    Mr. McDonough. The typical amount would be just a couple of 
days, so they cannot pretty themselves up. They know we are 
coming so, for example, they know that the top of the shop 
should be there, but we quite deliberately want a certain level 
of surprise in the inspections.
    Mr. Scott. And you have given them during this last year, 
is that right? It has been a year?
    Mr. McDonough. Last year, we did a limited inspection, as 
we call it, of the Big Four. They, by the way, volunteered to 
do that because we began those limited inspections in June and 
legally we did not have the right to inspect them until 
October. By the way, I thought that was a good sign of good 
will on their part.
    This year, we have a legal requirement to inspect each year 
eight firms, because there are eight firms in the United States 
and one in Canada which have more than 100 public company 
clients, issuers, so we have to inspect them annually. All the 
rest, which have one client or one issuer or more, we have to 
inspect every three years. That, by the way, is going to be a 
real chore this year because we are still a startup and we are 
still assembling our staff. Whether I will be able to get to 
one-third of the rest of them this year or whether we will have 
an extra burden in the second and third year, unfortunately it 
is likely we will have a bigger burden in years two and three.
    Mr. Scott. I want to get to my second question, too, so 
bear in mind my time, Mr. Chairman, but what has been the 
finding? What has been the result? In other words, you have 
given these periodic inspections to the top four. They have 
been limited inspections. Any surprises? What have been the 
findings?
    Mr. McDonough. We have made available to the four firms our 
reports. They have 30 days from when they got them, which was 
in the last day or two, for them to respond. However, the 
general feeling that we have, which is what I think you are 
looking for, is they are in fact paying attention to doing 
audits better, but they did not really have a whole lot of time 
to improve their performance before we were in there looking at 
them.
    Therefore, we found some situations where their issuing 
clients and the engagements we looked at did not appear to 
follow GAAP. That then becomes the province of the SEC, because 
SEC is in charge of accounting policy, not the PCAOB, but the 
auditor should bring it to the attention of the issuer, which 
then deals with the SEC if there is a restatement involved.
    In terms of overall really tough application of quality, 
there is room for improvement. One thing that I am very certain 
of is the inspections are a very good idea. I thought so before 
we did these and I am even more sure now.
    Mr. Scott. I think so, too. I think they are the most 
effective way to get confidence.
    And if you could, my other question concerning the foreign 
regulators and their concerns over overlapping.
    Mr. McDonough. There were enormous concerns and a great 
deal of noise coming from quite a number of foreign countries 
on the alleged extraterritoriality of Sarbanes-Oxley. The 
extraterritoriality comes for a very good reason. Foreign firms 
and foreign companies issue securities in the United States and 
the Congress wants to protect the American people and other 
investors in those securities.
    What we have been able to do is essentially the whole thing 
has been calmed down. We have had very good discussions with 
the Canadians. About one-third of foreign issuers are Canadian. 
We have had excellent discussions with the European Community. 
I made three trips to Brussels. Fortunately in my previous life 
at the Fed, I had worked with exactly the same people. We all 
figured out that they are trying to protect investors. We are 
trying to protect investors. Why don't we just do this 
together?
    So the way we are working it out, we have what we call a 
sliding scale. If an audit overseer in another country has, it 
kind of looks like the PCAOB, essentially that it be free of 
the profession both organizationally and financially, and 
therefore can oversee it as a true third party. In that case, 
we would ask that our inspection be actually conducted by the 
audit overseer in that country.
    So let's say we are talking about the United Kingdom, we 
would ask the United Kingdom overseer to do our inspection. We 
would send a couple of people over to make sure that they 
understood how we do things. Conversely, if there is an 
American company which sells securities in the London market 
and the UK would decide that they would like to do an 
inspection, we assume that the UK audit overseer would ask us 
to do their inspection for them.
    So it is 100 percent reciprocity. If we have a country in 
which the audit overseer either does not exist or would not 
have full confidence, then we will have to do much, much more 
of the inspection ourselves.
    Chairman Baker. Mr. Scott, your time has expired.
    Mr. Scott. Thank you very much, Mr. McDonough, for your 
fine answers, sir.
    Chairman Baker. Ms. Velazquez.
    Ms. Velazquez. Thank you, Mr. Chairman.
