[Senate Hearing 108-850]
[From the U.S. Government Publishing Office]
S. Hrg. 108-850
EXAMINING THE IMPACT OF THE
SARBANES -OXLEY ACT AND DEVELOPMENTS
CONCERNING INTERNATIONAL CONVERGENCE
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
ON
REGULATIONS IN THE UNITED KINGDOM AND HONG KONG, STRENGTHENING
CORPORATE GOVERNANCE AND INTERNAL CONTROLS, CONCERNS OF SMALL
COMPANIES, AND THE CHANGED BEHAVIOR OF AUDIT COMMITTEES, MANAGEMENT,
AND AUDITORS
__________
SEPTEMBER 9, 2004
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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senate05sh.html
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Bryan N. Corbett, Counsel
Martin J. Gruenberg, Democratic Senior Counsel
Dean V. Shahinian, Counsel
Stephen R. Kroll, Special Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
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TUESDAY, SEPTMEBER 9, 2004
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Enzi................................................. 3
Senator Sarbanes............................................. 4
Senator Allard............................................... 16
WITNESSES
Sir David Tweedie, Chairman, International Accounting Standards
Board.......................................................... 5
Andrew Sheng, Chairman, Securities and Futures Commission of Hong
Kong SAR....................................................... 10
Prepared statement........................................... 46
Response to a written question of Senator Shelby............. 100
Paul Boyle, Chief Executive, Financial Reporting Council (U.K.).. 13
Prepared statement........................................... 50
Douglas Flint, Group Finance Director, HSBC Holdings plc......... 27
Prepared statement........................................... 56
Arnold C. Hanish, Chief Executive Officer, Eli Lilly & Company... 29
Prepared statement........................................... 67
James S. Turley, Chairman and Chief Executive Officer, Ernst &
Young, LLP..................................................... 31
Prepared statement........................................... 89
Greg Bentley, CEO, Bentley Systems, Inc.......................... 33
Prepared statement........................................... 95
Leonard Moodispaw, President and Chief Executive Officer, Essex
Corporation.................................................... 35
Prepared statement........................................... 98
(iii)
EXAMINING THE IMPACT OF
THE SARBANES-OXLEY ACT
AND DEVELOPMENTS CONCERNING
INTERNATIONAL CONVERGENCE
----------
THURSDAY, SEPTEMBER 9, 2004
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 2:36 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing will come to order. As I have
told several of you, I am sorry but we have had two back-to-
back votes, and the floor prevails over the Committees, as
everybody knows.
One year ago upon the anniversary of the Sarbanes-Oxley
Act, this Committee held a series of hearings devoted to
examining the implementation of the Sarbanes-Oxley Act. At that
time, we reviewed newly promulgated regulations, discussed
upcoming rulemakings, and considered reforms already underway
in corporate boardrooms and accounting firms. To date, our
review has primarily focused on the domestic impact of the
legislation. This afternoon, the Committee broadens its
consideration of the Act by examining it in the context of
convergence of U.S. and institutional governance, accounting,
and audit principles.
Nearly simultaneous with the enactment of Sarbanes-Oxley in
2002, the Financial Accounting Standards Board and the
International Accounting Standards Board were formalizing an
agreement to undertake a convergence project. FASB and the IASB
agreed to work cooperatively in an attempt to develop a single
set of high-quality accounting standards that could be used
internationally. This project involves eliminating differences
between current standards and undertaking future projects
together in order to ensure that the new standards are similar.
As global capital markets evolve, the need for convergence on
accounting principles becomes more apparent.
First, a uniform set of international standards reduces the
compliance costs for corporations by minimizing conflicting
regulations. Second, uniform standards should facilitate cross-
border transactions by eliminating inefficiencies and promoting
comparability of financial information. The FASB and IASB
convergence project is one example of efforts underway to avoid
regulatory conflicts and promote international business. For
the past 21 years, the International Organization of Securities
Commissions has facilitated a multilateral dialogue aimed at
enhancing cooperation among international securities regulators
and improving the regulation of securities markets. As a
result, the benefits of convergence will become evident not
only with respect to accounting principles, but also regarding
auditing standards and governance principles.
And although differences will inevitably arise during the
convergence process as local jurisdictions promote particular
interests, it is important that the international dialogue
remain focused on long-term goals and that regulatory bodies
work toward consensus. Further, I strongly believe that we
should seek to insulate the convergence process from regional
political calculations. To the extent that political pressures
compromise the process, there is a risk that we fall behind
global developments and our standards are seen as inadequate.
If this occurs, U.S. companies may suffer the consequences of
less liquidity and restricted access to capital.
This afternoon, this Committee will examine the Sarbanes-
Oxley Act within this context of convergence. The legislation
has had a significant impact on international companies listed
in the U.S. markets and their auditors. It is important to
understand how international companies and the agencies that
regulate them are working to harmonize the mandates of the Act
with their respective national laws and business practices. As
the convergence process unfolds, we should be mindful of the
impact of our laws on international markets and how regulators
might address particular concerns during the implementation
process.
It has only been 2 years since enactment of Sarbanes-Oxley,
and the SEC and Public Company Accounting Oversight Board
continue to implement the Act and establish compliance
programs. As with any landmark legislation, companies will
experience a certain amount of uncertainty and compliance costs
as they implement the law and modify their business practices
and operations. Although I acknowledge increased compliance
costs associated with implementing Sarbanes-Oxley, I also
recognize that certain costs were necessary to restore investor
confidence and address the surprising erosion of business
principles. During the coming months as the implementation
process continues, we should be sensitive to the impact and
costs and benefits of new rules and regulations.
We have a very distinguished panel with us today to discuss
these issues. Sir David Tweedie is the Chairman of the
International Accounting Standards Board. Mr. Andrew Sheng is
Chairman of the Securities and Futures Commission of Hong Kong
and Chairman of the Technical Committee of the International
Organization of Securities Commissions. Finally, Mr. Paul Boyle
is the Chief Executive of the Financial Reporting Council of
the United Kingdom. I thank each of you for traveling here to
be with us today. We look forward to hearing your perspectives.
We will also hear from a second panel comprised of
executive officers from various domestic and international
corporations. The witnesses on the second panel will be: Mr.
Greg Bentley, President and Chief Executive Officer of Bentley
Systems; Mr. Douglas Flint, Group Finance Director of HSBC
Holdings and Member of the U.K. Accounting Standards Board; Mr.
Arnie Hanish, Chief Accounting Officer of Eli Lilly & Company;
Mr. Len Moodispaw, President and Chief Executive Officer of the
Essex Corporation; and Mr. James Turley, Chairman and Chief
Executive Officer of Ernst and Young. We look forward on the
second panel to their insights concerning the Sarbanes-Oxley
Act and how its implementation has impacted their businesses.
Senator Enzi, do you have an opening statement?
STATEMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. Thank you, Mr. Chairman. I thank you very
much for holding this important hearing and putting together
these distinguished panels. When we passed the Sarbanes-Oxley
Act a little more than 2 years ago, we faced a crisis of
investor confidence in our Nation's accounting and corporate
governance standards. The law was intended to restore the
financial accounting foundation of our public markets and bring
attention to the vital importance of corporate ethics and
corporate governance. There is little doubt that the law has
had the intended effect on the Nation's markets. In fact, it
has even had the intended effect on the Nation's schools and
colleges, as well as the businesses. I find a lot more ethics
courses everywhere.
At the time we passed the law, we recognized certain
sections of the law may affect companies and accounting firms
located outside the United States. However, we believed that
the extent would not impede or interfere with the operation of
foreign securities markets and/or accounting standards. Since
then, we have received many anecdotal stories about positive
and sometimes negative effects. It is my understanding that the
Securities and Exchange Commission and the Public Company
Accounting Oversight Board have undertaken extensive outreach
efforts to ensure foreign entities' concerns are taken into
consideration during the implementation of the Sarbanes-Oxley
Act. I applaud their efforts and their staff's efforts.
Today's hearing will help us to understand the extent of
the Sarbanes-Oxley Act on foreign accounting firms and
corporations. In addition, this hearing will help us to
understand the nature and progress made on the convergence of
U.S. and international accounting standards. Overall, the
convergence of accounting standards is a lofty goal. For many,
many years, the United States has been criticized that its
accounting and corporate standards were placing barriers on
foreign corporations and investments. Many believed that the
convergence of accounting standards will help to open doors for
foreign countries to list in the United States and for U.S.
investors to invest in foreign markets.
Generally, I have been supportive of the convergence
efforts as it will open new markets and create new efficiencies
for corporations. Currently, accounting firms and U.S.
companies have been focusing all of their efforts on the
implementation of the Sarbanes-Oxley Act provisions. While we
have just passed the second anniversary of the law, there is a
still a tremendous amount of compliance work to be done, such
as the oversight of the internal controls, as required by
Section 404.
On the international front, I understand that the
International Accounting Standards Board is working to finalize
many accounting standards in order to meet the January 1, 2005,
deadline established by the European Union for the recognition
of international accounting standards. This project, together
with the convergence efforts with the U.S. accounting
standards, is quite an undertaking. I would like to applaud the
IASB's effort to address accounting concerns of small and
medium-sized enterprises. The IASB released a request for
comments in July of this year to receive input from small
entities on implementation of accounting standards.
As you know, I requested the Financial Accounting Standards
Board to set up a small business advisory committee in which
FASB held the committee's first meeting in May, and I really
appreciate that response. As we have found out from Federal
agencies' rulemaking, it is always better to receive the input
of small business early in the process. Once a rule has been
finalized, then it is extremely difficult to take the small
business issues into consideration, which could have easily
been worked out in the final rule if the small business had
been consulted first. So, I really appreciate that effort on
behalf of FASB, and I thank you, Mr. Chairman, for holding this
hearing.
Chairman Shelby. Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Mr. Chairman, and I
welcome the panel that is before us and the one that is to
follow. And it is always a pleasure to have Sir David Tweedie
here before us.
The European Commission is working to adopt international
accounting standards beginning in 2005, as I understand it, so
a focus on convergence of U.S. and non-U.S. accounting and
regulatory standards is very timely.
The Financial Times reported just this Tuesday that a study
of 2,500 international companies showed, ``that U.S. companies
have risen to the top of a global comparison of corporate
governance standards. The Sarbanes-Oxley Act and other reforms
implemented following recent scandals have succeeded in
improving the relative performance of large U.S. companies by
more than 10 percent.''
The Financial Times also reported findings confirming ``a
link between share price performance and adherence to corporate
governance best practice.''
Convergence of standards can foster international
investment while maintaining or even enhancing investor
protection, but only if convergence embodies the highest
standards, and those standards are consistently applied by all
countries involved. U.S. investor protection, auditing,
accounting, and corporate governance rules should continue to
set or reflect the highest standards.
For this to be the case, it is my strongly held view that
independent regulators and standard-setters must remain free of
political interference.
We have been reminded during the past year that non-U.S.
companies are not immune from Enron-like breakdowns. Large
public companies in Italy [Parmalat]--the United Kingdom and
the Netherlands [Shell]--and Canada [Nortel and Hollinger]--
most of which are listed in the United States, are now faced
with evidence of poor internal controls, weak corporate
governance, and substantial audit failures.
Mr. Chairman, I look forward also to the testimony of our
witnesses examining the impact of the Sarbanes-Oxley Act. The
Act is now beginning to take full effect. The SEC and the
Public Company Accounting Oversight Board, the PCAOB, have
properly recognized that the Act creates a framework within
which they are granted significant discretions to make
adjustments consistent with the spirit of the Act. The SEC, in
one example, has proposed postponing accelerated reporting
deadlines for most public companies, because this is the first
year in which the crucial internal control certification rules
of the Act apply. Strong internal controls are not only
required for accurate financial statements but also to prevent
misuse or theft of corporate funds. Strong controls produce the
verified information without which independent board members,
and the other gatekeepers on whom investor protection depends,
cannot do their jobs. Properly implemented, those controls
support the ethical ``tone at the top'' for which SEC Chairman
Donaldson and others have called.
Mr. Chairman, before I close, I want to commend again the
leadership and staff of the SEC and the PCAOB. The SEC has
issued an unprecedented number of rules in a very short time.
The PCAOB has established itself as a serious and professional
organization in less than 24 months. The Washington Post
reported on August 27 that, ``Accounting scholars and industry
experts who read the Board's recently released partial
inspection reports of the Big Four accounting firms said they
were surprised at their thoroughness, especially because Board
inspectors were operating at barebones staffing levels at the
time. `This is a clear signal from the Accounting Board that it
is not business as usual,' said Charles Mulford, an accounting
professor at the Georgia Institute of Technology.''
I also believe that the U.S. Financial Accounting Standards
Board, the FASB, the PCAOB, and the SEC are conducting fair,
open, and transparent proceedings at which all parties have the
opportunity to be heard. I am sure those organizations will
consider carefully the views that will be expressed by all of
our witnesses here this afternoon. I look forward to hearing
their testimony.
Thank you, Mr. Chairman.
Chairman Shelby. Before we get into our witnesses, I want
to note we are fortunate to have Chairman Jeffrey Lucy of the
Australian Securities and Investment Commission and some of his
colleagues visiting us today. Mr. Chairman, it is a pleasure to
see you again, and I hope you will add something to this and
maybe take something from this hearing. Thank you very much.
Mr. Tweedie, we will start with you. All of your written
testimony will be made part of the hearing today in its
entirety. You proceed as you wish.
STATEMENT OF SIR DAVID TWEEDIE, CHAIRMAN
INTERNATIONAL ACCOUNTING STANDARDS BOARD
Sir David Tweedie. Thank you, Mr. Chairman, Members of the
Committee. I have been asked to appear here today in my role as
Chairman of the International Accounting Standards Board. This
is my second appearance now before the Banking Committee, the
previous occasion being in February 2002, and I wanted to use
this opportunity to give you an update on the work of the IASB
and, particularly, its joint efforts with FASB to bring about
international convergence of standards.
When I last appeared before the Committee, you were faced
with the response to Enron and the other corporate scandals.
Let me say that I believe that the work that this Committee
spearheaded and the many others involved with the creation of
the Sarbanes-Oxley Act has served as a catalyst for positive
change in accounting and financial reporting throughout the
world. Many other countries have accelerated similar reforms
and in Europe and elsewhere, many of the principles of the
Sarbanes-Oxley Act have been adopted. At the same time,
differences will undoubtedly still arise, and in particular,
between U.S. and other national and international audit
standards. I would suggest that the model for convergence being
used by the IASB and the FASB might provide a useful framework
for the convergence of audit standards worldwide. I will leave
it to Mr. Boyle to discuss the specific reforms in the United
Kingdom.
The effective functioning of capital markets is essential
to our economic well-being. In my view, a sound financial
reporting infrastructure must be built on four pillars: First,
accounting standards that are consistent, comprehensive, and
based on clear principles to enable financial reports to
reflect underlying economic reality; second, effective
corporate governance practices, including a requirement for
strong internal controls, that implement the accounting
standards; third, auditing practices that give confidence to
the outside world that an entity is faithfully reflecting its
economic performance and financial position; and, fourth, an
enforcement or oversight mechanism that ensures that the
principles as laid out by the accounting and auditing standards
are followed. The Sarbanes-Oxley Act refocused attention on
these pillars and provided many useful approaches that will be
used throughout the world to improve the financial reporting
environment.
As to the first of the four pillars I mentioned--accounting
standards--much has been accomplished both internationally and
in the United States during the last 2 years. Today, I would
like to focus on two specific developments in the standard-
setting world that I believe are of immense significance.
First, the growing acceptance of international standards
throughout the world. Second, the effort to bring about
convergence between international standards and U.S. GAAP. I
will come back to convergence shortly.
As the world capital markets integrate, the logic of a
single set of accounting standards is evident. A single set of
standards enhances comparability of financial information and
makes the allocation of capital across borders more efficient.
The development and acceptance of international standards
should also reduce compliance costs for corporations and
improve consistency in audit quality.
During the past 2 years, many countries have agreed to
adopt international standards for publicly traded companies by
either January 1 next year or January 2007. As widely reported
in the press, the European Union has adopted a regulation that
will require publicly traded companies to apply international
standards beginning next year. It is not often known that while
we have 25 member states in the European Union, we actually
have 26 different ways of accounting. Only Great Britain and
Ireland account the same way, which leaves 24, and, in
addition, countries can allow in certain areas the use of U.S.
GAAP or international standards. You cannot run a single market
with 26 different ways of accounting. It is expected that in
addition to the 7,000 listed companies in Europe, hundreds of
thousands of unlisted companies will now choose to adopt
international standards, depending on national law.
The momentum in favor of adopting standards is not limited
to Europe. Recently, Australia, New Zealand, and Russia
followed the European Union's lead in requiring international
standards. A Deloitte and Touche survey now estimates that 92
countries will either require or permit the use of
international standards for public accounts of listed companies
by January next year. Additionally, many other countries, such
as China and many of the ASEAN countries, have a policy of
seeking convergence of national standards with international
standards. We have recently offered Japan a similar convergence
deal as the agreement we had with the United States, and the
idea is that they would converge with both of us.
I want to touch on in some detail the convergence with the
United States, and I appreciate that this may be remote for
some of you, but coming from Scotland, I am used to that. One
of my partners in KPMG came with me to the islands off the west
coast of Scotland for an investigation, and being a London
partner he had to keep up-to-date, so he went into the news
agent and asked for a copy of the Financial Times and was a bit
taken aback when the old lady said to him, ``Will you be
wanting today's or yesterday's?'' But coming from London, of
course, he had to have to have today's. ``Well,'' she said,
``you will have to come back tomorrow.''
[Laughter.]
As I mentioned, the IASB and the FASB have made much
progress in the convergence of international standards and U.S.
GAAP during the past 2 years. We have received strong support
from the U.S. Securities and Exchange Commission and the
European Union, as well as from the corporate community
throughout the world. Indeed, the European Roundtable said this
was the most important project we could undertake and it is at
the top of their priority list.
Our convergence drive began formally after our first joint
meeting with the FASB and the IASB. At that meeting, in a
decision later formalized in what we call the ``Norwalk
Agreement,'' we agreed to try to eliminate the differences
between our existing standards in the near-term and work
together on long-term projects to ensure that the principles
behind, if not the wording of, the new standards will be the
same.
Our philosophy is clear. Our goal is to develop between us
a single set of high-quality standards that can be used
internationally. No matter whether a transaction takes place
here in Washington or in Wellington, New Zealand, or in Warsaw,
Poland, we will have the same answer. That is not the case at
present. This is not convergence for convergence's sake, but an
attempt to improve the consistency and quality of financial
reporting worldwide. I have already mentioned the potential
benefits for global capital markets. More narrowly in the
United States, as my colleague Bob Herz, Chairman of the FASB,
often says, this is an opportunity to ``kill three birds with
one stone,'' first, by improving U.S. reporting; second, by
simplifying U.S. standards and standard-setting; and, third, by
offering U.S. market participants the benefits of international
convergence, both for listing on the New York exchanges or for
American investors to invest overseas.
I want to give you examples of the depth of cooperation
which I think people do not quite realize exactly what we are
doing. We have a full-time IASB board member who maintains an
office at the FASB and participates in their deliberations. We
meet jointly twice a year. We have video links between each
other's meetings, so board and staff can participate in and
observe each other's discussions. We have joint staffing teams
to work on several projects.
Although there have been doubters on both sides of the
Atlantic, convergence has been and will continue to be a two-
way process in an effort to build a set of standards which we
would call ``the best of breed.'' We have shown our commitment
to change toward the better answer and to accept the input of
another standard-setter if we believe that he has a better
answer than either of us. The IASB has brought many
international standards in line with U.S. GAAP during our
improvements project getting ready for 2005, and our standards
on business combinations and discontinued operations are the
American standards.
The FASB has already published four exposure drafts related
to our short-term project and hopes to finalize these in the
near future. And as the Committee knows, the FASB has also
proposed bringing the U.S. requirements on accounting for stock
options in line with our standard, which requires expensing.
I realize that in certain circles this standard is as much
appreciated as the arrival of a virus in a maternity ward. But
it really is a very important standard internationally, and we
feel that this is an essential one, which is why FASB has taken
it on.
The other major projects on which we are working include
revenue recognition, performance reporting, and other business
combination issues. We are aligning our work programs to ensure
that we do not create new differences.
Without putting a specific date on it, we hope that the
major differences between our two standards will be removed in
the next few years. Elimination will increase pressure on the
SEC to remove the reconciliation requirement. We are trying to
ensure this does not have to be a political decision. We just
want to remove the differences so that reconciliation will not
be required at all.
The impediments to success. We face some serious
challenges. Some of them are intellectual. The standard-setting
bodies are facing difficult conceptual issues. On our agenda,
as in insurance accounting, we do not believe insurance
accounting is satisfactory anywhere in the world. We are
looking at off-balance sheet issues such as leasing and
pensions, which have even here in America billions of dollars
off-balance sheet. We also believe we need a new financial
instruments standard.
Reaching common agreement on such topics will not be easy
because we are all starting from different points with
different national practices and cultural backgrounds. What we
have to do is ensure that we engage with our constituents,
evaluate the many options, and choose what is generally
accepted as the best answer.
We have also to overcome resistance to change. We recognize
in the aftermath of Enron and the adoption of new accounting
standards and the issues of Sarbanes-Oxley that corporate
preparers and auditors have come through a turbulent period. It
is our responsibility to time the new requirements
appropriately. At the same time, we have to remember the
general public good and the potential long-term benefits that
will arise from promoting common financial reporting rules.
The other area we are going to have difficulties is the
question of rules versus principles. This is not going to be an
easy issue. I do not know if you have noticed, but the Lord's
Prayer has 57 words. The Ten Commandments has 297. The United
States Declaration of Independence--a big mistake that was--300
words.
[Laughter.]
And the European Commission's Directive on the import of
caramel products, 26,911 words.