    Mr. Chairman, while Sarbanes-Oxley was intended to apply to 
public companies, it is clear, and we discussed that already, 
that many smaller non-public companies are adopting the new 
PCAOB audit standards. For instance, not-for-profits with 
outstanding municipal debt, private companies with a large 
private shareholder base, or private companies seeking venture 
capital are finding that they might have to adopt in full or in 
part increased audit and internal control standards.
    What is your perspective on the adoption of PCAOB standards 
by non-public companies?
    Mr. McDonough. I think, Congresswoman, that there is much, 
much to be achieved if we can have essentially single audit 
standards. As a legal matter, we have the authority to set the 
audit standards for public companies. So there is a question 
of, well, what should private companies do? Should they have a 
separate set of standards? There is a certain amount of 
discussion about that, and I fear that there may be a certain 
amount of desire in certain parts of the accounting profession 
to keep some areas of responsibility, also known as turf, that 
they used to have.
    David Walker, who is a wonderful colleague, the head of the 
GAO, as you know, and I invited the head of the Accounting 
Standards Board to work with us in a forum so that as much as 
possible we could get the yellow book standards for the 
government, the public standards which are set by the PCAOB, 
and standards for private companies to be as close as possible.
    Why would you want the public company audit standards to 
set the way? The reason is that there are some public companies 
that actually go private, but not very many. Lots of private 
companies go public and you would not want an obstacle of 
vastly different auditing standards to be in the way.
    What I think is helpful, because I very much share the 
concern behind your question and your opening comment, is we 
have to ask everybody involved, including in the companies and 
in the audit firms, would you please use your heads? Figure out 
how much you really need in the way of what would be required 
for a huge company for the auditing, the methodology, the 
bookkeeping of a private company depending on its size. A large 
private company, as you suggested, with lots of private 
participants in its ownership probably needs something that 
looks very much like a public company.
    On the other hand, a rather small public company probably 
needs something in the real world that would look much more 
like a private company. So in trying to insert what you could 
either call cost-benefit or, what I say, really use judgment, 
we are really trying to make it as possible as I can 
conceivably make it for smaller public companies and for small-
and medium-size private companies to participate in this 
greater insight and credibility of financial statements without 
it being a cost which is just not, in some cases they just 
cannot bear the cost. They do not make enough money to do it.
    Ms. Velazquez. At this point, you do not think that we need 
to develop, or that there is a need for an alternative standard 
that would apply only for nonprofit companies?
    Mr. McDonough. I do not think that there is such a 
standard, but we do not have the authority to do anything 
except state an opinion on that.
    Ms. Velazquez. Okay. The PCAOB only annually examines firms 
that audit 100 or more public companies. For all others, it 
examines on a 3-year cycle. Do you believe that those firms 
receiving an annual inspection will be perceived by the 
marketplace to be the gold standard, and thus lead to further 
concentration in the public accounting industry?
    Mr. McDonough. I do not think it should. Is that a very 
good question? You bet. On the other hand, the Big Four really 
deal with big companies. The next four tend to deal with the 
remainder of the ones in the United States that we inspect 
annually. They tend to specialize on essentially medium-size 
companies. Since they are to a degree regional, they are 
medium-size companies in their own area, and they find that 
that is the best market niche for them.
    I think if I were a small-or medium-size company and I had 
an accounting firm that as on the 3-year cycle and I had 
confidence in that accounting firm, I would not spend a nano-
second thinking about changing to a big firm just because it 
got inspected annually. I just do not think there would be any 
need to do that.
    Ms. Velazquez. I know that the PCAOB has thought long and 
hard about how the results of examinations are going to be made 
available. Obviously, providing both investor and corporate 
clients with information concerning the degree of the 
reliability of audit work is relevant to a whole host of 
decisions. Could you tell me what information the public and 
corporate clients will receive and in what form?
    Mr. McDonough. In the area of quality control, the statute 
makes it very clear that if we find things that need 
improvement, that is, criticisms in the area of quality 
control, the firm has a full 12 months from the date of the 
report to fix those matters. If they do so within 12 months, it 
remains confidential forever. There were people who kind of 
wondered about that. My own view is that that gives us a very 
effective tool to say, fix it within 12 months or it goes 
public and you probably do not want it to go public. It is a 
wonderful discipline. It is like telling your kid you have to 
pass school this year.
    More broadly, we do believe that we have an obligation to 
the public to have as much to say in the examination reports as 
the statute permits. So rather than say we will put out a 
statement that says we examined firm X, period, which would be 
of no earthly interest to the public or no value to the public, 
we are interpreting the statute as one that says, very 
definitely in the quality control area, confidential. If we 
have a discussion of something that had to do with the 
experience, say, in accounting or auditing matters, of a 
specific issuer, we will discuss the concept, but not mention 
who the issuer was.
    So it is a very delicate balancing act between our keeping 
the confidentiality requirements of the statute and saying 
enough so the American people can judge how much progress is 
being made by the profession in general and the firm in 
particular.
    Ms. Velazquez. Do you intend to create a rating system?
    Mr. McDonough. No, we will not have a rating system. I 
think that is too simplistic and too given to people 
interpreting it, taking it too seriously.
    Ms. Velazquez. Thank you.
    Chairman Baker. Thank you, Ms. Velazquez.
    Mr. Sherman.
    Mr. Sherman. Thank you.
    We have been shaken, of course, by the failures, the two 
kinds of failures, if I can categorize them. One is exemplified 
by Enron, where the auditor pretended that what he saw was 
okay, and was being properly described in what turned out to be 
phony financial statements; and the WorldCom example where they 
pretended not to see the basic facts. There is no accounting 
principle where you can take a couple of billion bucks worth of 
operating expenses and capitalize them. It is not a matter of 
twisting a gap; it is more a matter of covering your eyes.
    With that in mind, one of the things I have been talking 
about before my colleagues, perhaps more often than they would 
like to hear it, is the need to look at the balance of power 
within the accounting firm, between on the one hand the client 
partner, who golfs with Ken Lay; who becomes useless to Arthur 
Anderson if Ken Lay takes his business elsewhere, if your job 
is to service a client that produces $50 million in revenue and 
that client goes elsewhere.
    And then the other side of that balance is the review 
department. At Arthur Anderson, perhaps unique among accounting 
firms, and this may oversimplify, it had a 100 percent balance 
of power in favor of the client partner. The review department 
was on a don't ask/don't tell basis. If the client partner does 
not feel he needs any advice, the review partner does not even 
see the questions.
    I have urged my colleagues here to provide by statute, it 
may in the view of many in Congress be more appropriate for 
your board to do this, but what are you doing to make sure that 
that Arthur Anderson structure is never allowed and that people 
whose job it is to assure quality control, people who never 
golf with any one client because they are involved in 100 
audits a year as reviewers, have the balance of power in their 
direction, and that if the reviewer does not think it flies, it 
does not go out the door, and that the reviewer actually gets 
to look at it before it goes out the door.
    Mr. McDonough. Congressman Sherman, I think that there are 
various aspects. We will be looking very closely at quality 
control in the firm. That has a lot to do with the review by 
the concurring partner.
    Mr. Sherman. A concurring partner in the same office?
    Mr. McDonough. The reviewing partner.
    Mr. Sherman. Or a review partner probably in the 
headquarters office?
    Mr. McDonough. It varies a bit with the firm. Essentially 
what you want is that there be a quality control in the firm. 
By the way, we had a very interesting discussion of this in our 
standing advisory group which advises us on how to look at 
auditing standards. The person who reviews the engagement 
partner's work gives what is called a negative assurance. Now, 
would it be better, and it is a question, and we are not quite 
sure----
    Mr. Sherman. I have limited time here. If you have a 
circumstance where you have a two-partner office and A is 
reviewing B's work and B is reviewing A's work, that may not 
assure your objective.
    Mr. McDonough. I believe we would point them in the 
direction that B should not be reviewing A's work.
    Mr. Sherman. The way I have seen this best is if a firm has 
a centralized, maybe not one, but several review departments. 
But to cut matters short, are you in a position where the 
reviewing partner must complete a review and if that reviewing 
partner decides that a clean opinion cannot be issued, that a 
clean opinion is not issued. Or are you going to allow the 
client partner to override the reviewing partner?
    Mr. McDonough. In I believe all four of the big firms, 
first of all, even in the period when Arthur Anderson had that 
arrangement, the remaining Big Four did not.