The SEC and the FASB have done some excellent research of
the possibilities and consequences of adopting a more
principle-based approach. Internationally, there is a clear
desire to maintain a more principle-based approach to
accounting. In the United States, I sense a similar desire to
reduce the complexity and sheer volume of accounting
literature. This will not be easy, but I believe the benefits
of such an approach will help reduce the complexity but, more
importantly, to improve accounting in general. It is not black
and white, and there will always be a need for some explanatory
guidance. But in promoting international convergence, we are
determined to focus on crafting principles that are
sufficiently clear to make a lot of detailed rules unnecessary.
Finally, if convergence is to succeed, we have to resist
attempts to reject standards through political processes rather
than the standard-setting process when local or regional
interests perceive adverse consequences in particular
standards. I am by no means dismissing the right of national
authorities and legislatures to examine the standards and the
need for effective oversight of the standard-setting boards.
What I am saying is that if political pressures in a national
or regional context are able to overrule standards that have
been developed in a deliberate and open manner, then we may end
up having a system of ``beggar thy neighbor'' standards, which
will not produce the consistency and quality of standards the
world's markets demand and will not lead to the appropriate
allocation of resources in the capital markets.
The standard-setting process, both in the United States and
ours, which is based on that in the United States, has
carefully constructed mechanisms aimed at assuring both
independence of the technical board and sufficient due process
including public consultation and transparent decisionmaking.
At the IASB, we have a body of trustees, chaired by Paul
Volcker, which has the responsibility for oversight and
ensuring that the IASB works in the public interest. Our
trustees' role is to protect the independence of the
decisionmaking process of the IASB, on the basis that neutral
and fair accounting standards, set independently, by people
seeking what they really genuinely believe is the best answer,
are in the best interest of investors.
As Mr. Volcker recently testified to another Senate
Committee, he said, ``The net result of politicized national
decisions would be to weaken, perhaps irreparably, one of the
foundation stones of effective accounting practices in a
rapidly globalizing world economy.'' I believe that allowing
such a situation to occur would be to waste a real, and
probably a once-in-a-lifetime, opportunity to develop truly
global high-quality accounting standards.
Gentlemen, the world is actually looking at the U.S. Senate
at this moment to see if it can deliver on this promise.
May I thank you, sir, for your continued support for
independent standard-setting and international convergence, and
in due course, I would very much welcome your questions.
Thank you.
Chairman Shelby. Mr. Sheng.
STATEMENT OF ANDREW SHENG
CHAIRMAN, SECURITIES AND
FUTURES COMMISSION OF HONG KONG
Mr. Sheng. Thank you very much. Good afternoon, Chairman
Shelby, and distinguished Members of the Senate Committee.
Chairman Shelby. Bring your mike close to you just a
little.
Mr. Sheng. Thank you. Thank you very much for inviting me
to testify about the international impact of the Sarbanes-Oxley
Act and the developments concerning convergence of
international securities laws. This is my first appearance, and
since I do not have the eloquence nor the humor of Sir David, I
beg your indulgence. I am extremely honored to meet you again,
Chairman Shelby.
Chairman Shelby. Thank you.
Mr. Sheng. And very honored to meet Senator Sarbanes of the
famous Sarbanes-Oxley Act.
[Laughter.]
I must give the disclaimer that the views I express here
are my personal views and do not reflect the views necessarily
of the Hong Kong Securities and Futures Commission, the
individual members of the Commission nor its staff, nor the
International Organization of Securities Commissions, IOSCO,
where I currently serve as the Chairman of its Technical
Committee, nor any of its members.
I am very delighted that the ASIC Chairman, Mr. Jeffrey
Lucy, who is a very, very good friend of mine and who is also a
member of the Technical Committee, is here this afternoon.
Now, as my testimony is already in written form, I will
only take a few minutes to summarize what I consider to be the
key points.
First of all, a short introduction to Hong Kong. Hong Kong,
a city of only 6.7 million people, is the largest stock market
in Asia outside Japan and is the eighth largest market in the
world in terms of market capitalization. Most of the major
United States banks, investment banks and securities houses,
operate in Hong Kong. As of the end of 2003, the securities of
21 companies were traded concurrently on the Hong Kong Stock
Exchange, the NYSE, and the Nasdaq. For example, the HSBC
Holdings, of which its Group Finance Director, Mr. Douglas
Flint, will be testifying later in this panel, HSBC is listed
in Hong Kong and NYSE.
Now, the globalization of international financial markets
has precipitated an increasing convergence between the Hong
Kong market and the United States model of securities
legislation. You have asked me to comment on our views of the
Sarbanes-Oxley Act. My personal view is that it was a quick,
decisive, and effective response to a potential erosion of
confidence in the U.S. capital markets resulting from the
scandals such as Enron and WorldCom.
Many of us in Asia--actually, you know, I cannot speak for
everybody, but I certainly admired and respected the speed,
determination, and decisiveness that the U.S. legislature
responded to restore investor confidence through the Sarbanes-
Oxley Act. The Sarbanes-Oxley Act has heightened awareness
around the world of the scope of the directors' fiduciary
responsibilities. It has also raised awareness of the need for
better corporate governance and auditor independence, the need
to improve oversight of the accounting and audit professions,
as well as the need to strengthen the protection of investors'
interests. It is indeed a landmark and benchmark legislation
against all other securities legislation of this type for which
the rest of the world has to benchmark against.
Now, market participants tell me that preparation to comply
with the certification and internal control review requirements
under Sarbanes-Oxley often identify control weaknesses that
they would have not noted before. These are areas clearly where
Sarbanes-Oxley made a significant and crucial difference, and
also an important signal to the market that good corporate
governance and auditing matters for deep and liquid markets. I
commend you all on the Sarbanes-Oxley legislation.
Our feedback from our industry, however, is that there is
some concern over the rising costs of compliance with the
increased regulatory requirements, not only in monetary terms
but also in terms of manpower and IT development. Some feel--I
am only reflecting the views of these participants--that the
requirement are restrictive and excessively onerous compared to
requirements applicable to corporations that do not have to
comply with Sarbanes-Oxley.
However, it would be fair to point out Hong Kong rules and
regulations do not conflict with the Sarbanes-Oxley
requirements. Hong Kong has similar, though not identical,
requirements to Sarbanes-Oxley, such as the requirement for
audit committees, responsibility for financial statements, and
prohibition of loan to directors.
I would like to say a few words about the growing need for
convergence in securities regulation worldwide. In the face of
today's globalized markets, regulators must work together to
facilitate cross-border listings while maintaining high
regulatory standards. There must be--and I totally agree with
you, Chairman Shelby--international convergence of securities
regulation.
I use the word ``convergence'' rather than
``harmonization'' because ``harmonization'' to me implies that
each jurisdiction would have identical or nearly identical
rules and regulation. ``Convergence,'' on the other hand,
recognizes while there are certain international regulatory
principles and objectives that each jurisdiction strives to
reach, they may adopt different rules and regulations to
achieve the same regulatory goals, such as the frequency of
auditor rotation and the composition and duties of audit
committees.
Now, Chairman Shelby, as you mentioned quite correctly, and
I think, you know, incisively, convergence of regulation
promotes investor confidence as their interactions with foreign
market participants and issuers are subject to the same
regulatory requirements as those in the domestic market.
Convergence also allows foreign and domestic issuers to compete
on a level playing field. It would lower transaction costs for
issuers and market participants who are currently dealing with
the varying regulatory requirements of all jurisdictions in
which they operate. So it would help contribute to deeper
liquidity and better access to capital markets.
Also, the most important, if not the most ambitious,
convergence exercise to date is probably the work undertaken by
the U.S. Financial Accounting Standards Board, FASB, and the
International Accounting Standards Board, IASB, the gentleman
to my right, to converge the U.S. GAAP with the international
financial reporting standards, IFRS. I personally agree with
and fully support such convergence of international accounting
standards and commend both standard-setters on their
outstanding work.
One of the much debated issues where accounting standards
are seeking to adopt common principles worldwide is the issue
of expensing stock options. I believe Sir David mentioned this
issue. I personally support the proposal to expense stock
options because financial statements should reflect the true
position of all transactions. In putting the case for this
treatment, I do not think I can personally improve on the sage
words of Warren Buffett. ``If options aren't a form of
compensation, what are they? If compensation is not an expense,
what is it? And, if expenses shouldn't go into the calculation
of earnings, where in the world should they go?''
In seeking convergence, the international regulatory
community must work together to avoid conflict in regulatory
approaches while maintaining high regulatory standards. This
can be achieved through bilateral dialogue between two
regulatory agencies or multilateral dialogue through
international organizations.
An international organization like IOSCO provides an
effective forum where securities regulators can exchange views
and explore new ideas and approaches to strengthen cross-border
securities regulation and cooperation in a coherent manner that
closes gaps in regulation, while avoiding duplication or
conflicts in regulation.
IOSCO has undertaken several projects designed to improve
the regulation of securities markets and the cooperation,
especially in cross-border enforcement, among its members. Now,
both the SEC and the CFTC are leading and prominent members of
IOSCO. IOSCO has issued regulatory standards and principles
that have become the principal framework and standards for
securities regulation around the world. These principles are
not legally binding and do not prescribe a certain type of
regulation or any particular regulatory structure; rather, they
reflect a consensus among securities regulators on the
regulatory objectives in each of these areas. For example, the
IOSCO principles governing oversight of auditors and auditor
independence, which were issued in 2002, have become the
international standard for regulation of auditors.
However, merely converging securities regulations to meet
an international best practice is not sufficient as disparities
in their implementation can nullify the benefits of
convergence. It is essential that there is some degree of
consistent interpretation, application, and enforcement of
these regulations to create a level playing field for a truly
global market.
The Hong Kong Securities and Futures Commission has a long
history of cooperating extensively with other regulatory and
law enforcement agencies, including the SEC and the CFTC. We
have entered into cooperation arrangements with our
counterparts in 33 other jurisdictions to exchange confidential
information or to facilitate cross-border investigation and
enforcement actions. The Hong Kong Securities and Futures
Commission is also one of the 26 signatories so far to the
IOSCO Multilateral Memorandum of Understanding, the IOSCO MMOU.
The IOSCO MMOU seeks to promote cooperation and information
sharing among the international securities regulatory
community, especially in the area of investigating and
prosecuting violations of securities laws and regulations.
Let me sum up by saying that tremendous strides have been
made in many areas in seeking global approaches to regulation.
Ongoing consultation and dialogue through international
organizations such as IOSCO are critical to the effort to
establish the high regulatory standards that the world's
investors expect. International convergence of regulations and
strengthened cooperation in the enforcement of these
regulations together offer the best way of creating a truly
global regulatory framework for the global securities market.
Thank you very much for your support and attention.
Chairman Shelby. Mr. Boyle.
STATEMENT OF PAUL BOYLE
CHIEF EXECUTIVE, FINANCIAL REPORTING COUNCIL (U.K.)
Mr. Boyle. Thank you, Mr. Chairman. I am honored to have
been invited to attend this meeting today to share with you our
experiences.
Like Sir David, I am Scottish, but like Mr. Sheng, I have
not brought with me any jokes this afternoon.
I would like to draw to your attention three issues from my
written testimony. The first relates to the regulatory regime
in the United Kingdom. In the United Kingdom, we, like you,
share a commitment to excellence in financial reporting and
corporate governance. We have recognized that at various times
over the last 15 years or so, our regime needed to adapt in
order to stay in tune with evolving public expectations, and my
written statement describes the adaptations in the United
Kingdom, the most recent of which takes into account the
lessons from the scandals in the United States and in Europe as
we have seen them. And the main vehicle for implementing that
adaptation in the United Kingdom is the Financial Reporting
Council, which has a wide and perhaps even unique range of
responsibilities covering not only corporate governance but
also financial reporting, audit, and the oversight of the
accounting profession.
Now, we believe that it is important that regulatory
regimes add value. We believe that good-quality corporate
reporting and governance is a necessary condition for wealth
creation. However, as a well-known American once said, it is
important to know your limitations. No regulatory regime can
eliminate all failures. We believe that any attempt to
implement such a regime would be a wealth-destroying venture.
There is, of course, no ready formula which one can use to
determine at what point do regulatory interventions in the
market become value destroying. We recognize that point may
vary from time to time and may vary from country to country.
And in the absence of any such formula, we think it is very
important to pay close attention to signals from the market,
signals from investors, from issuers, and from other market
participants, too.
Time will tell whether the judgments made in designing the
new regime in the United Kingdom were appropriate. If they turn
out not to be, I am quite sure that further changes will be
made. In the meantime, however, we can see that the new regime
was widely consulted upon and at present, at least, appears to
command widespread support in the U.K. marketplace.
The second issue which I would like to cover is
international convergence. Both of the other speakers have
referred to this issue, and given the increasingly global
nature of the capital markets, this seems a sensible policy
standpoint to take. This applies not just to international
accounting standards, but also to auditing standards. The
arguments which favor convergence of accounting standards apply
equally to auditing standards, and in this regard, in the
United Kingdom we are not just talking the talk, but we are
taking steps this year to increase the convergence of U.K.
auditing standards with the international counterparts, and my
written statements describes the mechanism which we have used
to accomplish that.
However, we do recognize that, as is the case for
accounting standards, convergence toward international auditing
standards cannot be unconditional. A consensus for convergence
is more likely to arise if the standard-setter is independent,
follows due process, and is free from political interference.
Like Mr. Sheng, we also believe that if we are to attain
the theoretical benefits from international standards
convergence, there must also be convergence of monitoring and
enforcement. Inconsistent or duplicative monitoring and
enforcement both reduces the effectiveness of regulation and
increases its costs. And the recent rapid emergence of
independent audit regulators, such as the PCAOB in the United
States and the FRC in the United Kingdom, is both a threat and
an opportunity in this respect. We believe that there should be
a mechanism for greater cooperation amongst the international
registry authorities in relation to audit, and we are keen to
play a role in facilitating this.
The final issue which I would like to comment on is
internal controls, and I do so with some trepidation in the
presence of this Committee and Senator Sarbanes in particular.
We share your belief in high-quality financial reporting, but
have not chosen in the United Kingdom to replicate the
requirements that the PCAOB has issued in implementing the
Sarbanes-Oxley Act. There are a number of reasons for that.
First, the position in 2002 in the United Kingdom was somewhat
different from yours. There had been in the United Kingdom
since 1992 a requirement for listed companies to have regard to
their internal controls and for boards of directors to review
the effectiveness of those controls. And those requirements
were further supplemented by the issue in 1999 of some guidance
which we refer to as the Turnbull guidance. Our belief is that
those requirements had brought about real improvements in the
attention paid by boards of directors to internal controls in
the United Kingdom. And perhaps it is worth highlighting that
when we refer to internal controls in the United Kingdom, we
are talking about controls over and above those which apply to
the financial reporting process but extend more generally to
operational compliance controls and risk management. And we see
internal controls as making a contribution to good business
management as well as to good financial reporting.
Second, there were, in the United Kingdom, concerns about
the cost-effectiveness of the regime as implemented in the
United States, and we thought that it would be sensible to
delay any changes in this regard and learn from your
experience. There is a lot of evidence now emerging about the
costs of implementation, but even now it is too early to make a
judgment, we believe, because we need to learn not only about
the implementation costs, which one might expect would be high,
but also about the ongoing costs of maintaining the system in
the future.
One factor in our minds is that many examples of financial
statement misrepresentations relate to management fraud, senior
management fraud, rather than failures in operational
accounting. And whereas internal controls can be particularly
effective in reducing the risk of operational accounting
errors, there are some concerns that they may be less effective
in dealing with senior management deception.
We have, however, taken further steps to improve the
effectiveness of internal controls over financial reporting in
the United Kingdom. First of all, we have strengthened the
powers and responsibilities of audit committees, and, second,
we have tightened the definition of independence for
nonexecutive directors and made it a requirement that only
genuinely independent directors participate in audit committee
meetings.
Finally, we have just commissioned a review of our Turnbull
guidance on internal controls. The group reviewing that
guidance contains both executives from business, chief
financial officers, auditors, and particularly it includes
investors, too. And it will assess whether or not our guidance
in this area is still in line with best practice and will
reflect on the lessons of implementing Sarbanes-Oxley. And the
person we have appointed to chair that group is Mr. Flint from
whom you will be hearing later this afternoon. If there is
agreement in the United Kingdom that further changes to that
guidance are required, then we shall certainly implement it.
I look forward to responding to your questions.
Chairman Shelby. Thank you for your testimony. We have got
another vote on the floor of the Senate, and we are going to
recess the Committee for about 15 minutes and come back, if you
will be patient with us. We are very sorry.
[Recess.]
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. [Presiding.] We will proceed with
questions. The first one is for Mr. Boyle. It is about
monitoring and enforcing accounting and auditing standards.
Now, my understanding is that the United Kingdom in the last 6
months or so has an independent regulator which you call the
FRC. Is that right? Financial Reporting Council.
Mr. Boyle. Yes. I am privileged to be its first chief
executive.
Senator Allard. Okay. Very good. Give us some insight on
it. I was hoping perhaps maybe you can share with us some of
your thoughts on how the Council can be more focused on
monitoring and enforcing the standards on a national level.
Mr. Boyle. Can I deal separately with, first of all,
accounting standards? And then I will say a few words about
auditing standards as well.
Senator Allard. That would be great.
Mr. Boyle. With regard to accounting standards, as a direct
consequence of the welcome developments here but in thinking
about how we should respond to that in the United Kingdom, we
have made a significant change in our enforcement regime. We
have had an accounting standards enforcement regime since
around 1990, but it was its practice to operate on a reactive
and complaints-driven basis. In other words, people would come
to it and say we think such-and-such a corporation's financial
statements may not be in order, go and investigate them,
please.
We have changed that now to move to an active monitoring
arrangement. Proactivity is the buzz word for that we use. And
we are on track this year in our first year of proactivity to
review 300 sets of financial statements out of a total listed
company population in the United Kingdom of around 1,200. And
that represents a significant increase in the intensity of our
enforcement activities.
Of course, the benefits of having an enforcement activity
are not necessarily to be measured in terms of how many sets of
accounts are restated. Our intention is to make it clear to
chief executive officers and chief financial officers that the
risk of your misstatements now being caught is high and that
will reduce the number of cases that we actually need to
require changes to the financial statements.
With regard to auditing standards, we have set up for the
first time this year an independent audit inspection unit which
is, right now, in the offices of three of the big four
accounting firms in the United Kingdom. We will shortly be
visiting the fourth one. And their work program is such that
they would expect to spend somewhere in the region of 9 months
of each year reviewing various aspects of the way in which
those audits firms conduct their work. Those would include
whole-of-firm procedures, including the tone at the top,
including the basis for partner appraisal and remuneration,
including quality control and risk assessment procedures in
those firms, and, in addition, taking the audit files for
individual financial statements and reviewing the way in which
those audits were conducted, not merely from a process point of
view but also reviewing the appropriateness of the judgments
made by the auditors in relation to those financial statements.
Again, this is a significant increase in the intensity of
enforcement of auditing standards in the United Kingdom.
Senator Allard. How do your accounting standards compare
with what we have in this country? And how do your auditing
standards compare with what we have in this country?
Without getting into a lot of detail.
Mr. Boyle. I will not get into a lot of detail,
particularly in the presence of Sir David, because before he
took over as the Chairman of the International Board, he was
for 10 years Chairman of the U.K. Accounting Standards Board,
so he is actually the best person to describe the U.K. model.
It is in many respects similar to that which is used in the
United States, but in addition, we have a clear commitment in
the United Kingdom to converge to international standards as
soon as we are permitted to do so by the European Union. I
would say in general the standard in the United Kingdom tend to
be less voluminous than the FASB standards, but we would like
to think they are of a comparable effectiveness.
In terms of auditing standards, again, I think we could
hold our auditing standards up for favorable comparison with
those in the United States. All of the important topics that
you would feel should be covered in a set of auditing standards
are covered in our auditing standards in the United Kingdom,
and we have, as I explained in my written testimony, got a
convergence program of our own to move our standards more into
line with international auditing standards, but with the
important qualification that where we think there is already in
the U.K. literature an important matter which is not covered in
the international standards, then we would supplement the
international standards to retain that requirement.
Senator Allard. What do you see, Sir Tweedie, as the
biggest problem in moving toward convergence?
Sir David Tweedie. I think the biggest problem is going to
be the principles versus rules issue. We have agreed with the
SEC and the FASB that we will actually harmonize and converge
at the principles level.
Now, the idea then is we move on to start writing joint
standards. We will give the pen to one member, be he an
American or one of our staff members, and the question then is
what detail is going to appear in that? And the real question I
think is going to be the litigious nature of the U.S.
environment. That is going to be our real problem, because the
accounting firms I think, not unnaturally having watched what
happened to Andersen, are looking for defenses, and therefore,
if you have a rule it is easy to say, well, it says here you
cannot do this, where principles are going to involve judgment,
and you will get one or two wrong. It is bound to happen.
In the United Kingdom if that were to happen, the defense
would be that the judgment, which would be documented, was made
on reasonable grounds and, okay, with hindsight you could say
it was wrong, but at the time that was a fair judgment, and
that would get you off in court. It is only if it is negligent
that you would be in trouble. So, I think that is the attitude
now. Of course, the U.S. courts, I am not sure how they would
react, and that is going to be one of the big issues.
Senator Allard. I would agree with that because I have had
a chance to visit with some individuals from the various
European countries including Great Britain, and the principles
versus rules seems to be the big issue out there. It is a
fundamental concept.
Is the rest of the world on principles and we are kind of
out here by ourselves on rules, or is there other countries
that have set rules like we do, and follow our general process
that we have in America?
Sir David Tweedie. I think you are really on your own. It
is not as though the American standards are not based on
principles, they are, but you have an awful lot of application
guidance, and that is the real problem. One of the difficulties
I think is if you have a rule-based system, you can get caught
because people can just obey the rules, and I think some of the
issues that occurred around the time of Enron were classics. It
is far harder to get past a principle. And if you have a rule,
for example, that says if A, B, and C happens, the accounting
is X, we know the investment bankers will come up with B, C,
and D, and then we have to have another rule to cover that.
Whereas if you have a principle, and use A, B, and C as an
example, you have caught the lot, and I think it is much more
effective.
So the rest of the world is actually on that basis.
Senator Allard. Here is the question I think that is
probably the most important of all to ask. The other ones have
been just background kind of laid out there. But what are the
essential guidelines that we need to have to have consistent
across the borders for a healthy system with international
trade? When I use that ``healthy system,'' I think investor
confidence, and assurance that you are going to get what you
pay for type a thing. What are the essential elements that we
need to have there?
Sir David Tweedie. I think what this Committee did has a
lot to do with that. When the crises first happened, we heard
all over the world that American standards, supposed to have
been the best, and now look what has happened. And then when
the dust settled, it turned out of course that it was not the
American accounting standards, it is the way that people had
actually twisted them and done it. That is where I think the
confidence came back again.
The reason for our existence in fact is exactly the point
you made. When we had the financial crisis in Asia in 1997,
companies collapsed without warning, and the accounts looked
all right, and that is when they felt it was going to take 5 or
6 years to put new standards back. It was not corporate
governance, it was bad accounting in those days. And that is
why they went for these international standards.
The reason they go for them, and New Zealand was a classic,
it has two or three very good standards we will probably make
global standards, but they decided to sweep them all away and
take international, because what they did not want was inward
investment coming and saying, well, we are almost the same as
international standards, because they felt they would lose the
advantage of the confidence that people knew exactly what they
were going to get as opposed to have various nuances that were
New Zealand related.
I think the key issues is if we can get these basis
principles agreed between the United States and ourselves,
corporate governance, which is a critical issue which really
failed in America, and that is what you have repaired, and that
is the real issue, is lack of confidence in the market, which
is a big problem, and there is confidence in the U.S. markets.
Senator Allard. I will turn the Committee over to Chairman
Shelby.
Chairman Shelby. [Presiding] Thank you, Senator Allard.
Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
First of all, I want to thank the members of the panel for
their testimony here today.
Sir David, the status of the present program, as I
understand it, is that the EU would adopt the standards of the
International Accounting Standards Board next year, is that
correct?
Sir David Tweedie. Yes.
Senator Sarbanes. Are many other countries also adopting
your standards?
Sir David Tweedie. Yes, the estimate is 92 going in that
direction, and they are really growing all the time. Russia is
there. China is coming. They have stopped doing their own
standards. They are gradually starting to bring international
standards in. Hong Kong is changing on January 1 of next year,
and New Zealand, Australia, all of whom have their own
standards board are just stopping and they are actually using
our standards. The reason I think is exactly the point that was
made earlier, it is for cross-border trade, the fact that if
you know what you are getting, the investment risk disappears,
or at least one of them, the accounting risk disappears.
So the idea really is they had a choice. Do they do U.S.
standards or they do international standards? Some countries,
Latin America, look more toward the United States. That is one
of the reasons they are keen on convergence too. If we bring
the two big standard-setters together and have the same basic
principles, then globally we will have the same accounting. We
think we can probably do that by the end of the decade.
Senator Sarbanes. I take it from your testimony, I noted
you said there was a once-in-a-lifetime opportunity, I think
was the way you put it? Was that the phrasing you used?
Sir David Tweedie. It was.
Senator Sarbanes. So that if we work through this
skillfully, we could have one set of accounting standards
worldwide?
Sir David Tweedie. That is the intention.
Senator Sarbanes. The monitoring and implementation of them
is of course a separate question, but at least the standards
would be a worldwide standard.
Sir David Tweedie. That is the idea. I think it was the
fact that after Enron we all realized that we could not risk
having a trading down of accounting standards and we had to
pick which one was the better one, and that is in a way why we
signed the agreement. We are also lucky, of course, that the
FASB and the SEC were very enthusiastic.
Senator Sarbanes. They are very strongly committed to the
convergence process, I know.
Sir David Tweedie. They are very strong.
Senator Sarbanes. I know. It has strong support amongst
many Members of the Congress, so I wish you well in that
endeavor. I am going to move on because we only get a limited
time here.
Mr. Boyle, obviously, I have to rise to the bait on the
404. I want to quote some excerpts from two articles that
appeared in the Financial Times on August 25 and one in The
Wall Street Journal on July 2. The Financial Times concerning
Royal Dutch Shell.
``The U.K.'s Financial Services Authority and the U.S.
Securities and Exchange Commission yesterday issued their
findings into wrongdoing that led Shell to admit in January
they improperly booked 20 percent of its oil and natural gas
reserves. Auditors of Shell's reserves warned the company as
early as January 2000 that its reserves figures may have been
overstated. The SEC is scathing about Shell's advice to
investors that it had changed its mathematics to recalculate
reserves, saying in its 1998 annual report only that estimation
methods have been refined.'' Interesting choice of words.
``Shell's decentralized system required an effective
internal reserves audit function, both regulators write. Shell
had engaged as a group reserves auditor, a retired Shell
Petroleum engineer who worked only part time and was provided
limited resources and no staff to audit its vast worldwide
operations.''
The Wall Street Journal article on Nortel. ``Nortel's board
is determined the company inaccurately employed an accounting
maneuver that made it look profitable when in fact it wasn't.
In some cases the dollar amounts of the many individual moves
were so small they were almost impossible to detect. In filing
a detailed restatement of 3\1/2\ years of financial results,
Nortel's auditor said the company had material weakness in its
internal controls.''
And in light of the situation that apparently arose at
Shell and at Nortel, why would you think that attestation and
audit of a company's internal controls is unnecessary? Would
this not suggest that this experience of these companies and
others that could be named suggest that directors who rely on
management for internal control assurances are in the same
position as directors who insist on internal and external
review of the adequacy of controls? Does it not underscore
actually the need for a strong internal control system?
Mr. Boyle. We absolutely believe in the benefits of a
strong internal control system, and as I mentioned in my
testimony, there has been a requirement for boards of directors
in the United Kingdom since 1992 to review the effectiveness of
their internal controls.
I think I also mentioned in my testimony that in many cases
of financial statement misstatements, the overriding factor has
been a deliberate attempt by the senior management to
misrepresent the company's true position, and it remains to be
seen whether or not those deliberate misrepresentations are
best dealt with through internal controls or not. There is a
serious danger that even the best internal control systems can
be overwritten by senior management, and the question that we
have to decide on in the United Kingdom, which we have not come
to a final decision yet, is, is it cost effective to put in
place a detailed system of audit of internal controls? Is that
additional cost appropriate, and does it deal with the
principal source of the difficulties in the cases you refer to?
We have not yet come to a definite view on that, and I
would say at this stage though, in the U.K. context, we have
not had pressure from investor organizations to put in place a
model which replicates the requirements in the United States.
Senator Sarbanes. Are you suggesting that you are already
doing much of the 404 under the existing regime?
Mr. Boyle. Absolutely, there is already a requirement for
companies in the United Kingdom to undertake an annual review
of the effectiveness of their internal control systems, not
just their controls over financial reporting, but their broader
operational and risk management procedures, and it is already
the practice in the United Kingdom for much of that internal
control review to be documented in order that the management of
companies can give assurance to the audit committee and the
independent directors that they have a reasonable basis for
saying that they have reviewed the internal controls.
What we have not done is specified the detail of how
companies should document those requirements, nor have we
required auditors to attest to the effectiveness of those
controls.
Senator Sarbanes. Obviously, we have that requirement. We
are working through it now. The General Electric people, let me
just quote what their finance chief, Keith Sherin said. ``The
absurd aspect of this backlash against Sarbanes-Oxley is that
companies are finding out that tightening their internal
controls is actually good for their business. We have seen
value in the 404 work. It helps build investors' trust and
helps give them more confidence. We have gotten positive
benefits from it.'' And he went on to say that of their
expenditures to implement it, about two-thirds of that money is
spent on its own employees, and he says, ``I consider that to
be a good investment.''
There are others who have said much the same thing. It is
interesting that it seems to be breaking into two camps. One
camp sees it as an opportunity to really strengthen the
internal operations of their company and reap benefits from it
and come at it with a very positive attitude in terms of the
benefits it can bring. Others, of course, are resistant and are
complaining bitterly about it, although as Paul Volcker and
Arthur Levitt pointed out, the ones complaining the most are
companies that for too long have lacked adequate internal
controls, and therefore the requirement for them requires a
major change in how they do their business.
Mr. Boyle. And if I may say, in the United Kingdom,
following the publication in 1999 of our Turnbull guidance,
there was initially quite a lot of resistance from companies as
to the additional cost that would be imposed at that stage.
However, I think the general consensus now is very similar to
the experience which you are now having in the United States,
which was the companies have indeed benefited from a greater
focus on internal controls, and the requirement for companies
to document that internally has led to the identification of
weaknesses and to improvements, and those requirements have
been in place in the United Kingdom for a number of years.
What we have not done, however, is to take those
requirements which are--if you look at the Turnbull guidance,
at the level of principal--I think the Turnbull guidance itself
is around 15 pages in length--we have not specified in detail
precisely how that assessment and documentation process is to
be conducted, nor have we found it necessary at this stage at
least to acquire auditor attestation of that.
Senator Sarbanes. Mr. Sheng or Sir David Tweedie, you have
any comments on this point?
Mr. Sheng. If I may say, in the U.K. type tradition,
actually attestation of the financial statements is already
built into the system in the sense, for example, in my
Commission's financial statements, I as chairman actually sign
it together with the chief financial officer, would have to
attestate that. It is not required by law, but by sheer
practice we do do that. There is a slight difference in the
sense that all board members under the U.K. type, of which the
Hong Kong companies ordinance follow, all directors are jointly
and severally liable for the accuracy of the accounts. So it is
already built in into the law. We have to attestate and we are
liable.
Where I think the Sarbanes-Oxley is more specific, it puts
the individual responsibility on the person who attestates.
Senator Sarbanes. Did you want to add anything?
Sir David Tweedie. I just think what Andrew said is
absolutely true. The auditors of course do examine the internal
controls, and it would be interesting to see what extra cost it
would be to actually comment on that. They may not wish to, but
it would be interesting to see what the cost would be. And a
statement put out by the directors, which they do internally, I
would not have thought would be a massive extra cost, but I am
sure Mr. Flint will tell you what he thinks about it. But in my
own view, I would not see where the massive costs are coming,
and the benefits of course are huge.
Senator Sarbanes. Thank you, Mr. Chairman. I just want to
make the observation to Mr. Sheng that I understand that the
Hong Kong Securities and Futures Commission, you have
historically had a very good working relationship with the SEC
on both enforcement matters and information sharing matters,
and obviously we think that is quite important, and I just
wanted to put that on the record here today.
Mr. Sheng. Thank you.
Chairman Shelby. Thank you.
Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman.
I mentioned in my opening statement that I had quite an
interest in the small businesses, and I want to congratulate
IASB on the commencement of their initiative for small- and
medium-sized enterprises. I applaud that effort.
It is my understanding that substantially more small- and
medium-sized businesses require certified financial statements
than in the United States. Could you give me some background on
how this project got started, how it is going, and where you
expect it to go?
Sir David Tweedie. When I was at the U.K. Standards Board,
we have a million companies in the United Kingdom, of which
only about 3,000 are listed, but nonetheless, almost all the
others had to produce accounts and there are some exemptions
now with the smaller ones, but very small. And we felt that we
were writing standards really for the capital markets and not
necessarily for the smaller companies. The question was the
sheer burden on these companies. The book of standards, which
was not as big as obviously the U.S. standards, but nonetheless
was a volume. Could we shrink that? What we tried to do is,
what we are experimenting with internationally, can we actually
look at these standards, extract the main principles from them,
then decide is there anything else that as a small business you
would require to operationalize this standard. And are the
disclosures that are really needed or just for the main
investors, because the banks obviously can ask for them. So we
managed to slash down the size of these standards. We have done
the same experiments internationally. Our pension standard,
which at present is 80 pages, we took down to 8. Of course,
that raises the question whether you need 80 pages for the main
one anyway, and that is the second stage, I suspect.
[Laughter.]
We genuinely believe we can. We are holding broadly the
same principles in the standards for measurement, and if there
is some cost benefit of having an approximation, well, let us
do that, but cutting a lot of the disclosures, and a lot of the
issues that are raised in the standards for the capital markets
really are not very relevant, so we have taken those out.
There is a little note that says if you want further
guidance you can always go look in the other standards, but
basically we hope that we will have almost a self-contained set
of standards for smaller companies.
Senator Enzi. I do appreciate that, and would be interested
in knowing some of the differences between the big businesses
and the small businesses. I will not ask that now because we
have a very limited amount of time.
Instead, Sir Tweedie, I would rather move on to a little
different topic, and that is that given the fundamental
differences between the United States and the European tax
systems, would you not agree that the current IASB proposal to
harmonize the accounting treatment of deferred taxes is at odds
with the strategic objectives of IASB's convergent project?
Sir David Tweedie. We will debate them, and I am not quite
certain which bit you are referring to. My views on the
American and international taxes standards are fairly well
know, and I think both of them are dreadful, but we are stuck
with them. Basically, there is an issue that I do not
particularly agree with in the international one which is going
to be debated with the FASB, but we have not made any decision
on it, Senator, and it will be interesting to see where we end
up on that.
Senator Enzi. But you would not be considering them
dropping that from your short-term convergence project?
Sir David Tweedie. I think we are trying to get it
together, but I think the issue to which you are referring,
which I think is overseas problems, that is going to be a big
debate we are going to have. We have not made any firm decision
on that. We may have to shift.
Senator Enzi. We have a few tax issues before the U.S.
Senate right now dealing with international trade too that we
have not quite worked out.
Mr. Boyle, it is my understanding that the United Kingdom
is balking a little bit at the accounting standards as they
apply to mergers. Can you give me a little bit more background
on that?
Mr. Boyle. No.
Senator Enzi. Okay.
[Laughter.]
Mr. Boyle. I am really not sure what lies behind your
question. My understanding in the United Kingdom is that we are
100 percent signed up to the convergence project, and indeed,
in the discussions which have been taking place in Europe in
recent months over their endorsement of the International
Accounting Standards Board, the United Kingdom has been in the
lead in arguing for full and immediate adoption of the complete
set of international standards. So we do not currently have any
concerns about the international standards, and we do not have
any particular concerns on measures. There was a major reform
of accounting relating to marriages and acquisitions, pushed
through by Sir David around about 10 years ago to eliminate
some of the abuses on marriage accounting, which had in fact
been at the heart of some of the proper scandals in the United
Kingdom in the late-1980's. That issue was resolved at that
stage and I am not aware of any new issues arising.
Senator Enzi. My information came from an article on April
29 of this year, and I was just going to get into some of the
difficulties of convergence, but I assume that we will get to
do some written questions and probably more detail.
Chairman Shelby. We will. We will leave the record open.
Senator Enzi. But I would like to know a little bit more
about some of those difficulties because we have a few mergers
in the United States too, and I want to see what the difference
is. So thank you.
Chairman Shelby. Thank you.
Regarding specific implementation issues, has there been an
open dialogue regarding accommodations that may be necessary
for foreign entities?
Mr. Tweedie.
Sir David Tweedie. We have not actually made many
accommodations when we are comparing the various standards with
those of the United States. If we are talking about the
international capital markets, we have to have the same thing,
so there has not really been any. There has been the odd little
transitional arrangement, but nothing much.
Chairman Shelby. How do international regulatory bodies
address the differences in the standard, divergent applications
for a particular standard? We talk about the best standard and
so forth. How do international bodies address those differences
and ensure consistent application of standards, which is what
we are trying to get at?
Sir David Tweedie. One of the areas we have come across is
where we have a different interpretation that has been taken
place, let us say in Europe compared to United States. That
will be picked up almost certainly by the local regulator, and
he may have to make a quick decision, but once there is
discovered that there is this difference, we would be notified,
and then together with the U.S. Emerging Issues Task Force, we
would issue a joint interpretation, or we will change the
standard to make sure it is crystal clear, but that is how we
try and stamp them out.
Chairman Shelby. What is the status of the international
debate regarding the fair value accounting treatment for
derivatives?
Mr. Sheng. This is very controversial at this stage.
Chairman Shelby. Very complicated.
Mr. Sheng. Sir David is on top of it.
Sir David Tweedie. Or underneath it.
[Laughter.]
Chairman Shelby. All over it, in other words.
Mr. Sheng. All over it. I think I am all for convergence in
this area, and I think it is very, very important that,
particularly in this area of reporting on derivatives, it is
pretty important that we have one consistent standard around
the world. It is my firm belief that timely and access to
accurate accounting information is a market fundamental, and
without a consistent standard applied globally, we are not
going to get that.
Chairman Shelby. Mr. Boyle, do you have any----
Mr. Boyle. No. If I may just elaborate. In the European
context in terms of your previous question about enforcement,
one of the benefits of the tighter integration of the markets
in Europe is that there is now agreement between the
enforcement organizations in Europe for close cooperation on
implementation issues such that they are in fact now proposing
to construct a database of interpretation issues which will be
accessible to all of the national authorities in Europe such
that when they are faced with an enforcement question, they can
consult the database looking for precedence to see has this
issue arisen in another country? They can then have a dialogue
with the appropriate authorities in that country to understand
why they took the view they took on enforcement, and that would
help, we believe, to reduce the divergence of implementation
enforcement.
Senator Sarbanes. Is there going to be an EU enforcement
mechanism?
Mr. Boyle. Because of differences in securities and company
law in each country, it does not make sense to have a single
European enforcement mechanism. So the alternative which is
intended to achieve similar benefits, is very close
coordination of the enforcement activities of the individual
national enforcement authorities. And it is for that reason
that this interpretations database is being constructed, and
there is already a committee of European enforcers which meets
from time to time to discuss how they will be handling these
important enforcement issues.
Senator Sarbanes. What is the mechanism by which the
coordinating body pushes a country that is lax in its
enforcement amongst the EU? I mean you could have a situation
in which 22 or 23 countries are all enforcing at a very good
standard, and a couple have fallen off the shelf. How do you
get them to where they should be so they do not constitute this
opening for lax practices?
Mr. Boyle. The mechanism for the responsibility for
ensuring that there is consistent enforcement activities, and
for dealing with poor enforcement, rests with the European
Commission itself. They have that general responsibility in
relation to all European directives. The regulation relating to
International Accounting Standards is a European-wide
regulation.
I have to say, the challenge of making sure that all these
European regulations is enforced is a massive one, and we
should not underestimate the difficulties of achieving that,
nor necessarily where this would come on their list of
priorities. But we are hoping that we can have a sharing of
best practice and there will be, frankly, peer pressure amongst
the different national regulators to raise their standards to a
high level, but ultimately the European Commission would thus
have the right to intervene and take issues up with national
authority.
Chairman Shelby. I want to take a moment and thank all of
you for coming so far, and to participating in this hearing
today because I think it is very important to Senator Sarbanes
and others on the Committee. We have had the opportunity to
meet with you, various parts of the world on these issues. We
will continue to work with you and the SEC and our
counterparts. I think the goal is to have an international
standard we can all work by, and our investors know what the
standards are. Is that basically correct?
Mr. Boyle. Thank you.
Chairman Shelby. Thank you so much, and we will move to the
second panel.
The second panel, I will announce it again. Mr. Douglas
Flint, the Chief Financial Officer, HSBC and a member of the
U.K. Accounting Standards Board; Mr. Arnie Hanish, Chief
Accounting Officer, Eli Lilly & Company; Mr. James Turley,
Chairman and CEO of Ernst & Young, LLP; Mr. Greg Bentley,
President and CEO of Bentley Systems; and Mr. Len Moodispaw,
President and CEO of Essex Corporation.
Senator Sarbanes. Mr. Chairman, I would like to welcome Mr.
Moodispaw in particular. He is President and CEO of Essex
Corporation, a small public company headquartered in Columbia,
Maryland that provides a specialized technological assistance
on communication issues, primarily to the Defense Department
and our intelligence agencies. They have grown from 45
employees and $4.5 million in revenues in 2002 to 240 employees
and an estimated $60 million in revenue in 2004. It is a
commendable performance, and I wanted particularly to bring it
to your attention.
Chairman Shelby. You have some up and coming constituents.
Senator Sarbanes. Yes, we do.
[Laughter.]
Chairman Shelby. All of your written testimony will be made
part of this hearing record without objection, and if we could,
because we do not know when we are going to be interrupted here
on the floor because we have the Homeland Security
Appropriations Bill before the Senate, we will be voting.
Mr. Flint, we will start with you. If you could sum up your
comments as quickly as you can, we appreciate it, since we have
the benefit of your written testimony.
STATEMENT OF DOUGLAS FLINT
GROUP FINANCE DIRECTOR, HSBC HOLDINGS PLC
Mr. Flint. Thank you very much for the opportunity. The
views I express are personal, but they are very important to
HSBC, not only in our own capacity as a major registrant and
one of the largest financial groups in the world, but also as
corporate governance impacts very much the investments and
lending activities we have, and it is clearly important that
the environment in which we operate has sound governance and
transparency.
There is absolutely no doubt in the couple of years there
has been huge attention given to governance, in the first stage
substantially over the role, the caliber, the independence of
directors and the construct of the board. But the Sarbanes-
Oxley Act was a welcome wake-up call, an essential wake-up
call, reinforcing the accountability of the board, the
responsibilities of the board, and making them clearly defined
in the area of financial reporting. Probably as important as
the Act in defining those responsibilities and accountabilities
have been the actions taken against those who have transgressed
in terms of the penalties, as all of us are now acutely and
regularly aware of the penalties of failure, and I think
reinforced not just by the bad names that we all like to
distinguish ourselves from, but some in recent years,
regrettably some of the marquee names that were historically
thought to be beyond that.
I think the issue that I want to spend a little bit of time
on is that while governance is undoubtedly recognized as the
responsibility and accountability of directors, there are some
issues in implementation namely how to evidence compliance.
Now, this is not a Sarbanes-Oxley issue, in my view, because
Sarbanes-Oxley is very, very clear. It has to do with the
implementation guidance and the way that implementation
guidance is being interpreted.