    Mr. Sherman. Are we going to leave it to the Big Four to 
decide, when they have forgotten Arthur Anderson, to go to a 
more aggressive marketing model? Or are you going to prevent 
them from adopting the Arthur Anderson approach or hope that 
their memory does it for them?
    Mr. McDonough. Oh, of course, of course.
    Mr. Sherman. So you are going to require that the reviewing 
partner, that you cannot issue an opinion unless the reviewing 
partner agrees?
    Mr. McDonough. If the reviewing partner says there should 
not be a clean opinion, the statute really requires that the 
reviewers review and approve. That is in the statute. So if the 
reviewing partner was a patsy, he or she is violating the law.
    Mr. Sherman. Got you.
    Mr. McDonough. The law is very effective. The other thing 
we do is we look at who gets paid how much. So if Joe the big 
business developer is being very well paid, and a good audit 
review partner is not, we will have a great deal to say to the 
management of the firm in our inspection.
    Mr. Sherman. I can say this because I was on track to 
become a reviewing partner long ago. I have never been so happy 
since I watched the movie Revenge of the Nerds to hear that the 
reviewing partners may get paid nearly as much as the client 
development partners.
    [Laughter.]
    I say that only because that could have been me.
    One of the other things that we saw in the Enron statement 
is that if you read the financial statements, they beg 
questions. They were obviously unclear. They hinted that 
something was being covered up.
    One of the ways for you to do your work is to actually read 
the financial statements and see, because there are limited 
number of audits where you can go out and look at the working 
papers. You could read, well, your agency could read the 
financial statements of at least the top 1,000 companies. We 
have urged the SEC to do so as well. Are you reading financial 
statements and circling the parts where it seems like something 
is being hidden, particularly in the footnotes?
    Mr. McDonough. Since the SEC does have the responsibility 
to read them, and they have a much bigger staff than I do, we 
are now cowering at 202 people. We are, however, starting what 
we are calling a financial risk analysis group which will start 
in July. That will be the organization within my shop, but as 
of July it will have two people in it. We will grow it, as we 
do the rest of the PCAOB, as rapidly as we can. I think 
realistically, Mr. Chairman, that we will have to assume that 
the SEC will just have more eyes to look at them than the PCAOB 
will for at least a while.
    Mr. Sherman. Finally, financial auditing is the only game 
where one of the teams gets to pick the umpire. I do not know 
whether this is even an idea worthy of discussion, but I will 
bring it up. I certainly do not know if it would be a good 
idea. One could imagine at some distant point that your agency, 
rather than the audited client, selected based on bids and a 
review of quality and price, which qualified auditing firm did 
the auditing. Would that be a better system or because then the 
client would have virtually no power over its own auditor, or 
should we stick with pretty much the present system?
    Mr. McDonough. The statute really envisions, and I think it 
is a big step forward, that it is not the CEO/CFO who decides 
who the outside auditor is, but the audit committee. Now, since 
that is new, in the real world we do not know how it is going 
to work. I doubt very much that there is a whole lot of 
enthusiasm, including by the way on my part, for our selecting 
who should do the audit, but there is obviously pressure on the 
audit committees to do their jobs properly so that that does 
not happen.
    Mr. Sherman. But the audit committee in many of these 
companies, every member of the audit committee has stock 
options and therefore a vested interest in the company showing 
positive results.
    Mr. McDonough. Yes, but I think that we are going to be 
able to see whether, perhaps despite that, the audit committees 
are carrying out their responsibilities to the investors. The 
law is actually pretty tough, and the PCAOB is certainly not 
giving any impression to the accounting profession that we are 
patsies. So I think that there is a new era of Sarbanes-Oxley, 
of its creation of the PCAOB, and I think we just have to see. 
A little bit of skepticism might be in order.
    Mr. Sherman. I am confident that as long as the whole 
financial world remembers vividly the mistakes that we have 
just seen that the current structure is likely to work. But 
when those lessons are forgotten, there may be some backsliding 
to old cultures. We have seen cycles of this, scandal, people 
get religion, then people forget it, then people see the 
immediate financial rewards, and then we go to another series 
of scandals.