Given that boards increasingly are having to be, and
rightly so, selected for their independence and experience,
there is perhaps a danger that the process is becoming the end
rather than the means to the end. And there is absolutely no
doubt--and I would share the comments of Keith Sherin at GE--
that there are aspects of documentation under 404 that are
necessary, and indeed essential, and I think we all stepped
back and thought about whether there were aspects of the way we
put accounts together where we could do more to demonstrate to
ourselves that we are getting it right.
But the interpretation that currently is about, that
requires all control systems to be documented in a way which
they were never designed to be done, in terms of attributing
commercial control attributes to the controls themselves, I
believe in some way risks devoting a disproportionate resource
to documenting systems where there has been no history or
expectation of weakness, rather than devoting the same amount
of resource to the areas where it is believed that more
attention could usefully be given.
This is not a cost issue, although it is costly. We, in the
banking industry, are not only coping with the implementation
of international accounting standards, which is a significant
challenge, but also Basel II, where the costs are significantly
higher, but the benefits I think are clearly to be seen.
In terms of practical issues, there are a number of things
that are beginning to concern us a bit. It is clear from
discussions we are having with all the accounting firms that
the absorption of their resources around the world is intense,
and I think it is perhaps good for us and perhaps good for U.S.
registrants also, that foreign registrants have a year's delay,
because I am not quite sure there is enough resource to do us
all at one go anyway.
Across geographies there are implementation challenges. I
think in the United Kingdom and the United States the tradition
of auditing was fairly similar and auditing standards were
similar, but once you move outside of those territories, there
is inconsistency within the big firms as to how they are
interpreting the requirements of Sarbanes-Oxley.
The control frameworks in many countries are less well
formalized, but not necessarily less effective in practice, and
that is causing implementation challenges, because while
directors clearly are responsible and accountable and recognize
that, for the risk of such a control framework, I do not
believe they should feel constrained to accept that type of
risk because of the rigor imposed of a single model of
documenting controls.
I worry a little bit in my position as Chief Financial
Officer about the concerns that I have to assuage of accounting
officers around the world who are faced with having to account
in local GAAP, move that into U.K. GAAP, prepare for
international GAAP, and provide the information to reconcile to
U.S. GAAP, against a framework where people are saying the
penalties for getting it wrong can be extreme. It is an
extraordinary burden to have to cope with four different sets
of accounting requirements, and I will come on to that in the
international accounting piece.
I would hope that at some point as this develops, that
there would be an opportunity to consider mutual recognition of
approved governments' regimes as part of the compliance or the
interpretation of compliance with Sarbanes-Oxley.
A few words on the international agenda. We clearly welcome
everything being done to perpare for a single language of
accounting. We are listed on five stock exchanges. We produce
accounts in 76 countries. The burden of tracking various GAAP's
and training people is huge. We have a commitment to
harmonization. Clearly, all rules will not suit all people at
all times, but the benefits from a single framework are well
beyond individual gripes about individual aspects of standards.
I had a meeting, when I was in Washington yesterday, with
the SEC, and I really do feel encouraged that the harmonization
agenda is shared, but the more that could be said to evidence
that to the non-U.S. constituents I think would be very
helpful.
A couple of last words on the auditing situation, which I
think is again of interest and of some concern. In terms of
auditing standards, it would be good if we could achieve global
convergence on rules on independence and if we could have a
global solution to liability. I think in that regard, one issue
that concerns us is the challenge that David Tweedie
mentioned--the debate between principles and rules and the
understanding that rules give more of a safe harbor as to how
things are done in a particular way.
But today we are faced with sometimes unintended
consequences of perverse but literal translation of accounting
language that was never designed for the circumstances in which
it is being applied, and I think it would be good if there were
overriding guidance that would take people away from perverse
literal translation of accounting rules to the principles that
the accounting standards were addressing.
That leads to a worry that today I believe more than in
history that auditors are being trained more in control
evaluation and GAAP application, rather than how to stand back
to understand whether the consolidation of the accounting
information that has been put together makes sense because it
is in my view still the case that the aggregation of GAAP from
within robust accounting systems is not necessarily going to
give accounts always that are the best communication of the
business enterprise being described.
I think one thing that I would like to see international
attention given to, just as the SEC made tremendous strides in
the MD&A in plain English, would be if the accounting and
auditing profession with guidance could make a plain English
audit report so that those into that read it could understand
what the auditors actually did and what objective they were
seeking to get to.
Thank you.
Chairman Shelby. Thank you.
Mr. Hanish.
STATEMENT OF ARNOLD C. HANISH
CHIEF ACCOUNTING OFFICER, ELI LILLY & COMPANY
Mr. Hanish. Thank you, Chairman Shelby and Ranking Member
Sarbanes.
My name is Arnold Hanish, and I am the Chief Accounting
Officer for Eli Lilly & Company, and I am here this afternoon
as the Vice Chairman of the Financial Executives International
Committee on Corporate Reporting. FEI is the leading advocate
of the views of corporate financial management representing
financial executives such as chief financial officers,
treasurers, and controllers.
FEI strongly supports the spirit and goals of Sarbanes-
Oxley, as it has strengthened the ability of financial
executives to institute continuous improvements in internal
controls and financial reporting, and to gain enhanced buy-in
by all employees of the need for strong internal controls. In
fact, FEI was one of the first business organizations to
provide constructive recommendations to Congress on improving
financial reporting and corporate governance.
One of these recommendations requiring audit committee
financial experts, now Section 407 of the Act, has succeeded in
having audit committee members better understand and
participate in the company's corporate governance process. It
is because of Sarbanes-Oxley that audit committee members are
much more actively engaged, all positive outcomes.
At my own company, Eli Lilly, we have held numerous
education sessions for members of our audit committee in order
to build their awareness of important and complex accounting
reporting issues and their financial accounting expertise.
We also would like to acknowledge the regulators' efforts
to provide implementation guidance for their internal control
related standards, and appreciate the recent comments of
regulators that adequate time be allowed for implementation of
new standards in the pipeline.
That said, documentation can supplement, but will not
supplant, judgment and honesty of the audit committee, the
board of directors, or senior management. This is the area in
which FEI would like to stress the fundamental concept that has
held the test of time, which is generally referred to as
substance over form. In the rush to implement Sarbanes-Oxley,
there has developed what seems to be an overemphasis on certain
additional or duplicative levels of documentation with a
declining value in terms of how much that additional
documentation adds to the effectiveness of internal control.
Let me give you an example. If a meeting of a company's
disclosure controls committee is held to discuss a financial
reporting matter, in our new post-Sarbanes-Oxley world, there
can be so much focus on testing by the auditors for
documentation that the meeting was held, that there is
insufficient attention paid to reviewing the substantive nature
of what was discussed, and the reason why the meeting was held
can be overshadowed by the need for a piece of paper
documenting the meeting. This really just does not make much
sense.
In grappling with implementation of the Act, some companies
are falling into the trap of stressing substance over form,
which ultimately does not benefit the reliability of internal
control, and as a result does not advance the intent of the
Act. Make no mistake about it, documentation for
documentation's sake will not deter financial fraud. In
reality, the increased sentencing guidelines will probably
provide the single most important disincentive for committing
financial fraud.
As we all move to implement the SEC and PCAOB standards
under the Act, we must remember that documentation should
supplement but not supplant management's judgment, integrity,
and honesty.
FEI has been surveying its membership on the costs for
implementing Section 404 of the Act. I have attached a copy of
FEI's January 2004 and July 2004 survey results to my
testimony. In July, FEI surveyed 224 public companies with an
average revenue of $2.5 billion to gage the compliance cost
estimates. The survey results showed the total cost of
compliance with Section 404 is now estimated at over $3 million
for the average company. This represents a 62 percent increase
versus an earlier estimate from our January 2004 survey of
almost $2 million for the average company.
While all companies are feeling the impact of the Act on
their bottom line, FEI recognizes the concern about the impact
the statute will have on smaller companies.
I am fortunate to have a staff of extremely competent CPA's
with anywhere from 5 to 14 years of public accounting
experience, but many smaller companies do not have that luxury.
Although the FEI July survey did not indicate a
disproportionate impact on smaller companies, logic tells me
that this is an area that should be closely monitored for a
burden that may be too great and where costs are
disproportionately higher.
In closing I would like to tell you a story about the
founder of my company, Colonel Eli Lilly and what I believe he
might have thought of the Sarbanes-Oxley Act. A veteran of the
Civil War, Colonel Lilly was also a pharmacist. He was
concerned that people were purchasing purported medicines with
no verification of safety or effectiveness. In response to the
state of affairs, Colonel Lilly chose to start his own company.
His goal was to provide medicines that passed high standards
and protected the public's health, safety and interest. He
further believed that medicine should be most properly
purchased on the advice of doctors, not from traveling
salesmen.
From the beginning, innovation, quality control, and its
counterpart, internal control, have always been a part of
Lilly's tradition. So if Colonel Lilly were here today, my
guess is he would probably applaud the Sarbanes-Oxley Act for
its emphasis on internal controls in providing greater quality
assurance in financial reporting. He would recognize the role
of the external auditor in providing third-party independent
attestations on these financial reports.
But he would also remind people of the importance of
innovation. We cannot lose sight of the forest for the trees.
We must not let internal control testing and related
documentation take over so much of our time that we lose focus
on the operation of strategic planning of our key products and
services.
This concludes my remarks. I would like to thank the
Chairman and Members of the Committee for allowing FEI the
opportunity to testify. Thank you.
Chairman Shelby. Thank you very much.
Mr. Turley.
STATEMENT OF JAMES S. TURLEY
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
ERNST & YOUNG, LLP
Mr. Turley. Thank you, Chairman Shelby, Senator Sarbanes,
and Members of the Committee. I am Jim Turley, Chairman and CEO
of Ernst & Young, and it is a great pleasure to be here with
you today.
In consideration of time, I am going to provide some brief
comments, but would certainly refer you to my written
testimony.
Let me simply say at the outset that the Sarbanes-Oxley Act
is working. It is having a positive effect on the behaviors of
auditors, audit committees, corporate management, and others.
The Act has allowed investors to put a wall between the
corporate and accounting scandals of the past and financial
reports in the future.
The Act has brought about historic change as 100 years of
self-regulation of our profession has been replaced by the
Public Company Accounting Oversight Board. As I have said many
times, both publicly and in print, I truly believe that the
formation of the PCAOB will prove over time to be one of the
best things that ever happened to my profession. A tough but
fair and independent regulator will make our firm and the
entire profession better.
As I noted, behaviors have significantly changed within
accounting firms, in audit committees and in corporate
management. First, inside the accounting firms themselves, the
changes that are taking place are substantial. In my written
testimony, I detail many of the efforts we have undertaken at
Ernst & Young, all designed with improved quality as the
objective. Audit committees are now in charge of the auditor
relationship. They hire and fire us. They evaluate our
performance, and they scrutinize each and every service we
deliver before we deliver it. This is the audit committee
approval process that Sarbanes-Oxley called for.
It is well known that audit committees are today meeting
more frequently and in significantly longer meetings. What is
less understood, and in my opinion, more important, is that it
is not just the quantity of meetings that is increasing, it is
also the quality. Again, my written testimony expands on this.
The Act has also changed management behavior. Among other
things, the CEO and CFO certification requirement has driven
very positive changes through the ranks of corporations,
cascading accountability for financial statement accuracy to
all business units in all parts of the globe. From my vantage
point, there is real reason for investors to have greater faith
in the integrity of financial information and in the capital
markets.
There are, however, other lingering challenges that the
accounting profession is focused on addressing. Our profession
has struggled for years with expectation gaps in two important
areas. There is an expectation gap between the amount of fraud
detection that the public expects and the level of assurance
that an audit is designed to deliver. The other gap, which has
received substantially less attention, relates to the precision
of financial reporting itself. Financial statements, in fact,
are based on many educated estimates and judgments.
Unfortunately, the expectation exists that financial reporting
is a very precise science.
The profession for years has felt that if only investors
could be educated about the limitations of financial reporting
and auditing, these gaps would go away. It is clear to me and
it is clear to others in my profession that better education of
investors is not enough. We need to work with the PCAOB to
strengthen the profession's ability to detect fraud and more
clearly identify the judgments and estimates that underlie so
much of today's financial reporting.
Obviously, all of this has to be done with a proper balance
between costs and benefits to investors.
The new internal control reporting requirement under
Section 404 provides investors, in my opinion, with greater
transparency into the strength of a company's internal
controls, and I think this is really a significant benefit. I
am concerned, however, that when the Section 404 reports come
out in early 2005 the benefits that come from increased
transparency could be diminished because too few investors may
be able to interpret what the findings mean. Absent additional
guidance or information, investors and others may misinterpret
and overreact to an assessment that a public company's internal
controls warrant improvement. Some may even wrongly equate an
internal control weakness with financial statement inaccuracy,
and there may even be more material weaknesses and internal
controls, and more adverse opinions than people originally
imagined.
For that reason, I believe a shared education effort among
our profession, the SEC, the PCAOB, issuers, and investors is
needed around the new internal control reporting process and
how to interpret findings and responses. The major firms are
committed to working with others in such an effort.
Before closing, I would like to briefly address the
recently released PCAOB inspection reports. Let me simply say
that our attitude is that while nobody likes to be inspected by
their regulator, I truly and firmly believe that Ernst & Young
and the entire profession will learn from the process and be
better for it.
This is a great profession that I am part of. We are doing
everything we can to meet the needs of the capital markets, and
we welcome the PCAOB's oversight and support in these efforts.
There are two areas on which we as a profession are very
focused, our ability to continue to attract and retain the best
people, and our ability to deal with the economic risks we
face, and these are serious issues deserving more in-depth
consideration than time allows today, but they are topics we
are working on both individually as a firm and as a profession,
so we can continue to play our unique role in the financial
markets in the future.
Thank you again for the opportunity to be here.
Chairman Shelby. Mr. Bentley.
STATEMENT OF GREG BENTLEY
CEO, BENTLEY SYSTEMS, INC.
Mr. Bentley. Good afternoon, Mr. Chairman and Members of
the Committee. My name is Greg Bentley. I am the CEO of Bentley
Systems, Inc. As a member of the American Business Conference,
founded by Arthur Levitt almost 25 years ago, I am honored to
represent a growing majority of our economy: Privately held
companies and businesses smaller than you hear from most.
Significantly, Bentley Systems remains a private company today,
despite having filed our preliminary registration statement for
an initial public offering in April 2002. We stayed the course
in registration despite the seven-figure cost of hiring a
second firm to reaudit our financials, replacing Arthur
Andersen. In retrospect, the attendant delay turned out to be
fortuitous, as it coincided with the promulgation of Sarbanes-
Oxley, whereupon we withdrew our offering.
I believe our experiences are relevant to your assessment
of policy formulations to stimulate continued entrepreneurship,
growth in the private sector, and a robust national economy. To
us, this is so critical that in return, I will divulge our
``secret sauce'' behind our business success to date.
Long before the recent advocacy of an ownership society,
Bentley Systems has fruitfully nurtured our ownership culture.
Our 20-year-old company has grown profitably, and primarily
self-financed, to rank among the larger firms within the global
application software industry. In the past decade, we have
created over 700 new jobs in the United States, with average
annual compensation here now of over $90,000, and our exports
contribute over $150 million per year to the U.S. trade
balance.
I and my four brothers who founded the company have always
recognized that our growth and success is entirely to the
credit of our colleagues, who comprise all of the key assets
for producing and vending our software. By 2002, the number of
colleagues to whom we had granted stock options was approaching
the limit of 500--made famous recently by Google--above which,
under current law, formal disclosures--and consequently, now,
Sarbanes-Oxley adherence--are required. The motivation for our
IPO filing was thus less to achieve public ownership per se,
but rather to make available deserved liquidity for these
longstanding option holders.
At this same time, it happens that I chaired the audit
committee of a large public S&P 500 IT services firm. My
personal experiences with the various emerging costs and
burdens of Sarbanes-Oxley compliance led us to conclude at the
time that such costs and distractions would not be prudent for
Bentley Systems.
In summary--as I realize you have other witnesses to
present the perspective of existing public companies--those
costs and burdens are substantial; they are still increasing,
and their ultimate extent is still uncertain. Nonetheless, most
of us are prepared to accept that in the aggregate, these costs
are probably justifiable to preserve confidence for public
investors.
But beyond the new compliance costs, what settled Bentley's
IPO withdrawal was the mismatch between new corporate
governance requirements and our own ownership culture.
It remains especially implausible to me that our founders
would relinquish control to a majority of such potential new
independent directors as would be willing to expose themselves
to the perfect storm of liability risks unleashed by Sarbanes-
Oxley, especially for new public companies.
Even if consistent and predictable fundamental performance
could be a given, I believe that the volatility in practice of
U.S. GAAP accounting standards makes financial restatements
more likely than not.
To the extent that convergence with international
accounting standards would reinstate principles-based
accounting rather than rules-based accounting, every CEO should
favor such a change.
In the meantime, occasional downside earning surprises are
inevitable, with impact on stock prices. Unfortunately,
Sarbanes-Oxley has increased our very real apprehension that
hairtrigger plaintiffs' lawyers will misuse the Act's standards
to exploit these gotchas as their windfall opportunities.
From a public policy standpoint, in fact, I believe that
relatively simple litigation reform could more immediately and
effectively redress the excessive risk aversion that Sarbanes-
Oxley has engendered than complicated rework of its complex
moving parts.
Otherwise, growing and prospering companies like Bentley
Systems will tend to remain private indefinitely. Not only will
IPO's be less prevalent, but so will acquisitions of private
companies by public companies, who would thus incur unaddressed
Sarbanes-Oxley liabilities.
Now, are there national interests that may be at risk when
a larger segment of our economy consists of larger private
companies? Well, there is presently an abundance of equity
funds seeking private company investments, fostered by the
recent structural tax reforms. Rolling those back, to any
extent, would reduce growth funding for our privately led
economy, while making them permanent will even more
substantially increase the ability of firms like Bentley
Systems to invest in faster growth of our exports and our
employment.
But financing would be useless without the key ingredient
in our Bentley recipe, the ownership culture by which we
attract, incent, and reward the colleagues whose intellectual
property creation we are all dependent upon. And the good news
is I think there can be some simple public policy changes
within the purview of your Committee that could serve even to
improve on our original recipe.
My first modest proposal would be to exclude equity grants
to employees from the applicable count toward 500 securities
holders, since such grants are not the result of any securities
purchase decisions.
I would also suggest a policy direction to update the form
of ownership culture--which gets beyond the tedious controversy
over the options expensing--as a first step in international
accounting standards convergence. It would be an unfortunate
side effect of the stigma which this negative attention is
attracting to options, for companies to significantly reduce
the breadth and scope of their option programs without
substitute ingredients to sustain their ownership cultures.
Of course, absent the current accounting bias, granting
outright shares instead of options would even more completely
align employee incentives, to the downside as well as upside
with that of the stockholders at large. Unfortunately, the
employee would be subject to income tax upon vesting--without a
source of liquidity now that Sarbanes-Oxley precludes loans
from the employer--in the absence of a public market.
So an evident solution would be to grant the stock into the
employee's qualified retirement account, where its value could
presumably accumulate tax-advantaged. That would serve to focus
companies and employees on long-term, stable career
development.
Bentley Systems already makes annual company contributions
in stock to our U.S. colleagues' profit-sharing accounts. These
are over and above the company's cash matches of colleagues'
own 401(k) contributions, so this incentive is always
incremental to baseline retirement funding, rather than a
substitute. And many other companies take advantage of ESOP
plans authorized by Congress to encourage employee ownership.
The problem with either approach, as a candidates to
replace broad employee stock option programs, is that ERISA
requires such contributions to be nondiscriminatory,
essentially proportional to cash compensation for all
employees. But in the United States and at Bentley Systems, we
have always recognized that our colleagues' efforts and results
are not correspondingly distributed equally. The ownership
culture cannot generate its potent incentive leverage when it
is made into an entitlement.
So, I would finally ask that you consider creating an
exception under ERISA for discretionary outright grants of
stock to employees for the purposes traditionally served by
option grants. This ownership culture secret sauce should be
restored and reinforced as a key ingredient in our corporate
national economic strategies.
Thanks very much and I look forward to your questions.
Chairman Shelby. Thank you.
Mr. Moodispaw.
STATEMENT OF LEONARD MOODISPAW
PRESIDENT AND CHIEF EXECUTIVE OFFICER
ESSEX CORPORATION
Mr. Moodispaw. Mr. Chairman, Senators, thank, you for the
opportunity, and I am certainly mindful that you have my
statement in front of you, so I will just make a few comments.
I would like to make them in the perspective of the world I
live in.
It is interesting. Much of what Mr. Bentley said, I argue
when I talk about the benefits of being a small public company.
I will come back to that in a moment. But my perspective starts
out with I was a trial lawyer for a long time, and I thought I
had graduated when I became a CEO in terms of public respect. I
learned very quickly after Enron and WorldCom that that did not
happen that way. I do not know where I am going to go next, but
whatever profession I go to, watch out, because we are all in
trouble.
[Laughter.]
Senator Sarbanes. Do not move in this direction.
[Laughter.]
Mr. Moodispaw. We are a small cap company, and so, people
could say, well, wait a minute, now: you are not the subject of
404 yet. We will be subject to 404 next year, and we are very
mindful of the impact of 404, so we are already looking very
hard at it.
I agree and am pleased with Senator Enzi, who comments on
the small business aspects of it. I do believe that the costs
are disproportionately high on smaller businesses. The Act
takes care of that by talking about management integrity. I
worry sometimes, having been a trial lawyer, as to whether I
can pass that test, too, but there is that opportunity. It is
very subjective, but it is there.
We are also a Government contractor. Most of our work is
done with the intelligence and Defense Departments. So we are
already subjected to Defense Contract Audit Agency and Defense
Logistics Agency Review. So many of the controls and the very
basic things that have to be done to satisfy SOX and 404 are
already in place for us. What we have learned is, as we look at
404, is that we are becoming more formal--this gets back to Mr.
Flint's documentation--but as we look at the processes and
procedures, and I will say, we do that, and I will be reminded,
it is not written down.
So we are now writing those things down. That is not all
bad. We have learned that we are improving efficiency by
getting audit committees and more independent people involved
earlier on in some acquisition issues and more risk assessment
before we go spend money on new technology. That is not all
bad, either. The board independence and the ability to bring in
the proper data for audit committees and the board is a good
thing. I never had the opportunity, but given the opportunity
to have a bunch of friendly people sitting around telling me
what a great job I am doing that, I would love that.
But that is not going to make the kind of company I want,
which is a company with the utmost integrity. So the checks and
balances are excellent. The requirement to go off and look for
independent accounting expertise has turned out to be a big
boon to us, particularly as we do acquisitions. We did two
acquisitions of private companies in the last year. Certainly,
Sarbanes-Oxley was one of the things we looked at as we
examined those companies.
What we looked at was not whether it was good or bad and
whether we would buy them or not buy them. Because of SOX, what
we looked at was what was going to have to happen, what would
we have to do to make them compliant? Some of them are remote:
Melbourne, Florida; Texas, and we have one person doing all the
accounting and all the finance. How do we split those things
up? Who do they report to? Good questions to ask whether or not
we were required to do it. It is like making your children eat
their vegetables or take their medicine: you have to do it, and
the benefits certainly outweigh the cost. I would rather not
have the costs, but they are there, and I do believe we have
the benefits.
When I read about and hear about the complaints about
Sarbanes-Oxley, I am reminded of an article in The New York
Times not long ago. I believe it was entitled, ``The Dog Ate My
Homework,'' and it listed all the excuses CEO's use when their
performance is suffering. And Senator Sarbanes, I would like to
commend you on the rapid rise that Sarbanes-Oxley has made on
that list, because now, we hear CEO's will somtimes use that as
an excuse, although Goldman-Sachs did a survey and said it
barely made the screen. But when it is convenient, just like
the weather or just like Krispy Kreme blaming a low-carb diet
when they have a bad quarter, we will throw out Sarbanes-Oxley,
I am sure.
One of the issues that has been discussed, and Mr. Bentley
discussed the reverse of this has been will public companies go
private? First off, that is very expensive; second, if I tried
to do that, I believe those shareholders out there would be
wondering what I am trying to hide. I believe the SEC is
putting in place some significant requirements so that it would
be very difficult to do that. So, I do not think it will save
any money. I think it will cost money and would subject me to
further scrutiny.
When we look at the reverse, as Mr. Bentley has done, and
he mentioned the cost of getting ready for it. When I am on the
street, New York, Boston, all of the places I have to go to
talk to the investment community, the beautiful people, as I
like to call them, I can think of lots of reasons not to be a
public company. But none of them are Sarbanes-Oxley, because
again, I believe the cost is outweighed by the benefits, and I
think the cost of going public leaves those costs
insignificant.
As I mentioned, some of what Mr. Bentley said described our
company. We are a small public company. We give stock options.
It is going to be harder if the rules get passed, but we give
stock options to every employee, because we want them to feel
like they are a part of the company, and they like it because
if they have a good quarter----
Chairman Shelby. Do you expense those options?
Mr. Moodispaw. Not now. As I say, we are going to be facing
that. We report it----
Chairman Shelby. Okay.
Mr. Moodispaw. --but we do not expense them.
But if they have a good quarter, if we have a good quarter,
announce that their stock jumps. And this rise that Senator
Sarbanes was nice enough to comment on, our shares were $4 a
share when we began. They are now at $9 a share. We have a lot
of employees who had options at $1 a share. They feel very much
a part of the company, and therefore like those, and again, I
think being a public company makes them more beneficial.
In closing, I draw an analogy to Y2K. To me, what we are
going through with Sarbanes-Oxley is a lot like Y2K. There was
a lot of looking for skinny bears behind trees as to what Y2K
might bring. It brought a lot of money--I do not mean E&Y when
I say this but auditing companies and consulting companies who
went off and advised people about those skinny bears behind
trees, and when it happened, a lot of good, important things
were accomplished, but it was a nonevent, and we will look back
on SOX in that way.
Thank you.
Chairman Shelby. Thank you.
Thank all of you.
Many contend that the compliance costs and resources
associated with implementing the internal control provisions of
Section 404 are too burdensome. What type of cost-benefit
analysis should the regulators apply as they continue
implementation and begin compliance programs?
Mr. Flint.
Mr. Flint. I think that is a very difficult question,
because the cost of failure can only be seen with retrospect.
And we all pay insurance hoping we never actually make a claim.
I do believe, though, that in a world where we have created a
governance framework, where the quality of directors and the
independence and the operation of the board is being improved,
it is legitimate to give them some element of discretion to
allow them to exercise judgment into determining how they
execute their responsibilities under 404, because while as I
said in my remarks, I think there are a number of areas that we
have woken up to that we would be better to formally document
how we get to where we get to, there are a great number of
areas where we already document things enormously.
We are subject to regulation by 370 regulators, so we have
documentation of controls that is extremely detailed, but it
was not structured in the way that to the correct
interpretation of what is required by the PCAOB guidance to
deliver particular accounting attributes. It just was never
designed that way nor could it have expected to be. And I think
there are many, many elements of our operations where the risk
of error is really small, but the cost of documenting in a
different way those systems is very high.
I would like to believe that responsibility could be given
to directors to make that judgment, because they are
accountable, and they can see the penalty for failure. I think
they would devote the resource to the areas that they feel more
concerned rather than omnibus.
It has to be a judgment. I do not think there is a silver
bullet.
Chairman Shelby. What we are trying to do, I suppose, and
the question comes up, is there a way to implement Sarbanes-
Oxley that ensures investor protection without creating
unnecessary compliance burdens? How do we reach that? Because
what is our real goal? Our real goal is integrity in the
marketplace, right?
Mr. Flint. Right.
And indeed, Senator, we accept that fully. And indeed, all
of us who signed our certificates in relation to 2003 on
Section 302 took the same responsibility and accepted the same
accountability as we will take next year; only we will have to
show our workings. And it is the degree to which we need to
show our workings that I think is unnecessary in part, but I
think because of a fear of criticism of not being omnibus the
process has been overengineered in the application of the 404
responsibilities.
I have no difficulty with the 404 responsibilities at all,
but I would like to have discretion, I would like to be
accountable for how much documentation is required, which was
what the PCAOB said as well, but the accounting firms
interpretation is different.
Chairman Shelby. Sure.
Mr. Turley, would you just briefly address how you and your
clients are working to implement Section 404, and what should
investors and market participants expect from Section 404
reports when they are addressed next year?
Mr. Turley. Well, I think both our clients--the issuers--
and our firm are working very, very diligently to uphold the
law, the Sarbanes-Oxley law, and also the standards as put out
by the PCAOB and the SEC. And as others have said, it is a very
big effort.
I think the big benefit from 404 is going to come from the
transparency and insight that it is going to be provided for
investors into the strength of a company's internal controls. I
think the costs involved are being felt today while the
benefits are largely going to be felt in the future. I think
that because it is a new law, it involves new standards, it is
a first-time implementation, and I think we do need to do a
better job of educating investors as to what it means. What do
internal controls really mean? What does it really mean to have
management assert to the strength of its internal controls and
have an audit firm audit those internal controls?
What does it mean if a company receives a clean opinion on
its financial statements but a material weakness or an adverse
opinion is provided relative to the companies's internal
controls? I think these are all things that are first-time
implementation issues that we need to all work on together. The
PCAOB, the SEC, issuers, all of us, need to make sure we
educate people on that.
Chairman Shelby. Mr. Bentley and Mr. Moodispaw, what impact
has Sarbanes-Oxley had on capital formation, in other words,
keeping companies from going public, staying private and so
forth?
Mr. Bentley. Well, the apprehension about going public,
just to pick up on----
Chairman Shelby. You mentioned that earlier.
Mr. Bentley. Yes, is less so; frankly, the cost of
compliance than it is what is unknown--and, in particular, as
to liability. Although I think Sarbanes-Oxley was a very
effective and timely piece of legislation that deserves a
chance to work, my concern as a prospective issuer is that
there would be inadvertent aspects of noncompliance or
something that goes wrong the first time through, that is not
material, that is going to be seized upon to create a
liability.
Chairman Shelby. Unintended consequences?
Mr. Bentley. Yes, that is the concern.
Chairman Shelby. Mr. Moodispaw.
Mr. Moodispaw. We did a capital raise last year, a
secondary offering; we were already public, but we went on the
road. And the travel alone should deter anybody from doing
that, much less the SOX requirements, but we raised $32 million
last year from a lot of large funds around the country.
There was very little discussion of Sarbanes-Oxley amongst
the institutions as we went around. My concern is that it
almost becomes a checklist kind of thing: they will ask the
question, are you compliant? If you are compliant, they move
on. But it did not inhibit us at all.
Chairman Shelby. Mr. Flint, has there been an impact? Has
Sarbanes-Oxley created an impact on the capital raising
decisions of international companies, in other words, to list
or not list?
Mr. Flint. I think it is too soon to say. I think that
people are pausing for thought as to whether to list in the
United States. I mean, we would still list today in the United
States. The benefits are important. I think what has changed,
though, in the last 5 years, really, as a result of the
introduction of the euro is that the U.S. capital markets used
to be necessary for the raising of both equity and debt
capital. Today, it is really only necessary to have a listing
if one intends to make an acquisition in the United States. The
European markets can raise debt in size as deep as the U.S.
markets now.
So, I think it has made some companies question the cost-
benefit of a U.S. listing, yes, and indeed, you have had very
few foreign registrants in the last year.
Chairman Shelby. I know.
Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
First of all, because I think it is an important point, I
want to follow up, Mr. Chairman, on something that Mr. Turley
said, and then, you touched on it in your questions. I think it
is important to develop an understanding so that a report that
cites an internal control weakness is not then transposed into
a financial statement inaccuracy, as Mr. Turley has underscored
in his statement, both written and oral here today.
And as I understand it, you are engaged now in a process, I
take it you and the other major accounting firms, with both the
SEC and the PCAOB to try to work out a way in which you can
educate and inform on that particular issue. Is that correct?
Mr. Turley. Yes, we are. We are working with the PCAOB,
working with the SEC, working with FEI, and others. We would
like to work with everybody, because I do think that it is
important that investors understand the differences between the
opinion that they read on the financial statements themselves
and the accuracy thereof and the strength or weaknesses within
a system of internal controls. I think it is very important
that people understand that we and others are working hard on
helping that.
Senator Sarbanes. Yes, well, you can have a weakness in
your internal controls, have an absolutely accurate financial
statement, or conversely, have no weakness in your internal
controls and have an inaccurate financial statement; is that
not the case?
Mr. Turley. Well, the converse would be harder than the
former.
Senator Sarbanes. You hope. You would certainly hope so.
Mr. Turley. In some ways, the audit of the financial
statements is basically a question of, is the financial
statement put in front of you free of material error after the
external audit?
Senator Sarbanes. Right.
Mr. Turley. The audit of internal controls is really a
question of could there have been an error in the financial
statements management put together before the external audit?
So if an external audit identified a material error in a set of
financial statements, and that error was then corrected by
management in its accounts before they were published, the
financial statements would get a clean opinion; I think it is
likely that the internal controls would have been weak in that
case.
Senator Sarbanes. Yes; Mr. Hanish, in The Wall Street
Journal on June 21, you were quoted as saying Sarbanes-Oxley,
``triggered a comprehensive review of how Eli Lilly documents
corporate controls, and the discipline of that has been
tremendous. The review uncovered some redundancies, allowing
the firm to eliminate some steps it was taking needlessly. We
added some controls as well. In all, it was time and money
well-spent.'' Is that still your view?
Mr. Hanish. Absolutely, absolutely.
Senator Sarbanes. All right.
Mr. Hanish. I think that overall, as I indicated both in my
remarks for FEI but also my own personal view is that the
impact of Sarbanes-Oxley is still very positive. The impact
that it has had on documentation has been quite positive. I
think our ability to potentially identify redundancies, reduce
certain activities, streamline operations, we view that as a
positive, and we will be spending a lot more time in 2005 as we
get beyond this initial mountain that we are trying to climb
right now, to be able to spend more time reviewing the flow
charts and the various pieces of documentation that we have.
I think the challenge, however, is in identifying various
gaps, there is a lot of focus on form over substance, and
documenting the fact that something took place as opposed to
looking at what truly occurred, I think, has been a significant
focus on the part of the auditors during this period of time.
Senator Sarbanes. Well, it is a new system that is being
put in place, and the precedents have not fully been
established, and I presume through an interaction between the
auditors, the PCAOB, and the SEC, it will get to a state of
reasonableness. In fact, I have seen some of these handbooks
that have been prepared, either by the accounting firms or the
lawyers, saying to a company what is required by Sarbanes-
Oxley, and I have looked at some of that, and I have said, now,
wait a second: Where in the Act is that required?
So they are going to great lengths, and in many instances,
beyond what is required. In fact, Mr. Bentley, I wanted to ask
you on that point, you state that you decided to remain private
because your company did not want to have a majority of
independent directors. Now, where in Sarbanes-Oxley is there a
requirement that a public company have a majority of
independent directors? On their audit committee, but where in
the Act do we require that a public company have a majority of
independent directors?
It is true that the exchanges and best practices now are
instituting that requirement of a majority of independent
directors, but I do not think that requirement is in the Act.
Mr. Bentley. No, that was part of the exchanges'
fulfillment of their obligation under the Act to update their
listing requirements.
Senator Sarbanes. No, no, the Act required the SEC to make
sure the exchanges had certain listing requirements that went
essentially to the role of the audit committee, both its
composition, its hiring and firing of the auditors, its being
appropriately funded and so forth. But there is nothing in the
act requiring independent directors. Now, it is true that that
is now becoming a requirement. The exchanges are making it a
listing requirement, and all of these private best practices
seminars now within the business community are reaching that
conclusion.
But I put that question to you just make the point that we
are addressing here. In other words, it is not the Act that
requires that, is it?
Mr. Bentley. Well, to update the facts as I understand
them, the first drafts of the exchange listing requirements
from both the New York Stock Exchange--where we were listing--
and Nasdaq required an outright independent majority on the
board for the first time.
Senator Sarbanes. Well, I am not questioning that. I am
only questioning your assertion that that was required by the
Act. I do not think that is the case.
Mr. Bentley. I think the Act only required them to issue
new standards. Those were the standards they issued. And that
had not been the case when we filed, so we were faced with a
situation of it being impossible to comply, because we did not
have the independent directors and did not feel that we could
recruit them under the atmosphere of uncertainty at the time.
Since we are trying to be fastidious about the facts here:
The exchanges amended their listing requirements to permit
there to be an exception to the majority independent board
requirement for a so-called ``controlled entity.''
Now, Google, which I think could have resorted to that
exception, did not, although I congratulate them on their
successful IPO. Of course, there is only one Google, and you
cannot extrapolate from that to other companies. But they saw
the virtue of selling to their investors that there are
founders who have a track record, and you can confidently
invest in those who do control the company.
So, I think there has turned out, just as you are
suggesting, to be some accommodation in the world to what
looked like outright dogmatic extremes to start with. We are
coping.
Senator Sarbanes. Well, I want to be very clear on this,
because it does point out a problem. People come to us, and
they complain about something or other, and then, when you
investigate it, it turns out that what they are complaining
about is not a consequence of the Act. It is some other action
that has been taken by one or another of the regulatory
authorities or some best practices that have been adopted by
the industry.
All the Act required was for the SEC to prohibit the
listing of any security of an issuer that is not in compliance
with the requirements of any portion of paragraphs 2 through 6,
which all deal with the audit committee, not with the board of
directors. So the Act has no requirement that the board of
directors be independent, although it is true that the
exchanges put that in as a listing requirement, but that was a
separate decision from the Act.
Now, as you point out, the exchanges have since come back
and made an accommodation on that listing requirement. I just
do not want to have to carry more of a burden than is
necessary.
[Laughter.]
Now, Mr. Hanish, I want to ask you about this survey. I am
very interested in these surveys you cited.
Mr. Hanish. Yes.
Senator Sarbanes. The FEI survey about the increase in
costs between January and June. Were exactly the same companies
used in the January survey and the June survey? Well, let me
put the question to you. I am not really trying to trap you
here.
Mr. Hanish. Okay.
Senator Sarbanes. It is my understanding that the same
companies were not used entirely and that the shift that took
place was that more large companies were included in the June
survey than had been included in the January survey. Therefore,
their costs for doing the 404 would be higher, and therefore,
that explains the difference between the survey findings, at
least in part, if not in whole; I do not know the answer to
that question, but it would explain in part the increase in
costs which you cited.
In effect, we did not have a comparison of apples-to-
apples. It differed somewhat, and it differed in the direction
of including in the second sample larger companies who would
have had larger costs to do the 404 certification. Am I correct
in that understanding?
Mr. Hanish. Essentially, the survey in July had more larger
companies.
Senator Sarbanes. Right.
Mr. Hanish. Companies that had revenues in excess of $5
billion than the January survey.
Senator Sarbanes. Right.
Mr. Hanish. It was certainly not an identical composite of
companies.
Senator Sarbanes. In fact, I understand that the survey
found the total 404 costs actually fell for the smallest
companies, those with revenues less than $100 million, between
January and July.
Mr. Hanish. I am not sure about that point, but you may be
right, but I am not sure about that point. But I do know that,
for example, we would not have participated in the January
survey, because we had not resolved all of our costs with our
external auditors. So it was inappropriate, for example, for
Eli Lilly to participate fully in the January survey as opposed
to the July survey, where by that time, we had resolved our fee
negotiations with our external auditors.
So we would not have been in a position at that point in
time to respond to the January survey. I think that was part of
the issue with January. A lot of the large companies had not,
like ours, at that point in time, had the opportunity to
resolve all of their fee discussions with us.
Senator Sarbanes. No, I understand that. My only problem is
if you are comparing two surveys and saying the costs have
risen, but you are including in the later survey which
supposedly demonstrates the increase in cost more larger
companies than were included in the earlier survey who are
going to have larger costs, then obviously, the costs are going
to go up. It does not establish, I think, the point that was
asserted.
Mr. Hanish. I think the point that I was trying to make in
the remarks was not so much that the costs had gone up because
of additional activities in that period of time but because of
more companies being surveyed, more and better information
available to us that the costs, the average costs to comply
have certainly increased over what the January survey would
suggest that the costs would have been on average, because now,
we have better data or data from some larger companies as well
to throw into the mix.
Senator Sarbanes. Finally, Mr. Chairman, I know I have run
over my time. I would like to have included in the record a
Wall Street Journal editorial, July 30, 2004, by Bob Greifeld,
the president and CEO of Nasdaq, entitled, ``The View from
Nasdaq,'' and I would just mention a couple of points that
Greifeld makes in the----
Chairman Shelby. That will be included in the record
without objection
Senator Sarbanes. First, he writes with respect to Section
404, ``I believe that even beyond the improvement in public
confidence, the vast majority of businesses will benefit from
going through the process of establishing, maintaining and
reviewing the internal control structure that Section 404
requires. While every nickel counts, complying with Sarbanes-
Oxley, in my view, is money well spent. I can affirm that it
has not hindered our ability to innovate.''
And then, he goes on to say,``A concern raised by critics
is that Sarbanes-Oxley deters private companies from going
public. I am sure there are some isolated cases, but on the
whole, the claim is nonsense. There are 150 companies in the
pipeline who have filed to list their IPO's with us. Year-to-
date, more than 92 companies have gone public on Nasdaq
compared with just 10 in the same period in 2003. The
executives of these companies understand they will be governed
by Sarbanes-Oxley.''
And he then goes on to say, ``So far this year, 10
companies from abroad have listed on the Nasdaq. The faith and
integrity of the U.S. markets is one reason. We want more
foreign listings. Sarbanes-Oxley will help.'' Those are just
certain excerpts from the article.
Chairman Shelby. Sure.
Senator Sarbanes. Thank you very much.
Chairman Shelby. Thank you.
Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman, and I thank the
panel for all of the excellent testimony that they gave. I just
have a couple of questions. Mr. Turley, in your testimony, you
mentioned the upcoming Section 404 reports that will be coming
due for the large corporations in February of 2005. Does the
PCAOB auditing standards provide for different treatment or
approaches for auditors based on the size of the company? Are
small businesses treated any differently under the standards?
Mr. Turley. Well, no, Senator, the standards really are
written as applying one standard to all-sized companies, and I
think that as I talk to companies around the country, large and
small this issue we have been talking about today on the costs
versus the benefit does come up. Companies large and small
that--in my judgment--look at applying 404 as all cost, no
benefit, get just that: They get all cost, no benefit. Those
that look at it as a way to improve processes get improvements.
Senator Enzi. Well, to the extent that the PCAOB wanted to
facilitate flexibility based on concerns that might apply to
small public companies or specific industries, would it be
helpful or even necessary for additional guidance to be issued
by PCAOB? Otherwise, it would seem the auditor would be placed
in a difficult position if you were asked for flexibility
without written direction. Would that be the case?
Mr. Turley. Senator, I think what you are asking is a
complex issue. Because investors in small companies are, I
think, looking for really the same things that investors in
large companies are looking for as it relates to when they see
a set of financial statements and have, if you will, the same
opinions written on the financials and the same opinions
written on the 404 requirements, they would have the same
expectations, whether there are three more zeroes on the end of
the big company or not.
I think that historically, our profession has shied away
from encouraging different standards, if you will, based on
whether it is large cap or small cap. I think that to the
extent that PCAOB would like to entertain differences or the
SEC would like to entertain differences for small companies, I
think it would be necessary for guidance to come out.
Senator Enzi. Okay, thank you.
Mr. Bentley, I also serve on the Health, Education, Labor
and Pensions Committee, and I want to thank you for your
specific suggestions in your testimony that deal with
retirement in particular, and it gives us a third approach to
some sticky problems. So, I appreciate it.
Thank you, Mr. Chairman.