    So I think in today's world, audit committees are going to 
be, dare I say it, religious. I think I have given way too long 
a homily here. I thank the Chair.
    Chairman Baker. Always a pleasure, Mr. Sherman.
    Mr. McDonough, in the hearing, I just had a follow-up 
question. The Sarbanes-Oxley Act's creation of the PCAOB, the 
focus on audit independence, on professional conduct by 
auditors, all are certainly important and significant steps 
moving us in the right direction.
    I am curious, not in your capacity as chair or as a member 
of PCAOB, but given your general willingness to make a personal 
observation on matters of some controversy, I am concerned that 
a retrospective rules-based system in a world which moves so 
quickly, and even with the best of professional conduct, tells 
you where the corporation was 91 days or more in the past. It 
does not really indicate to you where the corporation might be 
going in the future.
    There are certain academic views in the world. A book 
called Value Reporting was recently written which made some 
pretty common sense points. Many of your observations are 
rooted in the ``reasonable man'' standard. Whether the highest 
level of accounting methodology is appropriate for a small firm 
or not ought to be judged by the CEO and the CFO, and other 
such examples.
    I am wondering, not that we should set aside what we have 
accomplished with Sarbanes-Oxley, but might there not be 
advisability in examination of and consideration of a more 
real-time disclosure methodology as perhaps ostensible business 
reporting language now and pilot by the FDIC; perhaps material 
fact disclosure; if you are losing a customer that is 30 
percent of your income, if you have a need for a particular 
commodity and the supply is running out, customer satisfaction 
surveys, people are buying your widget by the thousands, but 
they are returning them by the thousands.
    Should the committee concern itself in going forward about 
looking at a more forward-looking system, perhaps principles-
based as opposed to rules, in providing the kind of disclosure 
to the markets that really is helpful to markets, as opposed to 
strictly the current system?
    Mr. McDonough. Mr. Chairman, I think the answer is yes, but 
let me put it in context. I think that one of the most 
pernicious things that came along in the 1990s was the intense 
concentration on quarterly earnings and on forecasting 
quarterly earnings and making the forecasts. It was a terrible 
development because it is essentially what led to a certain 
number of companies cooking the books. Some of them were 
sources of the scandal and some others were probably being 
aware that on an accounting statement, every number there is an 
estimate, including cash if you are involved in more than two 
countries where you have to a currency conversion.
    I think what we need to do, and what you suggest would be 
part of it, would be that all of us have to work on the 
corporate leadership of America to say what is really important 
is the future of your company. We ought to be building for the 
future. If part of the cost of building for that future is that 
this quarter does not look all that great, responsible, 
sensible investors should be saying that is good, because that 
company is going to have a more powerful future.
    I started in one of my other activities to say we need 
about 20 of the greatest companies in America who would decide, 
we are not going to sweat the quarterly earnings. We are going 
to build our company for the future, and since we, let's say 
you could get 20 of them, that we are going to be the leaders. 
The investors will say, those are the companies that really 
make sense. And then getting number 21 to 3,002 is easy because 
leadership is there.
    I think anything that Congress could do which would point 
in the direction of what is the company going to be like in the 
future, and then the kinds of disclosures you describe would be 
very helpful. I think it is much to the good.
    Chairman Baker. When I learned that a tel-com could report 
revenue in the current quarter from the sale of broad-band 
capacity for a system that is not yet built, it said to me we 
may have a great system, but I do not know if it is giving me 
useful information.
    Mr. McDonough. Precisely.
    Chairman Baker. I think that there has got to be a way to 
incentivize that type of long-term growth and earnings. I 
completely agree with the insidious effect of the 90-day 
earnings report. When you had a brick and mortar company that 
had never had a loss in the preceding 20 quarters, and they 
make seven cents instead of eight and they get hammered; then 
you have a principals-based company with no physical location 
of operation and they only lose four cents instead of five and 
their stock price goes up, the world is upside down.
    Mr. McDonough. You bet.
    Chairman Baker. Thank you.
    Ms. Maloney.
    Mrs. Maloney. Thank you for holding this oversight hearing. 
I would like very much to welcome Bill McDonough, who happens 
to be a constituent, and congratulate him on his really 
outstanding career in New York at the New York Fed, and now 
taking on one of the great challenges for the safety and 
soundness and restoring the confidence in our financial 
markets.