Chairman Shelby. I want to thank all of you. We have got
another vote on the floor, as I knew we would, on Homeland
Security appropriations. I want to thank everybody for, one,
your patience sitting through the first panel. I thought it was
a good panel and for also your contribution here today. And a
lot of you have come from way off, and we will continue to do
oversight on all legislation, including Sarbanes-Oxley. I think
we learned from hearing from you. Thank you very much.
The hearing is adjourned.
[Whereupon, at 5:14 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF ANDREW SHENG
Chairman, Securities and Futures Commission Hong Kong SAR
September 9, 2004
Good afternoon, Chairman Shelby and distinguished Members of the
Senate Committee.
Thank you for inviting me to testify about the international impact
of the Sarbanes-Oxley Act and developments concerning convergence of
international securities laws.
A Brief Background About the Hong Kong Securities Market
First, I must give the disclaimer that the views I express here are
my personal views and do not reflect the views of the Hong Kong
Securities and Futures Commission, the individual members of the
Commission nor its staff, nor of the International Organization of
Securities Commissions (IOSCO), where I currently serve as Chairman of
its Technical Committee, nor any of its member jurisdictions.
Hong Kong is the largest stock market in Asia outside Japan and is
the eighth largest market in the world in terms of market
capitalization. There are a total of 1,074 companies listed on the Hong
Kong Stock Exchange with a total capitalization of $713.9 billion as at
the end of July 2004 and market turnover of $486 billion for the 12
months ending July 2004.
Hong Kong is the leading international financial centre in its time
zone, with 80 of the top 100 global banks having offices in Hong Kong,
as well as most of the major U.S. investment banks and securities
houses. Hong Kong has the largest concentration of international
accountants and legal offices in Asia outside Japan. As at the end of
2003, the equity securities of 21 companies were traded concurrently on
the Hong Kong Stock Exchange and New York stock exchanges (19 companies
on the New York Stock Exchange and 2 on Nasdaq). A major feature of the
Hong Kong market is that roughly 80 percent of Hong Kong listed
companies are incorporated outside Hong Kong, primarily in Bermuda, the
Cayman Islands, and the mainland of the People's Republic of China.
Another feature of the Hong Kong market is that unlike many other
Asian markets which are retail dominated, local and overseas
institutional investors account for 28 percent and 39 percent
respectively, of the total market turnover during the period 2002-
2003.\1\ Overseas investors, principally institutional investors, have
increasingly become dominant players in the Hong Kong stock market.
U.S. investors are active in the Hong Kong market and, likewise, Hong
Kong investors are familiar with U.S. and other international markets.
---------------------------------------------------------------------------
\1\ Understanding Investors in the Hong Kong Listed Securities and
Derivatives Markets, Essie Tsoi, Research & Planning Department, Hong
Kong Exchanges and Clearing Limited (July 2004). Available on the SFC
website at http://www.hksfc.org.hk/eng/statistics/html/index/
index0.html.
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Hong Kong Regulation of Issuers
All issuers whose securities are listed for trading on the Hong
Kong Stock Exchange must comply with the Securities and Futures
Ordinance and other Hong Kong securities regulations, such as the
nonstatutory Listing Rules \2\ and the Takeovers Code,\3\ irrespective
of their place of incorporation.
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\2\ The Rules Governing The Listing of Securities on The Stock
Exchange of Hong Kong Ltd.
\3\ Codes on Takeovers and Mergers and Share Repurchases (Takeovers
Code).
---------------------------------------------------------------------------
For historical reasons, our Listing Rules are based on the Listing
Rules of the United Kingdom. The Hong Kong Stock Exchange is currently
finalising a new corporate governance code for listed issuers called
the Code on Corporate Governance Practices, which is benchmarked
against the U.K. corporate governance code, known as the ``Combined
Code.'' The Hong Kong Code operates on a comply-or-explain principle.
Since the Securities and Futures Ordinance came into operation in
April 2003, all initial public offerings of securities in Hong Kong are
filed with both the Hong Kong Stock Exchange and the Securities and
Futures Commission (the HKSFC), thus strengthening the enforcement of
disclosure requirements by issuers. The Hong Kong Stock Exchange is
responsible for enforcing its Listing Rules, and the HKSFC is
responsible for enforcing corporate disclosure requirements pursuant to
the Securities and Futures Ordinance. It is a criminal offence under
the Securities and
Futures Ordinance to provide the HKSFC with false or misleading
statements in a corporate disclosure filing.
The Hong Kong Government has also agreed to amend the law to give
statutory effect to the more important listing requirements in the
Listing Rules. Once these statutory listing rules come into force,
listed issuers, their directors, and corporate officers will each be
criminally and civilly liable for compliance with the specific
disclosure obligations set out in the rules. These rules, too, will not
distinguish between domestic and foreign issuers.
The Hong Kong accounting and auditing standards essentially follow
the International Financial Reporting Standards and the International
Standards on Auditing. The Hong Kong accounting standards reflect 95
percent of the current International Financial Reporting Standards and
are on course to be fully compliant with International Financial
Reporting Standards.
Similarly, the Hong Kong auditing standards-setting body is in the
final stages of completing an exercise to make some minor amendments to
current Hong Kong auditing standards to bring them into full compliance
with International Standards on Auditing by January 2005.
The Hong Kong and United States Market
There are considerable United States and Hong Kong cross-border
securities and capital transactions. The HKSFC has always valued its
long and productive relationship with the U.S. Securities and Exchange
Commission (the U.S. SEC) and the Commodity Futures Trading Commission
(CFTC). In October 1995, the HKSFC entered into Memoranda of
Understanding with the U.S. SEC and the CFTC, respectively, to enhance
our mutual cooperation in the administration and enforcement of
securities laws in our respective jurisdictions.
The HKSFC is also a signatory to the IOSCO Multilateral Memorandum
of Understanding \4\ (IOSCO MMOU), the first global information-sharing
and enforcement cooperation arrangement among securities regulators
introduced in 2002. The IOSCO MMOU sets a new international benchmark
for cooperation among securities regulators in order to enhance
enforcement of securities laws internationally. Through the IOSCO MMOU,
the world's securities regulators have set the broad terms of
cooperation and assistance a securities regulator must offer to its
fellow securities regulators in order to be considered a responsible
member of the international regulatory community.
---------------------------------------------------------------------------
\4\ IOSCO Multilateral Memorandum of Understanding Concerning
Consultation and Cooperation and the Exchange of Information (May
2002).
---------------------------------------------------------------------------
The globalization of international financial markets has also
precipitated an increasing convergence between the Hong Kong and United
States models of securities regulation. In my view, the Hong Kong
Government's decision to give statutory effect to the more important
provisions of our Listing Rules moves Hong Kong closer to the U.S. SEC
regulatory model.
Impact of the Sarbanes-Oxley Act on Hong Kong
U.S. based firms, and companies whose securities are traded both in
Hong Kong and the United States , are already familiar with the
Sarbanes-Oxley Act and are required to comply with its requirements. My
personal view of Sarbanes-Oxley is that it was a quick and effective
response to potential an erosion of confidence in U.S. capital markets
resulting from high profile accounting frauds and corporate governance
failures at issuers such as Enron and WorldCom. Sarbanes-Oxley
heightened awareness around the world of the scope of directors'
fiduciary responsibilities. It has also raised awareness of the need
for enhanced corporate governance and auditor independence, the need to
improve oversight of the accounting and audit professions, as well as
the need to strengthen the protection of investors' interests. Market
participants tell me that preparation to comply with the certification
and internal control review requirements under Sarbanes-Oxley often
identified control weaknesses. These are areas clearly where Sarbanes-
Oxley made a difference.
On the other hand, there is industry concern over the rising costs
of compliance with Sarbanes-Oxley's increased regulatory requirements,
not only in monetary terms, but also in terms of manpower and IT
development. Some feel that the requirements are restrictive and
excessively onerous in nature, compared to corporations that do not
have to comply with Sarbanes-Oxley.
However, it must be pointed out that Hong Kong rules and
regulations do not conflict with Sarbanes-Oxley requirements. Our
regulatory regime covers most, but not all, of the main areas addressed
in Sarbanes-Oxley, albeit in much less detail and with less
prescription. For example:
Audit Committees
Our Listing Rules require companies whose securities are listed in
Hong Kong to set up audit committees composed of a majority of
independent nonexecutive directors, one of whom must have appropriate
accounting or related financial qualifications or expertise.
The Code on Corporate Governance Practices that will be
incorporated into the Listing Rules will recommend that a listed
issuer's audit committee review and monitor the independence and
objectivity of their external auditors and the effectiveness of the
audit process. The Code will further recommend that the audit
committee's terms of reference include a responsibility to advise the
board of directors on the appointment and removal of the external
auditors and to approve the remuneration and terms of engagement of the
external auditor.
Responsibility for Financial Statements
Directors have a legal obligation to prepare statements of accounts
that give a true and fair view of the company's financial position at
the end of its financial year. Failure to do so is a criminal offence
under the Companies Ordinance.\5\ Although the company's statement of
accounts is signed by two of the directors, the board of directors has
collective responsibility for the company's accounts as it must be
approved by the board of directors.\6\ This contrasts with the
Sarbanes-Oxley obligations that require the chief executive officer and
the chief financial officer to certify, amongst others, that the
financial statements and other financial information in the company's
financial report fairly present in all material respects the financial
condition and results of the company as of, and for the periods
presented in the report.
---------------------------------------------------------------------------
\5\ Section 123 of the Companies Ordinance (Chapter 32).
\6\ Section 129B of the Companies Ordinance (Chapter 32).
---------------------------------------------------------------------------
Once the statutory listing rules come into force, listed issuers,
their directors and corporate officers will each be criminally and
civilly liable for false and misleading financial statements published
by an issuer.
Prohibition of Loans to Directors
Hong Kong company law prohibits loans to directors. There are
certain exceptions to the general prohibition, particularly for banks,
which are allowed to lend money or provide guarantees or any security
to their directors, provided the terms of the financial assistance
given are no more favorable than those given to third parties.\7\
---------------------------------------------------------------------------
\7\ Section 157B of the Companies Ordinance (Chapter 32).
---------------------------------------------------------------------------
Convergence of Securities Regulations
Contradictory or duplicative regulations in different jurisdictions
covering similar regulated activities in various capital markets place
a heavy burden on issuers, market participants, and investors active on
a cross-border basis in those markets. With the advent of
globalization, conflicting regulatory requirements of different
jurisdictions can impede cross-border capital flows or create barriers
to entry to the provision of services on a cross-border basis by a
financial services firm. With respect to the regulation of cross-border
transactions and services in the international capital markets, each
national securities regulator has had to assess its regulatory
requirements, within the context of its domestic law, to try to strike
an appropriate regulatory balance. On one hand, regulators do not want
to impose or maintain regulations that increase costs to market
participants without enhancing investor
protection. On the other hand, the role of regulators is to protect
investors and maintain investor confidence through the imposition of
appropriate regulations, notwithstanding the resulting costs to market
participants. Maintaining market confidence is paramount, and
regulators internationally agree on the need to facilitate cross-border
capital formation without jeopardizing investors' interests.
To achieve this, securities regulators around the world must take a
global view of regulation and work together. There must be
international convergence of securities regulation. In my view, such a
convergence of regulations applicable to capital markets
internationally would be beneficial to all who participate in those
markets. For example, it would facilitate individual jurisdictions'
move toward a common goal of implementing effective securities
regulations locally; thereby minimizing costs to market participants
whilst maintaining uniformly high levels of investor protection and
confidence in capital markets.
Please note that I use the term ``convergence of securities
regulation'' rather than the term ``harmonization of securities
regulation.'' I do this intentionally because, as I see it,
``harmonization of securities regulation'' implies that each
jurisdiction would have identical or nearly identical rules and
regulations. This is not a realistic goal as securities regulations
must fit each jurisdiction's legal and regulatory environment and
reflect the realities of their different market structures. As these
differ significantly internationally, a full harmonization of
securities rules and regulations is not strictly feasible.
``Convergence,'' on the other hand, occurs when two or more sets of
regulations gravitate toward one another to achieve almost identical
regulatory principles or objectives. Convergence of regulation
recognizes that while there are certain international regulatory
principles and objectives that each jurisdiction strives to reach,
different rules and regulations can achieve the same basic regulatory
goals, such as the frequency of auditor rotation, and the composition
and duties of the audit committees. However, I feel strongly that
international securities regulations must converge at international
best practices; in ``a race toward quality'' rather than ``a race to
the lowest common denominator.''
Why Is Convergence of Regulatory Standards Important?
With international convergence of regulation, investors could be
confident that their interaction with foreign market participants and
issuers are subject to the same regulatory requirements as those in the
domestic market, allowing foreign and domestic issuers and market
participants to compete on a level playing field.
As an added benefit, convergence of regulation will reduce
compliance burdens and encourage multiple market access. Market forces
rather than regulatory costs would become the determining factor for
issuers and investors alike in choosing the markets they wish to
participate in and the extent of such participation. International
convergence of regulation will lower transaction costs for issuers and
market participants who are currently dealing with the varying
regulatory requirements of all jurisdictions in which they operate
while promoting the highest standards of investor protection. As market
forces would be the driver for the selection of markets, jurisdictions
around the globe would strive to enhance their regulatory model and
market infrastructure. At the same time, investors would enjoy greater
protection of their interests.
The work by the U.S. Financial Accounting Standards Board and the
International Accounting Standards Board to converge the U.S. GAAP with
the International Financial Reporting Standards is probably one of the
most important, if not the most ambitious, convergence exercises to
date. True convergence of the U.S. GAAP and International Financial
Reporting Standards would eliminate the need to reconcile statements of
accounts prepared in accordance with one set of standards with results
that would pertain using the other set of standards. Upward convergence
would enhance investor protection in all jurisdictions that adopt
International Financial Reporting Standards, as investors will be able
to easily compare the financial statements in all of these markets. The
progress toward market integration and the reduction in the regulatory
burden of multiple market access will largely depend on the success of
this effort. I personally agree with and support such convergence of
international accounting standards and commend both standard-setters on
their work.
One of the much debated topics where accounting standard-setters
are seeking to adopt common principles worldwide is the issue of
expensing stock options. I support the proposals to expense stock
options. I believe that financial statements should reflect the true
position of all transactions. Granting employees stock options is a
form of compensation; it gives employees a benefit and is an expense to
the company. In putting the case for this treatment, I cannot improve
on the sage words of Warren Buffet: ``If options aren't a form of
compensation, what are they? If compensation is not an expense, what is
it? And, if expenses shouldn't go into the calculation of earnings,
where in the world should they go?''
How do Regulators Achieve Convergence of Their Regulatory Standards?
The international regulatory community must work together to avoid
conflict in regulatory approaches and facilitate cross-border business
while maintaining high regulatory standards. This can be achieved
through dialogue, be it bilateral dialogue between two regulatory
agencies or multilateral dialogue through international organizations,
such as IOSCO. Both SEC and CFTC are prominent members of IOSCO.
IOSCO provides an effective forum where securities regulators can
exchange views and explore new ideas and approaches to strengthen
cross-border securities regulation and cooperation in a coherent manner
that closes gaps in regulation, while avoiding duplication or conflicts
in regulation. For instance, Hong Kong participates in an IOSCO
Chairmen's Task Force that is developing a Code of Conduct for Credit
Rating Agencies. This Code of Conduct seeks to address many of the
concerns raised by the industry, and the role credit rating agencies
play in modern financial markets. The proposed Code will follow the
general structure of an IOSCO Statement of Principles Regarding
Activities of Credit Rating Agencies adopted in October 2003 and would
serve as a model code of conduct for credit rating agencies all over
the world.
Since its establishment 21 years ago, IOSCO has undertaken numerous
projects designed to improve the regulation of securities markets and
the level of cooperation among its members, including issuing
regulatory standards and principles. These standards and principles are
not legally binding and do not prescribe a certain type of regulation
or any particular regulatory structure; rather, they reflect a
consensus among securities regulators on regulatory objectives in each
of these areas. Each IOSCO member jurisdiction may then devise the
means most appropriate to its own structure and circumstances by which
to implement the IOSCO principles. Through IOSCO, the member countries
work together to develop the highest standards of regulation. For
instance, the IOSCO principles governing oversight of auditors \8\ and
auditor independence \9\ have become the international standards for
the regulation of auditors. These IOSCO principles have become the
principal framework for securities regulation in many countries.
---------------------------------------------------------------------------
\8\ Principles for Auditor Oversight (October 2002).
\9\ Principles of Auditor Independence and the Role of Corporate
Governance in Monitoring an Auditor's Independence (October 2002)
---------------------------------------------------------------------------
Is Convergence of Regulatory Standards Enough?
However, merely converging regulation to meet international
standards and principles is not sufficient; as disparities in the
implementation of these regulations can nullify the benefits of
convergence. It is essential that there is some degree of consistent
interpretation, application and enforcement of these regulations to
create a level playing field for a truly global market. IOSCO has a key
role to play in this regard and increasingly it is focusing its
attention on facilitating the implementation of its standards and
principles among its member jurisdictions.
The HKSFC has a long history of cooperating extensively with other
regulatory and law enforcement agencies, including the SEC and CFTC. We
have entered into 33 cooperation arrangements with our counterparts in
other jurisdictions to exchange confidential information or to
facilitate cross-border investigation and enforcement actions. The
HKSFC is also one of 26 signatories so far to the IOSCO MMOU. Through
IOSCO, and more particularly the IOSCO MMOU, we have sought to promote
cooperation and information sharing among the international securities
regulatory community, especially in the area of investigating and
prosecuting violations of securities laws and regulations. The IOSCO
MMOU does not create legally binding obligations on its signatories nor
does it supersede domestic laws. Nonetheless, it has encouraged a
number of jurisdictions to enact laws to permit their securities
regulators to share information and cooperate with their foreign
counterparts in accordance with the international benchmark articulated
in the IOSCO MMOU.
Conclusion
Let me conclude by saying that in light of today's globalized
markets, regulators face a multitude of challenges. Not only are the
issues complex, with financial innovation and market developments
raising new issues daily, but also investor expectations are at an all-
time high. The recent high-profile global financial and securities
fraud scandals have rocked the world's financial markets and
underscored the need for high standards and cross-border cooperation.
Tremendous strides have been made in many areas in seeking global
approaches to securities regulation. Regulators must continue to work
together, through international organizations such as IOSCO, to
establish the high regulatory standards that the world's investors
rightly expect and to cooperate on cross-border enforcement actions.
International convergence of regulation and strengthened cooperation in
enforcement of these regulations together offer the best way to create
a truly global regulatory framework for the global securities market.
Thank you for your attention.
----------
PREPARED STATEMENT OF PAUL BOYLE
Chief Executive, Financial Reporting Council (U.K.)
September 9, 2004
Mr. Chairman and Members of the Committee, it is my privilege to
appear here today as the first Chief Executive of the United Kingdom's
new Financial Reporting Council (FRC), a position which I took up a few
months ago. The aim of the FRC is to promote confidence in corporate
reporting and governance in the United Kingdom. We believe in wealth
creation. We believe that our role in promoting confidence in corporate
reporting and governance can make the creation of wealth more likely.
I hope that our mission means that we are in a position to assist
the Committee in its review of the impact of the Sarbanes-Oxley Act and
developments concerning international convergence.
In my remarks this afternoon, I wanted to focus on three matters,
which I think will be particularly relevant to the Committee's review:
the new regulatory regime for accounting and audit in the
United Kingdom, under the control of the FRC, which was designed
following the Enron and WorldCom cases;
the FRC's stance on international convergence of accounting
and auditing regulation; and
the United Kingdom's approach to promoting high standards of
internal control in public listed companies.
The New Regulatory Regime in the United Kingdom
It is an indication of the increasingly global nature of the
capital markets that the corporate scandals (including Enron and
WorldCom and the related collapse of Andersen) which shocked U.S.
investors have also had a significant impact on the U.K. market,
notwithstanding the fact that there have been no cases of comparable
significance in the United Kingdom for some years.
In fact, the United Kingdom had experienced cases of similar impact
a little over a decade earlier, in the late 1980's. At that time there
were a number of examples of large and apparently profitable companies
which suddenly collapsed into bankruptcy. These cases had prompted the
U.K. Government to commission a review of the arrangements for the
setting and enforcement of accounting standards in the United Kingdom.
This review led in 1990 to the removal of the responsibility for
setting accounting standards from the accountancy profession and the
establishment of an independent standard-setting body (the Accounting
Standards Board (ASB), whose first Chairman was David Tweedie). In
addition, a new body, the Financial Reporting Review Panel (FRRP) was
established to review cases of alleged failure to comply with
accounting standards and to ensure that financial statements which did
not comply with those standards were corrected. The ASB and the FRRP
were established as subsidiaries of a new organisation, the FRC, which
was responsible for raising the funding for these new activities and
for ensuring their independence. The FRC's Council was composed of a
broad selection of representatives from the business community in the
United Kingdom, including public companies, investors and the
accountancy profession.
The new arrangements worked well during the 1990's. The ASB, led by
Sir David, embarked on a major programme of reform of accounting
standards in the United Kingdom. The main accounting abuses which had
contributed to the corporate scandals of the 1980's were tackled. The
new standards dealt with complex and politically sensitive topics
including off-balance sheet finance, pensions, acquisitions, and so-
called ``big bath'' provisions. During this period the ASB demonstrated
its ability to influence financial reporting internationally by working
with the International Accounting Standards Committee, FASB and other
national standard-setters. The FRRP established its credibility by
taking a firm stand in requiring a number of companies to restate their
financial statements or to undertake to amend their accounting
practices in future. The true impact of the FRRP far exceeded the
number of cases which it actually dealt with because once its
credibility was established auditors used the unpleasantness of an FRRP
investigation as a mechanism to persuade some clients to improve their
accounting practices.
There were two other themes in corporate reporting and governance
during the 1990's which are important to an understanding of the
development of the regulatory regime in the United Kingdom.