    I know from talking to other New Yorkers, he was offered 
many, many other positions and he turned them down to take this 
one because he thought it was very important for the country. I 
truly do want to welcome you here.
    I would like to ask, what do you think about FASB's recent 
proposal to expense stock options? As one who is really trying 
to get a good accounting of what is happening, do you think 
companies should be required to expense stock options?
    Mr. McDonough. Congresswoman, thank you for the kind words. 
I do, indeed, live in your district and continue to vote there.
    [Laughter.]
    Mrs. Maloney. I better behave myself.
    Mr. McDonough. We have an enormously full plate, as you can 
easily imagine, and accounting policy, which is what we are 
discussing here, is not part of it. So if you would forgive me 
doing something which you know is enormously uncharacteristic, 
I would like to say that since that is the responsibility of 
FASB and the SEC, that the PCAOB cannot have an opinion on it 
and should not have an opinion on it, and as Chairman of the 
PCAOB, ergo, I should not.
    Mrs. Maloney. Okay. Then getting back to Sarbanes-Oxley, 
which is your responsibility, I hear both sides from my 
constituents. Some feel that we were not as strong as we should 
be. Some firms tell me that is absolutely killing them; that 
they have to spend millions and millions of dollars on 
accounting that they feel is in some cases unreasonable.
    Could you comment on it? You have been implementing it now. 
What is your reaction? Do you think we became too strict? Do 
you think we should be stricter? Do you think we have put too 
much of a burden on businesses? Could you just give a sense of 
how you feel about what we did?
    I would like to say that Congress does not like to really 
dictate to the private sector. We want to respect the private 
sector and support them. They are the engine that runs this 
country. But when there are abuses, we are forced to act and we 
try to do it as reasonably and as professionally and as 
balanced as possible. Were we balanced? Is it working? Were we 
too strong? Were we not strong enough? Do you have a sense of 
it for us?
    Mr. McDonough. There were two main products of Sarbanes-
Oxley that the business community looked at, the requirement 
that the CEO and CFO say that the financial statements are 
accurate or they are in violation of a criminal statute. There 
was much shock when you passed that, however, everybody has 
been doing it, and you do not hear very much about it anymore, 
which I think is a good thing.
    What they are concerned about now is the internal control 
at a station. The management, as you know, has to assess the 
adequacy of internal controls over financial reporting, and the 
outside audit firm has to attest to it, which as we established 
is essentially a second audit of internal controls. Is that 
justified? For large companies, I think there is no question it 
is.
    Chairman Oxley quoted General Electric, its management said 
that they had spent $30 million worldwide on the Sarbanes-Oxley 
Section 404 assessment and they thought it was money well 
spent. I thought that was a very accurate and sensible 
statement and much to be applauded. The fact that they said it 
publicly is the part that should be applauded. I can assure you 
it was very helpful to us.
    In the case of large firms, if they had good internal 
controls, which they should have had, there is only the 
additional expense of actually documenting the internal 
controls. They probably should have had that also. So I am not 
very sympathetic to any protestations by the large issuers on 
the cost of Sarbanes-Oxley implementation. I think it is 
necessary expense, important expense, and the Congress very 
correctly interpreted the view of the American people that it 
simply had to be done better.
    Especially in response to your colleague, Ms. Velazquez's 
concerns about the affect on small-and medium-size companies, 
what we are trying to do is to say that in both the case of the 
companies themselves and the audit firms, they should be using 
good judgment. The amount of internal control you need for a 
small-and medium-size company clearly is not what a big 
complicated company needs. Therefore, the extent of the 
internal controls should reflect the reality of the company and 
the auditor should use good judgment in establishing whether 
the amount of internal controls put in place are adequate.
    If in both cases they say, we passed the test, then our 
inspectors when they inspect the accounting firm, and if they 
look at that particular engagement, as I said earlier, I think 
that they should say, if the company issuer showed good 
judgment and the audit firm in its attestation showed good 
judgment, whether our inspector would have done it exactly the 
same way is not particularly relevant. We should decide whether 
the judgment that was expressed by the issuer and the auditor 
were appropriate. If so, it passes.
    I think this sort of judgment, also known as common sense 
approach, which is what we tried to work in to get as much 
cost-benefit consideration into the statute as we could push it 
to deliver, that is how we are trying to come up with a 
realistic, but I think also appropriate under the statute, 
reaction to not having the stuff become so expensive that it is 
really making firms spend money that simply is not justified.
    Mrs. Maloney. My time is up. We thank you for taking this 
very challenging position. Any time you create and put into 
place something new, it is always particularly a huge 
challenge. At this time, it is very important to have respect 
in our markets and the accuracy of them. So I appreciate your 
work and thank you for being here today.
    Thank you, Mr. Chairman.
    Chairman Baker. The gentlelady yields back.
    Mr. Sherman.
    Mr. Sherman. Yes, I wonder if I could ask some additional 
questions.
    Chairman Baker. Okay.
    Mr. Sherman. I would like to pick up on where your members 
of Congress left off, and that is, what can you do as a board 
to describe, provide examples, provide guidance so that smaller 
issuers and their accounting firms can tangibilitize your words 
right here before us that only a reasonable amount of internal 
control, documentation of internal control, and auditing and 
proving that the internal control exists and is documented, 
will be engaged in by small firms? Because there is a tendency, 
especially in the period right after the falsehoods are 
revealed in the culture, to go in the direction of saying, 
well, if GE has to do it, then the small issuer has to do it as 
well. Are you able to issue some guidance or some explanation 
so that if GE spends $30 million, that is fine, but some 
company with $100 million of revenue is not spending $300,000?
    Mr. McDonough. In our auditing standard number two, 
Congressman, we aligned our internal control standards with the 
COSO approach. I am very familiar with that because that is 
what we used at various institutions that I ran before I came 
to the PCAOB. COSO is a broad, highly flexible framework for 
internal control that can be used by a variety of companies. It 
does not require that all companies have the same internal 
control. It is very flexible.
    What is important is that all public companies have 
effective internal control and we are very much aware that what 
is needed to be effective at a large company might not be 
needed at a smaller one. In fact, I would go so far as to say 
it clearly is not needed.
    Mr. Sherman. Again, with limited time, there may be some 
unique circumstances or some companies that have bad internal 
control that really need to get their act together, but looking 
at the average $100 million revenue company in the United 
States, what should be, under the rules that you are trying to 
make clear, the costs for the average $100 million a year 
company to comply?
    Mr. McDonough. We try not to answer that, not to duck, but 
you could have two companies in two different----
    Mr. Sherman. I am not saying that any one company can do 
this. That is like saying, what is the price of an average car. 
That does not mean you get a Lexus for that price, but for all, 
say, 1,000 companies that fit that, or hundreds of companies 
that fit that, not any one, what should be the range? How 
expensive should this be to the American economy for that 
sector?
    Mr. McDonough. I really cannot give you a reasonable answer 
to that, because I want it so much to be that which makes sense 
for the individual company and not a penny more.
    Mr. Sherman. But you think if we did that, that the average 
$100 million company would be spending $500,000 on this?
    Mr. McDonough. I frankly do not know.
    Mr. Sherman. Okay. I hope that there would be some cost-
benefit thinking, and that even if you do not know now, that 
your board would know.
    Mr. McDonough. You know why I hope you would come to the 
point of wishing I would not do that? It is because as soon as 
we put out a number, the company that really does not need to 
spend that much would think it had to spend that much.
    Mr. Sherman. Then you would put out a range, would be nice, 
which would indicate that there are a variety of factors like 
what industry you are in, not just what----
    Mr. McDonough. Could I leave it if we think that we could 
put something out that would make sense and be positive, we 
would do it. I am not sure that we can do it.
    Mr. Sherman. Okay, because there are a lot of folks who 
feel they need to do something that I think if you and I looked 
at it, it would be overboard.
    I just want to comment on some of your comments. It would 
be great to live in a world in which investors did not just 
look at earnings per share, and did not just look at this 
quarter's earnings per share. I do not think we will get there. 
There are so many people who want to trade a stock today; want 
to compare a stock to any one of 50 other stocks; and want to 
do it online before they go to work in the morning. Likewise, I 
hope that the religion, the fear of God inspired by the 
imprisonment of at least a few, and it has not been enough, 
will last.