The first theme was the progressive move away from entirely self-
regulation of auditing by the accountancy profession toward independent
regulation in a statutory framework. The initial moves were made in the
early 1990's with a significant tightening of the long-standing
restrictions on who could perform audits in the United Kingdom to those
who were members of certain professional bodies. A statutory
requirement was introduced for the professional bodies to be recognised
by the Government against detailed requirements as to their audit
qualifications and the rules and practices governing the conduct of
their members. A requirement for registration of auditors was
introduced. The effect of these changes was that the accountancy
profession retained the primary responsibility for regulation of
auditors but it was required to do so within a statutory framework and
it was subject to oversight by the Government. In the early 1990's the
accountancy profession also agreed that 50 percent of the members of
the audit standard-setting body should be nonauditors, which was a
significant development at that time.
In the late 1990's the Government became increasingly persuaded
that public expectations required greater independent oversight of the
regulation of the profession. The Government agreed with the main
professional bodies in the United Kingdom that certain key regulatory
activities, including the setting of auditing standards and ethical
standards, would be transferred to an independent but nonstatutory
regulator, the Accountancy Foundation, which was to be entirely funded
by the profession. The Foundation commenced operations in 2000.
The second theme was the emergence of a consensus about the
importance of corporate governance. This consensus (which is
considerably stronger now than it was when the subject was first aired)
has been built up around a series of reviews, starting with the Cadbury
Report which was published in 1992 and which was extended by two
further reviews later in the decade. These further reviews led to a
consolidation of the various recommendations in a document known as the
Combined Code on Corporate Governance.
The key propositions in the Combined Code are that it is important
to avoid an undue concentration of power at the top of a company, that
Boards of Directors should have a strong group of nonexecutive
directors who are considered to be independent, that Boards need to be
properly organised to ensure that companies are run for the benefit of
their shareholders rather than for the management and that there should
be full disclosure of directors' remuneration. A distinctive feature of
the Combined Code is that it recognises that recommendations on best
practice in corporate governance may not be appropriate in all
circumstances. The Code, therefore, operates on a ``comply-or-explain''
basis which means that public listed companies are expected to follow
the provisions of the Code in full or to explain in what respects they
have departed from it.
One specific recommendation of the 1992 Cadbury Report which may be
of particular relevance to the Committee relates to internal control. I
will return to this topic in the third section of my remarks.
The 1990's was, therefore, a decade in which there had been
considerable change in the regulatory regime for financial reporting,
auditing, and corporate governance in the United Kingdom. By the end of
the decade the U.K. arrangements were in many respects more developed
than those in other major financial markets.
This was the position in the United Kingdom when the major
corporate scandals in the United States and the collapse of Andersen
occurred. Although it had been some years since there had been scandals
of equivalent significance in the United Kingdom, the Government
decided that it would be prudent to consider whether further
strengthening of the regime in the United Kingdom would be appropriate.
During 2002 the Government commissioned four reports on different
aspects of the regime and the results of these reviews were announced
in January 2003. One direct result of these reviews was a significant
widening and deepening of the role of the FRC, including taking over
the functions of the Accountancy Foundation with effect from 1 April
2004. It is, however, a feature of the new regime in the United Kingdom
that the accountancy profession is still expected to contribute to the
regulation of its members.
The FRC is now a unified, independent regulator which:
sets, monitors, and enforces accounting and auditing
standards;
oversees the regulatory activities of the professional
accountancy bodies and has specific statutory responsibilities in
relation to the regulation of audit; and
promotes high standards of corporate governance.
The main changes in the FRC's role have been:
The FRRP has changed from being complaints-driven to actively
looking in a risk-based way for failures by U.K. public-listed
companies to comply with accounting standards.
The FRRP will also now review interim financial statements
rather than merely annual reports.
An oversight board will take over the Government's role in
monitoring the regulatory activities of the professional bodies,
including determining whether their procedures are adequate for
their members to retain their statutory status as qualified
auditors.
A new audit inspection unit will monitor the auditors of all
listed companies and major public interest entities, with the scope
of its work including the ``tone at the top'' of the major firms
and the appropriateness of the judgements on individual audit
assignments.
The board which is responsible for the setting of auditing
standards has been given the additional responsibility for setting
ethical standards for auditors and is now totally independent of
the accountancy profession.
A new scheme will investigate and, where appropriate,
discipline audit firms and individual accountants in cases which
involve public interest issues.
We will keep under review the Combined Code on Corporate
Governance which has already been strengthened to increase the
influence of independent nonexecutive directors and the
professionalism of the way in which Boards operate with, in
particular, increased responsibilities of audit committees.
The FRC only assumed its new functions on 1 April and so we are in
the early stages of establishing our credibility and authority as a
unified regulator. We have already commenced each of our new functions,
although some of our new statutory powers await the enactment, likely
to be later this year, of a Bill which is currently before the U.K.
Parliament.
We believe that the issues of corporate reporting, auditing,
professional standards of accountants and corporate governance are all
closely related. The capability to look at the issues in a joined-up
manner was the rationale for the FRC's new range of responsibilities,
which we believe is broader than any of our international counterparts.
It means that we are well-placed to implement an effective regulatory
regime for the United Kingdom which we hope will command respect in
other countries. We believe that our aims are very much aligned with
the aims which Congress had in mind when it passed the Sarbanes-Oxley
Act.
We are, however, very clear that no system of regulation can ever
eliminate the possibility of corporate reporting failures: We believe
that it is impossible to achieve zero failure and any attempt to do so
would destroy wealth rather than facilitate its creation.
International Convergence of Accounting and Auditing Regulation
The FRC is committed to working toward international convergence of
accounting and auditing regulation. This reflects the long history of
the United Kingdom as a country whose economic success has been based
on international trade. This remains true even though international
financial services are now much more important to our economy than the
heavy industries of ship-building and steel-making which were once at
the heart of the U.K.'s economic power.
The United Kingdom is a major international financial centre, with
a share of global capital markets which far exceeds its relative size
as an economy: Some aspects of our approach to the operation of those
markets must be working well.
International convergence is most commonly discussed in relation to
accounting standard-setting, and I will set out the FRC's position on
that topic, but there are other aspects of accounting and auditing
regulation for which there will be benefits from international
convergence.
We share the vision that there should be a single set of high
quality accounting standards for use in all of the world's capital
markets. We believe that it is important that those standards are set
by independent standard-setters, following due process and free from
political influence. In this regard, we fully support the work of the
International Accounting Standards Board (IASB).
As the Committee will be aware, within the European Union (EU) a
Regulation requires listed companies to apply international accounting
standards, as endorsed by the EU, in their consolidated financial
statements for financial years commencing on or after 1 January 2005.
The FRC has a clear and public commitment to the proposition that this
means that listed companies should be required to use the full suite of
accounting standards published by the IASB.
The process by which international accounting standards will be
implemented in the consolidated financial statements of public listed
companies in the United Kingdom is wholly dependent on the endorsement
of those standards by the EU. The European endorsement process has
generally been proceeding well but has run into some difficulties
concerning the particular standard on the measurement of financial
instruments and at this stage the eventual outcome in relation to that
standard remains unclear.
The responsibility in the United Kingdom for the conduct of the
negotiations with our European partners rests with the U.K. Government
and the FRC has no direct involvement. However, our advice to the
Government is that in principle the best outcome is full and immediate
endorsement of all of the IASB's standards. In the event that such an
outcome is not possible to achieve we have significant concerns about
outcomes which involve amending the provisions or scope of the
standards published by the IASB. Should one of the IASB's standards not
command sufficient support in Europe then a preferred alternative to
amending that standard may be to leave it as unendorsed. In either case
it is important that those companies who wish to implement them are
permitted to do so. We believe that many British companies will choose
to implement the full set of international standards even if they are
not required to do so.
We are very encouraged by the expressions of commitment on the part
of the authorities in the United States to the process of international
convergence. We are supportive of the ``Norwalk'' agreement between
FASB and the IASB which sets out their joint ``commitment to the
development of high-quality, compatible accounting standards that could
be used for both domestic and cross-border financial reporting.'' We
very much hope that the United States can remain committed to that
goal, which we believe will be strongly to the long-term benefit of
companies and investors in all markets.
The FRC's Accounting Standards Board remains responsible for the
standards which apply to entities other than public listed companies.
The ASB is committed to full convergence to international standards for
U.K. domestic reporting purposes and has been consulting on how best to
achieve this goal.
The FRC is also committed to international auditing standards,
notwithstanding the fact that there is not yet full support for an
international harmonisation project comparable to that for
international accounting standards. The FRC's Auditing Practices Board
(APB) has in recent years devoted considerable resource to assisting
the International Auditing and Assurance Standards Board (IAASB) in its
efforts to improve the quality of the international standards.
In order to take advantage of the improved protection against
fraudulent financial reporting and aggressive earnings management which
recently issued international standards offer, the APB has announced
its intention to implement International Standards on Auditing (ISA's)
issued by the IAASB in the United Kingdom for 2005 financial
statements. The APB believes that adopting the ISA's is a more
effective means of improving auditing standards in the United Kingdom
than the alternative of rewriting the existing suite of U.K. standards.
The APB recognises that some international standards remain to be
revised and it is contributing to that work. In the meantime, the APB
also believes that in some respects the existing U.K. standards are
stronger than the equivalent ISA. In order to avoid a reduction in the
quality of U.K. standards the APB will incorporate some additional
material from existing U.K. standards into the ISA's. Examples of areas
in which the APB has found it necessary to supplement the international
standards include:
Going concern;
Related party transactions; and
Reporting to audit committees.
This additional material will be clearly differentiated from the
international material and, over time, the APB hopes to be able to
withdraw the additional material as the relevant ISAs are updated by
the IAASB.
We believe that there is a risk that the absence of a widely-shared
commitment to international auditing standards convergence could lead
to a waste of resources on standard-setting around the world plus
subsequent inefficiencies caused by audit firms and their clients
having to adhere to several sets of standards.
We acknowledge that some jurisdictions may be unwilling to accept
auditing standards such as ISA's which do not contain the level of
detailed requirements to which they have become accustomed. We believe
that the U.K.'s solution to this problem (that is, taking the ISA's as
the foundations for U.K. standards but supplementing them with
additional requirements which are believed to be appropriate in the
domestic market) is a model which other jurisdictions may find
attractive. If this model were to be adopted more widely it would have
three main advantages:
improved comparability of standards in different countries;
reduced cost of domestic standard setting; and
an easier path to future international convergence.
Standard-setting is, however, only one element of accounting and
auditing regulation. Monitoring and enforcement of standards are
equally important. Although there have been accounting and auditing
standard-setting arrangements for many years, monitoring and
enforcement are much less well-established, particularly independent
monitoring and enforcement of auditing standards. It is only a year or
so since the Sarbanes-Oxley Act established an independent regulator in
the United States. It is less than 6 months since the FRC became the
independent regulator in the United Kingdom.
The arguments in favour of international standards convergence
(that is, the benefits to companies and investors of lowering the costs
of cross-border transactions) apply equally to monitoring and
enforcement activities. Indeed, it could be argued that much of the
effort devoted to international standards convergence will be wasteful
if there are inconsistent or duplicative national approaches to
monitoring and enforcement. Inconsistency will constrain the
improvements in investor confidence; duplication will increase costs
for both companies and investors.
The FRC believes that, whereas a very high degree of international
standards convergence is attainable over not too long a period (that
is, it is possible to envision a single set of accounting standards in
use in all of the world's major capital markets), the nature of the
issues to be resolved in relation to monitoring and enforcement
convergence mean that our ambitions for international convergence need
to be different. The national differences in the factors affecting the
design and intensity of monitoring and enforcement activities (for
example, companies and securities law, the strength of the accounting
profession, the extent to which investors are able to exert influence
over companies, etc.) are likely to persist for a long time.
Despite these limitations, we believe that there is merit in
pursuing convergence of monitoring and enforcement activities. We
believe that there would be considerable benefits for companies and
investors if national authorities could take account of the monitoring
and enforcement arrangements in other countries when considering what
additional procedures need to be applied to foreign registrants and
their auditors. Although national authorities will need to make an
assessment of the equivalence of the foreign country arrangements, we
do not believe that it is either necessary or desirable for those
arrangements to be identical in order to be of value. There is,
however, no doubt that international agreement on common principles
would greatly facilitate cross-border regulatory co-operation.
Given the recent creation of independent audit regulators in a
number of countries, and the likelihood of this number increasing in
future, we believe that there would be merit in the establishment of an
international mechanism to facilitate exchange of information and the
development of common principles which would help to reduce the risk of
inconsistency or duplication. Such a mechanism would perform a similar
role in relation to audit regulation to that performed by the Basel
Committee in relation to banking regulation and IOSCO in relation to
securities regulation.
Promoting High Standards of Internal Control
One specific recommendation of the 1992 Cadbury Report was that
Boards of Directors should ``maintain a sound system of internal
control to safeguard shareholders' investment and the company's
assets.'' It is worth noting that for this purpose internal control
includes not only controls over financial reporting but also ``all
controls, including financial, operational, compliance controls and
risk management.'' The Code also requires Boards to conduct an annual
review of the effectiveness of their internal control system and report
to shareholders that they have done so.
In 1999, a group convened by the Institute of Chartered Accountants
in England & Wales published guidance (known as the ``Turnbull
Guidance'') for companies on how to implement the provisions of the
Combined Code. The Turnbull Guidance is formally annexed to the Code.
The inclusion of a requirement in the Cadbury Report for companies
to assess the effectiveness of their internal controls was
controversial and there was initially considerable uncertainty and
nervousness on the part of companies about the practical implications.
As time has past many companies have taken the requirement seriously
and we believe that the Combined Code requirement has led to
improvements in risk management practices in public companies.
There are two key differences between the requirements of the
Combined Code and that of Section 404 of the Sarbanes-Oxley Act. First,
under the Combined Code, boards of directors are not required to report
to shareholders on the effectiveness of internal control, although they
are required to disclose the process applied to deal with material
internal control aspects of significant problems disclosed elsewhere in
the financial statements. Second, there is no requirement in the
Combined Code for auditors to review and report on the effectiveness of
the internal control system.
At present in the United Kingdom, although there remains general
commitment to the merits of high standards of internal control, there
would be considerable anxiety on the part of both companies and
investors about the cost implications of any proposal that these
requirements be introduced. We will, however, keep the position under
review.
The FRC is pleased that the SEC has concluded that the Turnbull
Guidance is a framework which is suitable for evaluating internal
controls as required by Section 404, even though it is somewhat less
detailed in its contents than the COSO framework.
The FRC is aware that there have been a number of developments of
best practice in relation to internal control both in the United
Kingdom and internationally, particularly as a result of the Sarbanes-
Oxley Act, since the Turnbull Guidance was published. In the light of
this the FRC has recently announced a review of the guidance. The
review group will be chaired by Douglas Flint, Group Finance Director
of HSBC Holdings plc who I understand will be appearing before the
Committee later today.
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PREPARED STATEMENT OF DOUGLAS FLINT
Group Finance Director, HSBC Holdings plc
Background
HSBC is the largest banking group outside the United States and the
second largest in the world measured by market capitalisation. At 3
September the Market Capitalisation was $178 billion. HSBC operates in
76 countries employing some 232,000 staff.
HSBC is subject to primary regulation by the U.K. Financial
Services Authority (FSA) on its global operations. As a U.S. Bank
Holding Company it is also subject to regulation by the U.S. Federal
Reserve. In all it is regulated by approximately 370 different central
banks and regulatory authorities at a cost, in aggregate, estimated in
2003 at $400 million.
HSBC is listed on five stock exchanges--the United Kingdom, Hong
Kong, New York, Euronext Paris, and Bermuda. The last two arose
primarily as a result of acquisitions. The New York listing was
obtained in 1999.
HSBC has made two public U.S. company acquisitions since obtaining
its New York listing; Republic New York Corporation in 1999 and
Household International in 2003.
HSBC is widely held with in excess of 190,000 shareholders. It is
estimated some 15 per cent of the shares are held by U.S. investors.
Douglas Flint has been Group Finance Director since 1995 joining
from KPMG; a CV is appended to this submission (Appendix I).
HSBC is grateful for the opportunity to contribute to this
hearing; the views expressed are personal to Douglas Flint.
Corporate Governance and the Impact of Sarbanes-Oxley
There is no question that there is an immediate and urgent need to
reestablish confidence in the public markets through which investors
entrust their savings and wealth is created through efficient
allocation of resources. The spectacular collapses and outrageous
frauds visited on public markets in recent years demanded a public
policy response.
It was inevitable that the U.S. response would be first given that
the early failures took place in its markets and also that the
mechanisms exist for prompt affirmative action. It was also inevitable
that the impact of U.S. legislation would be far reaching as it
encompassed the global operations of companies listed in the United
States, not just their domestic U.S. operations. The threat of
litigation in U.S. courts for failure to comply certainly has
concentrated minds. It was also inevitable that other jurisdictions
would explore their own responses to corporate misdeeds not only in
response to the outcry which followed frauds in their own markets, but
also to construct frameworks more in keeping with their own domestic
governance models.
As a result, companies like HSBC face multiple governance codes and
initiatives, some enshrined in law, others in Stock Exchange regulation
and others in Best Practice codes. Inevitably there will be conflicts
in what is required.
In relation to Sarbanes-Oxley specifically, there is no question
that it has reminded boards forcibly of their responsibilities and
their accountability for the accuracy of public reporting; that of
itself has been an immediate and welcome wake-up call across the world.
It has also reminded companies that the responsibilities they have
are direct responsibilities and cannot and should not be ``delegated''
to third parties such as their auditors or lawyers.
The weaknesses of the auditing profession have also been
highlighted which has caused many companies to reappraise the quality
of advice they had been relying on, particularly in relation to
presentation under U.S. GAAP when it was not their primary accounting
model.
However there are unfortunate consequences, perhaps unintended,
which may frustrate the overriding objective of the legislation to
improve public reporting. Among these I would include the following:
The way Sarbanes-Oxley is being implemented by the accounting
profession following the PCAOB guidance has become meticulously
prescriptive and detailed, no doubt in response to fear of
litigation for having omitted something, with prescription being
seen as the best defence. From the standpoint of the company it
feels like having to document everything to prospectus or
litigation standard just in case that is the standard decided by
the courts to be necessary at some later point in time. The clear
danger, increasingly evident, is that the process becomes the
objective rather than the means to the end. It worries me that
increasing resources in the Big 4 auditing firms are devoted to
documenting control processes in companies rather than auditing
business by understanding it in the first instance. Good financial
reporting comes from understanding the business being portrayed in
financial terms far more than understanding the control processes
through which the financial results are processed.
Sarbanes-Oxley necessarily is written in general terms yet is
being interpreted to mean or require all manner of things--and
there is no-one who can challenge an interpretation with
confidence. This is a real issue when implementing Sarbanes-Oxley
across multiple geographies as the global accounting firms are not
consistent at all in what they do. However, the auditing profession
has the final say given that the auditors have been empowered as
the sole authority, by virtue of their obligation to report
independently on financial reporting controls.
It is perhaps curious that so much trust is being placed on
the judgement of the auditors as regards financial reporting as few
have any experience as preparers and the expertise in accounting
system design that existed within the firms largely departed when
consulting was separated due to conflicts. In a world where
directors are rightly subject to increased accountability and
greater scrutiny it is worth challenging whether the impact of the
independent audit opinion on financial reporting controls improves
the process or serves to discourage directors from exercising a
judgement that shareholder interests are properly served by
expanding/acquiring a business with weak formal financial reporting
controls mitigated by sound business model profitability. The
existence of some weakness in financial reporting controls is
increasingly likely as accounting standards become more
prescriptive and complex and require implementation in short
timescales across wide geographies with linguistic challenges to
training. Accounting officers are therefore becoming increasingly
concerned that they are exposing themselves to unknown risk as they
seek to implement unfamiliar and complex new requirements. For
example, the pending International Accounting Standard on Financial
Instruments stretches to over 400 pages with implementation
guidance. It would be unsurprising if there were implementation
challenges.
There is a governance penalty now for being U.S. listed which
is significant in terms of time and money where the cost benefit is
difficult to see. The responsibilities for directors have not
changed and they were able to sign their Section 302 certificates
in 2003 without the paperchase now being required under Section
404. We estimate some $30-50 million in implementation cost to
compile the database of financial reporting controls we know we
have but were not originally documented to describe specifically
the financial statement control assertion they address. It is
interesting also to note the current trend toward private equity
investment in many markets where the largest professional
shareholders are increasingly making a judgement that higher
returns may be available from investments not subject to public
reporting obligations/protections.
Inevitably Sarbanes-Oxley is drafted with a U.S. governance
framework in mind and, when taken together with the detailed
guidance issued by PCAOB, application internationally is
complicated by virtue of different governance models and indeed
legal frameworks which can act to frustrate the detailed
requirements of the Act but without necessarily impairing the
overriding objective. As an international registrant we hope that
as time evolves the possibility of mutual recognition of approved
governance regimes might be contemplated to avoid costly
duplication of demonstrating compliance with equivalent regimes in
different formats.
International Financial Reporting Standards (IFRS)
HSBC is a strong supporter of the move toward a globally
recognised, robust framework of accounting both for our own reporting
and as a consumer of financial information as a lending and investing
operation. Partially as a result of the cumulative aggregation of
different disclosure requirements across the five jurisdictions through
which we are listed, together with increased regulatory requirements
our Annual Report in 2003 reached 380 pages of which 40 were devoted to
reconciling United Kingdom to U.S. GAAP. With the implementation of
IFRS in 2005 requiring explanation of the differences against U.K. GAAP
as well as reconciliation to U.S. GAAP we expect the Annual Report and
Accounts for that year to grow to around 450 pages which is beyond the
comprehension of all but a small segment of the professional analyst
community. Indeed, we are concerned that the Annual Report and Accounts
has already lost its role as the primary communication medium between
management and shareholders.
The training and monitoring burden necessitated as a consequence of
multiple GAAP reporting is significant, and is exacerbated as a result
of the impact of Sarbanes-Oxley. The impact on accounting system design
of requiring data to be held to accommodate tracking of different GAAP
reporting is significant and of negligible value to shareholders.
It is clear that shareholders concentrate almost exclusively on the
GAAP reporting pertinent to the most liquid market in which shares
trade; this suggests there is no ``silver bullet'' of truth in
financial reporting but that consistency and comparability are valued.