    But I would hope that we would build our structure for what 
happens when the culture gets lazy and the investors stay lazy. 
I will not say lazy, but stay surface and immediate and quick, 
because no one wants to hold a stock if they think it is going 
to go down for a month. They can always buy it back later, 
unless there is a tax reason, and to think that they are going 
to say, well, I will ignore quarterly reports. I will ignore 
the fact that I believe the stock is going to go down for the 
next 6 months, because I think 10 years from now it is going to 
be a good stock. There are just a lot of investors who are 
going to look at quarterly reports, not just annual reports.
    Finally, what can you do so that auditors are opining on 
something other than just a fund statement and income statement 
and a balance sheet? It is not just how accurately we report 
that which was decided for the important stuff over a century 
ago as relevant, and was decided to be relevant for every 
industry. When are we going to have standards on how auditors 
can report on employee turnover, backlog, and hundreds of other 
things where the numbers, I mean, I would rather know some of 
those numbers than know earnings per share for a quarter about 
a company.
    Will we have standards coming from your shop or elsewhere 
as to how these audit firms can start opining on something 
worth opining on?
    Mr. McDonough. I think the first thing you do is change, if 
necessary, the accounting standards, which is SEC's area.
    Mr. Sherman. Backing off from this, the accounting 
standards will say, generally accepted accounting principles 
will say, here are the rules for creating an income statement; 
here are the rules for creating. I do not know of anybody who 
has an accounting standard for defining backlog or employee 
turnover rates.
    Mr. McDonough. Actually, they could mandate disclosure of 
anything.
    Mr. Sherman. They could. You could also say, here is how 
you audit that, and for different industries, there are going 
to be different numbers. But an accounting firm, an auditing 
firm ought to be able to say, here is what we mean by employee 
turnover for this issuer, or here is what the issuer says it 
defines it, and we opine that under that definition their 
employee turnover rate is 3.2 years.
    Mr. McDonough. Congressman, as we work on the auditing 
standards, which is a huge work in progress, we will have to--
--
    Mr. Sherman. I am not saying you have to do it this week.
    Mr. McDonough. We will have to establish what we really 
think auditors should do.
    Mr. Sherman. I hope that you would think that they should 
opine upon and give people confidence in some number that would 
not be part of the accounting statements issued by every issuer 
in the year 1901. But rather, that you would give them guidance 
on how to opine on some of the things that investors today want 
to know about companies in particular industries.
    Chairman Baker. Mr. Sherman, I just want to point out, it 
was four or five questions ago when you said ``finally.''
    Mr. Sherman. That is a device I use to try to get more time 
to ask for.
    Chairman Baker. A typical accountant. You drag it out and 
drag it out.
    [Laughter.]
    Mr. Sherman. It is more like a typical lawyer.
    Chairman Baker. Thank God I am neither.
    Mr. McDonough, I just want to express again my appreciation 
for your appearance here today and commend you for the good 
work of your own and of the board to date. I particularly am 
appreciative of your continued repetitive statement concerning 
the ``reasonable man or woman'' standard, as the case may be, 
being the guide by which these decisions are being made.
    The consequence of this, however, is because of the manner 
in which you conduct your business and the board's significant 
responsibilities for the conduct of corporate reporting, there 
is a high level of confidence by members of this committee in 
the work you are doing.
    That therefore brings about a significant standard of 
reliance on your judgments. I would hope that in the course of 
your future work, that as your findings lead you to 
conclusions, that the Congress needs to either be informed of 
or needs to act on, that you would feel quite free in not 
waiting for the committee to seek out your guidance, but to 
unilaterally opine at will as warranted for us to be able to 
work closely with you in this effort.
    It is clear to me that our rules do need constant scrutiny; 
that our current system, and I am going to agree here briefly 
with Mr. Sherman, does need modification to give the markets 
the information we really need; and that is a long-term 
project, as well as doing something about the insidious 
earnings report. But I wholeheartedly agree with your 
representations here this morning, and thank you very much.
    Mr. McDonough. Thank you, Mr. Chairman.
    Chairman Baker. Our meeting stands adjourned.
    [Whereupon, at 11:52 a.m., the subcommittee was adjourned.]


                            A P P E N D I X



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