In the 5 years HSBC has been reconciling to U.S. GAAP, notwithstanding
significant differences in reported net income for complex technical
reasons in individual years, there has been virtually no shareholder
interest in understanding these differences beyond the brief
explanations included in the accounts. In professional shareholder
face-to-face meetings the subject virtually never arises.
As progress is made in delivering IFRS we have a number of
concerns:
The construction of IFRS is increasingly rules rather than
principles based, in part to meet concerns of preparers and
auditors that, without definition, criticism could be attracted for
the exercise of judgement in interpreting how to apply a standard
in nonstandard circumstances; as an aside we note an increasing and
regrettable trend in auditing to avoid being seen to apply the
intent of accounting standards in face of a possible but bizarre
literal application of standards to events which were never
contemplated when the standard was designed. Such legalistic
construction continues to risk the corruption of accounting and
thereby limits the confidence that users will have in financial
reporting. Notwithstanding the difficulties involved we believe
that there is need for an overriding standard akin to the United
Kingdom's ``true and fair view'' to govern financial reporting
permitting, indeed requiring, nonapplication of accounting
standards in circumstances where the resulting accounting is
materially misleading. Clearly, as in the United Kingdom, full
explanation would be required and auditor concurrence or
qualification added.
In this regard I would draw attention to the remarks of Lord
Penrose in his report on the collapse of Equitable Life, a
significant U.K. life assurer on the dangers of seeking
perfection in accounting before requiring change to practices
known to be deficient.
Proposals, exposure drafts, and similar consultation exercises are
not a substitute for normative standards. The continuing
failure to produce acceptable standards and secure their
implementation is a failure in a professional duty owned to the
public. It is a failure in duty to shareholders in proprietary
companies. It is a failure in duty to policyholders in
proprietary and mutual companies. Those with the responsibility
to produce appropriate standards must have it impressed on them
that what is required are practical standards of general
application that will provide consumers of accounting
information and their advisers with ready means of assessing
the financial positions of the providers of financial products.
A search for perfection in his area will fail. To await
agreement among the wide range of interests affected will
involve interminable delay.
We are concerned that there is as yet no clear timeframe to
disapply reconciliation to U.S. GAAP upon application of IFRS for
companies enjoying a secondary listing in the United States. If the
real value of IFRS is to be achieved accounts prepared under IFRS
must be accepted in all markets without reconciliation. We
recognise there is still work to be done to prove the complete and
robust nature of IFRS but it would be helpful to have confirmed
that following that accreditation the reconciliation burden will be
relieved.
As a matter of policy it would also be helpful if ongoing U.S.
requirements rewarded behaviour consistent with the harmonisation
agenda, perhaps by reducing the burden of producing comparative
information and accelerating relief from reconciliation to U.S.
GAAP for registrants who fully adopt IFRS as opposed to those who
may take available options to apply restricted versions of IFRS
permitted under national discretion.
We are concerned that although much is being done to harmonise
the workflows of the IASB and FASB to ensure increasing convergence
as standards are refreshed and updated there are notable
differences of timescale in important areas which could lead to
frustration of the harmonisation agenda. In particular, we see
difficulties in the areas of pension accounting, scope of
consolidation and share based payment. The current difficulties in
Europe finalising IAS39 are also illustrative of the theme.
Auditing Standards and Auditor Independence
HSBC regrets intensely the lack of choice in today's public
auditing market with the existence of only four global firms a
potentially disruptive feature. Unsurprisingly as the firms face
similar issues they have a shared interest in acting together thereby
evidencing the concentration of power they enjoy. As a global
organisation operating in 76 countries we need a single firm to co-
ordinate our audit and indeed our regulators demand it.
It is with deep concern that we see the auditing profession flexing
its muscles currently within the protection of a statutory and
regulatory monopoly for auditing services by threatening withdrawal of
service provision to key sectors including banking if they do not
receive protection from unlimited liability. I do not believe this is
in any way an acceptable position to take but it is one that can only
be taken in an oligopolistic industry structure.
The reality for banking organisations is even more extreme as the
independence rules operate to exclude the nonincumbent firms from
eligibility in the short-term to take on the audit unless significant
work is done by both the firm concerned and the bank to maintain
independence. Given concentration in the provision of global banking
services and the concentration in auditing services, arranging such
standby independence is a real commercial problem. Some relief to
exclude from the independence rules normal transactions on arms length
terms from specified large banking organisations would be welcome and
not in my view of public policy concern.
This having been said, we support the auditing profession in its
objective of limiting its liability. The potential consequences of
further limitation in the supply of auditing services is of concern to
us both as a consumer of such services as an audited entity and as a
user of audited accounts as a lending organisation. My submission to
the Department of Trade and Industry charged with reviewing this matter
is appended to this submission (Appendix II). I would draw particular
attention to one paragraph.
If auditors are to be allowed to restrict their liability then I
believe it is also important that the audit report given is in plain
English. Today's report has evolved to a list of exclusions and caveats
with the actual opinion the smallest segment of the report. The very
technical language used for the audit report gives auditors the ability
to claim that everything they did was in accordance with auditing
standards and in accordance with the applicable GAAP which is fine,
except that it is unclear to the average reader of an annual report and
accounts what this means. I believe a longer form report more
descriptive of what the auditor actually does would be beneficial both
to understanding what the report means and as a way of focusing
auditors as to what the primary purpose of the audit is.
This comment draws together much of what is said above in that
auditing has increasingly become a technical compliance service which
looks to form rather than substance. This undoubtedly is driven by fear
of litigation yet I suspect users still believe auditors have taken
care to understand the business model as well as verifying that the
financial reporting control framework operates effectively. I genuinely
believe governance would be more effective if auditors were required to
report along the lines set out in Appendix III, which was part of my
input to the DTI review in the United Kingdom, as opposed to a
technical report referring to their industry standards. Indeed such a
report would in my view be more valuable to users than a supporting
opinion on financial reporting controls under Sarbanes-Oxley.
PREPARED STATEMENT OF ARNOLD C. HANISH
Chief Accounting Officer, Eli Lilly & Company
September 9, 2004
Thank you Chairman Shelby, Ranking Member Sarbanes, and Members of
the Committee for this opportunity to appear before you today.
My name is Arnold Hanish and I am the Chief Accounting Officer for
Eli Lilly & Company. I am here this afternoon as Vice Chairman of
Financial Executives International's (FEI's) Committee on Corporate
Reporting (CCR). FEI is the leading advocate for the views of corporate
financial management, representing financial executives who hold
positions of critical importance in the integrity of financial
reporting, such as chief financial officers, treasurers, and
controllers. We take this responsibility very seriously, and I am
pleased to have the opportunity to share our views with you today on
the important issue of the impact of the Sarbanes-Oxley Act (the Act).
My remarks will largely focus on Section 404 of the Act, which
addresses internal control over financial reporting.\1\
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\1\ FEI was among the first organizations to make constructive
comments to Congress by issuing, in March 2002, ``FEI['s] Observations
and Recommendations [on] Improving Financial Management, Financial
Reporting & Corporate Governance.'' Several of these recommendations
were ultimately incorporated in the Sarbanes-Oxley Act. (Attachment 1).
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Strengthening Corporate Governance, Internal Controls
First, FEI strongly supports the goals of the Sarbanes-Oxley Act,
as it has enhanced the role of corporate financial executives and
created a greater appreciation for that role within the corporate
environment and among the public generally. It has also strengthened
the ability of financial executives to institute continuous
improvements in internal controls and financial reporting, and to gain
enhanced buy-in by all employees of the need for strong internal
controls. Specifically, the Act has resulted in the following positive
developments:
Strengthening the tone at the top by requiring certifications
of financial statements by CEO's and CFO's, and by requiring
management and auditors' reports on internal controls over
financial reporting.
Strengthening the incentives for high quality financial
reporting that can be relied upon by the public, by increasing
penalties for doing otherwise, including, importantly, the Federal
sentencing guidelines for criminal conduct in connection with
fraudulent financial reporting.
Strengthening the requirements for audit committees, which
play such a critical role in corporate governance on behalf of the
investing public. We are particularly pleased to see enhanced
requirements for independence of the members of audit committees,
financial literacy requirements to enable them to better understand
and participate in the corporate governance process, and to engage
committee members more actively in the audit committee meetings. In
addition, the length and frequency of audit committee meetings have
increased as a result of Sarbanes-Oxley, ,which is a positive
result for corporate governance and the investing public.
At my own company, Eli Lilly & Co., we have held education
sessions for members of our audit committee to build their
awareness of important accounting and reporting issues and
their financial accounting expertise. In addition, the number
of audit committee meetings has increased from 4 to 9 per year,
with a corresponding increase in length of the meetings.
Making the internal control process more rigorous, and
heightening accountability.
Limiting transactions such as loans to officers, which is part
and parcel of good corporate governance.
Strengthening the ability of accounting professionals to look
at all levels of reporting deficiencies, multidimensionally; that
is, individually and collectively, and in a particular time period,
as well as cumulatively over time. Further, the Act has raised the
bar on the need to correct deficiencies in a timely manner. As
such, the Act has increased the awareness of all levels of
employees about internal control deficiencies and the need to
correct them before they become significant deficiencies or
material weaknesses.
Before Sarbanes-Oxley, companies had internal control processes in
place, tested them, and corrected deficiencies. Companies have long had
what are referred to as ``management letters'' from their auditors in
which certain internal control weaknesses are noted, in addition to
reports of their internal audit staff. In addition, companies in
regulated industries such as mine, are subject to an additional level
of inspection from their respective regulators, and receive reports
from their regulators on internal control related matters. These
inspection reports are in addition to management reports from their
internal and external auditor. In this regard, the advent of the Act
has not added something entirely new, particularly for highly regulated
industries. But, it has added gravitas to the impact of any reports of
substantive internal control weaknesses and the need to correct them by
raising the bar of public disclosure of material weaknesses. Public
companies must take appropriate action to issue ``clean'' reports, that
is, showing that the system of internal control over financial
reporting is ``effective,'' and without material weaknesses. At the
same time, the criminal penalties provide a strong disincentive for
fraudulent attempts to circumvent these requirements.
As such, we believe the heightened emphasis on internal controls,
corporate governance, and the enhanced role of financial executives in
this process, have all been very positive outcomes of the Sarbanes-
Oxley Act.
However, there are growing concerns by many FEI members about
particular issues that are becoming increasingly evident now that we
have the benefit of real experience in implementing the Act. The
remainder of my statement will address these issues.
Substance Over Form
FEI would like to suggest some important guidelines, based on its
members' experiences in implementing the SEC, PCAOB, and listing
standards resulting from Sarbanes-Oxley.
Testing of Internal Control Must Follow Standard of ``Reasonable
Assurance''
The SEC and PCAOB rules implementing Sarbanes-Oxley allow for
testing and assessments of internal control over financial reporting in
line with the long-held standard of ``reasonable assurance.'' The
concept of ``reasonable assurance'' has been chosen over ``absolute
assurance'' because the cost of obtaining ``absolute assurance'' if
there even is such a thing would be astronomical, and some debate
whether Sarbanes-Oxley as written is so costly as to be causing some
public companies to go private, or deterring private companies from
going public. Thankfully, the Sarbanes-Oxley Act and the resulting
regulations did not seek ``absolute assurance'' regarding internal
controls, but there remains a fine line being walked by preparers and
auditors between ``reasonable assurance'' and ``absolute assurance.''
In addition, while the Sarbanes-Oxley Act was created to try to
prevent the kinds of egregious financial reporting fraud that flashed
across the headlines, it is important to recognize that internal
control and documentation alone will not necessarily eliminate or
remove the risk to financial reporting posed by management override. It
is integrity, above all, that will be the driving force in combating
fraudulent financial reporting. And it is the threat of being paraded
across the television screen in handcuffs, and the dual threat of
increased jail time, that serves as the strongest deterrent to
financial reporting fraud, not the many levels of documentation which
can become an end in itself, rather than a means serving an end, to
support high quality, reliable financial reporting.
Documentation can Supplement, but will not Supplant, Judgment and
Honesty
This is the area in which FEI would like to stress the fundamental
concept that has held the test of time, which is generally referred to
as ``substance over form.'' In the rush to implement Sarbanes-Oxley,
there has developed what seems to be an overemphasis on certain
additional or duplicative levels of documentation, with a declining
value in terms of how much that additional documentation would add to
the effectiveness of internal control.
Let me give you an example where the focus on documentation is so
great, it seems to be overcoming the focus on the substance of the
matter being documented. If a meeting of a company's disclosure
committee is held to discuss a financial reporting matter, in our new
post-Sarbanes-Oxley world, there can be so much focus on testing for
documentation that the meeting was held, that there is insufficient
attention paid to reviewing the substantive nature of what was
discussed. The reason why the meeting was held can be overshadowed by
the need to search for a piece of paper documenting that meeting.
There are, of course, additional burdens on companies with
multinational operations, in extrapolating these controls, testing
and documentation. At my company, we had tried to ``spread the
pain'' by moving it from the top down through divisions and
subsidiaries, to the ultimate process owners. Some would argue that
the processes were fine and the controls were in place, but we now
must go through what some believe are documentation exercises that
are bordering on the excessive and do not serve the intent of
Sarbanes-Oxley. Many gaps identified related again to the signoff
or documentation that an activity took place.
In grappling with implementation of the Act, some are falling
into the trap of overemphasizing form over substance, which
ultimately is a use of time and resources that does not benefit the
reliability of internal control, and does not benefit investors.
Make no mistake about it, documentation for documentation's sake
will not deter financial fraud. In reality, the increased sentencing
guidelines will probably provide the single-most important disincentive
for committing material financial reporting fraud. As we all move to
implement the SEC and PCAOB standards under the Sarbanes-Oxley Act, we
must remember that documentation should supplement, but does not
supplant, management's judgment, integrity, and honesty.
Cost-Benefit of Implementation
Let me address the overall cost-benefit of the Sarbanes-Oxley Act.
The degree of testing and documentation of internal controls forms the
largest part of the cost, and incorporates the need to pay internal
staff, both finance and internal audit, as well as the external
auditor, and other external experts such as software consultants and so
forth, to enhance systems related to testing, documenting, and
reporting on internal controls. The benefit side of the equation, while
it includes the strengthening of the role of the financial reporting
and internal control process and individuals involved in that process,
is still largely an intangible benefit, always more difficult to
measure and quantify, such as ``increased shareholder confidence.'' And
while FEI certainly supports such benefits, we believe that part of
good corporate governance encompasses not only strong internal
controls, but also an eye toward budget, profitability, and as such,
cost-benefit issues.
When the Act and resulting SEC and PCAOB standards were being
drafted, FEI urged regulators to maintain flexibility and judgment that
would promote efficiencies rather than redundancies, and minimize
extraneous, labor-intensive procedures that were time consuming and
expensive. Now that companies have 1 year of implementation behind
them, FEI is hopeful that reasonable approaches will be developed that
will make future year compliance of the Sarbanes-Oxley Section 404 less
costly. However, whether it will be less costly, of course, remains to
be seen, but it is our hope that reasonableness will prevail,
particularly in the roll forward of continuous testing and
documentation in future years after this first year baseline is
established.
Over the past 2 years since the Sarbanes-Oxley Act was passed, FEI
has surveyed its membership as to expected costs for implementing
Section 404 of the Act. I have attached a copy of the January 2004 and
July 2004 survey results to my testimony. \2\
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\2\ See Attachments 2 and 3 for results of the January 2004 and
July 2004 FEI surveys, respectively.
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FEI's Cost Survey on Implementing Section 404
FEI's most recent survey of the cost of implementing Sarbanes-Oxley
Section 404 was conducted in July 2004. FEI surveyed 224 public
companies, with average revenues of $2.5 billion, (the range being
under $100 million to over $5 billion in revenues) to gauge Section 404
compliance cost estimates. Highlights of survey results are as follows:
The total cost of compliance with Sarbanes-Oxley Section 404
is now estimated at $3.14 million for the average company.
This represents a 62 percent increase versus the earlier
estimate, from our January 2004 survey, of $1.92 million for the
average company.
We anticipate these estimated costs for Year One
implementation will continue to rise as we close out this first
year of implementation.
Breaking down the overall 62 percent increase in estimated costs
between the January and July estimates, we saw a 109 percent rise in
estimated internal costs (such as internal audit and other internal
costs), a 42 percent jump in external costs other than the auditor
(such as, costs of external consultants and software packages), and a
40 percent increase in estimated audit fees attributable specifically
to the 404 internal control attestation. In total, companies surveyed
estimate a total incremental increase in audit fees of 53 percent for
the attestation on internal control over financial reporting, versus
their annual audit fee for their financial statement audit. In raw
dollars, this represents an incremental audit fee estimated at $823,200
for the audit of internal control over financial reporting, for the
average company.
Small Company Concerns
While all companies are feeling the impact of the Sarbanes-Oxley
Act on their bottom line, FEI recognizes the concern about the impact
the statute will have on smaller companies. At my company, I am
fortunate to have an extremely competent staff of CPA's with 5-10 years
experience, but many smaller companies do not have a staff of that
level of depth and breadth, these smaller companies do not always have
excess resources to pull from, and potential costs of outsourcing these
services could be particularly burdensome. And while FEI's survey of
224 companies did not indicate a disproportionate impact on smaller
companies, logic tells me that this is an area that should be closely
monitored for a burden that may be too great, and where the costs are
so high, that being a public company may not seem to justify the costs.
Regulators and Cost-Benefit Concerns
As a result of the passage of Sarbanes-Oxley in July 2002, there
has been an extremely high volume of rules, regulations, accounting and
audit standards generated. This ``regulation overload'' required by the
Act, has been created because all the regulations and standards became
effective within a relatively short period of time. It has been a huge
struggle for companies and auditors to digest all these new regulations
and standards let alone implement them. FEI wants to acknowledge the
efforts on the part of the regulators and standard-setters for not only
recognizing this ``regulation overload,'' but also for taking steps to
provide relief.
SEC
FEI would also like to point out and acknowledge the SEC's
recognition of the burden its accelerated filing deadlines for 10-K's
and 10-Q's proposal could have placed on some companies, and the
Commission's willingness to postpone final implementation of the
accelerated filing deadlines to allow companies to devote their
resources to Sarbanes-Oxley Section 404 implementation.
FEI would further like to acknowledge the SEC's efforts to provide
additional implementation guidance on its Sarbanes-Oxley Section 404
related rulemaking by issuing their Frequently Asked Questions or
``FAQ'' document in June which provided additional guidance. This
guidance has proven to be extremely helpful to both preparers and
auditors as they work to comply with Section 404 requirements.
PCAOB
Similarly, FEI would like to acknowledge the efforts of the PCAOB,
in their issuance of implementation guidance relating to their
respective standard on the audit of internal control over financial
reporting, in the form of Staff Questions & Answers or ``Q&A's'' issued
by the PCAOB in June. We applaud these efforts to issue implementation
guidance to clarify standards and thereby reduce implementation
burdens. At the same time, we believe that such guidance should not
preempt the amount of flexibility and principles-based approach that is
necessary for substantive implementation of the rules envisioned under
the Act. That is, regulators should not take an overly rules-based
approach as they contemplate standards.
FASB
The private-sector standard-setter, the FASB, also has a
fundamental requirement to consider the cost-benefit of its rules, and
to seek to issue standards that can reasonably be implemented. FEI's
Committee on Corporate Reporting (CCR), supports the private-sector
standard-setting process, and sent a letter of such support earlier
this year.
We appreciate the role that the private sector can play in the
standard-setting process, and we take an active role in commenting on
proposed standards as well as participating on FASB task forces and
advisory bodies. The main general concern we have recently expressed to
the FASB, is that they need to follow careful and thoughtful due
process in developing standards, and that sufficient time be allowed
for comment on proposed standards, and for implementation of final
standards. This concern has been especially great during Sarbanes-Oxley
implementation, including, but not limited to, Section 404, and the
myriad of SEC and PCAOB rules that have been promulgated as a result of
the Act. We hold periodic discussions with members of the FASB, and
have strongly encouraged them to be reasonable in allowing sufficient
time for its constituents to give thoughtful analysis to proposed
standards, and that they consider major reporting deadlines when they
issue proposed and final standards.
We have also commented about the volume of proposed standards and
recently finalized standards that require more attention from
management and auditors, and are also of keen interest to users of
financial statements. For this year-end in particular, we have strongly
encouraged the FASB to avoid requiring the year-end implementation of
standards issued in the fourth quarter, in order to provide sufficient
time to implement those standards. We have discussed with the FASB that
just because an Exposure Draft of a proposed standard has been out for
a substantial period, does not mean that companies would be prepared to
implement that Exposure Draft quickly, should the FASB decide to issue
a final standard. As is often the case with many FASB standards, the
final standard often differs sufficiently from the Exposure Draft, that
it requires wholesale changes in implementation versus what would have
been required for the Exposure Draft.
We would like to acknowledge the FASB's recent decision to extend
due process on its Revenue Recognition project, due to a significant
change in the project's scope. We asked the FASB to allow for more time
to consider and provide feedback on the direction the project is
headed, and wish to thank the FASB for their recent decision to provide
the opportunity for more thoughtful contemplation and discussion of the
underlying concepts being considered. We believe this delay will allow
companies to focus on Sarbanes-Oxley implementation this year, and will
bring the FASB's deliberations on revenue recognition into a more
parallel mode with the IASB, which plans to issue a preliminary views
document on revenue recognition later this year. (The FASB similarly
recently decided to issue a preliminary views document as a first
step.)
Conclusion: The Need for Internal Control and Innovation
Unquestionably, FEI continues to fully support the spirit and
intent of Sarbanes-Oxley. FEI believes that the statute has
strengthened the role of financial reporting and internal control and,
in doing so, has strengthened confidence in the capital markets.
In closing, let me share a story about the founder of my company,
Colonel Eli Lilly, and what I believe he might have thought of the
Sarbanes-Oxley Act. A veteran of the Civil War, Colonel Eli Lilly was
also a pharmacist, and was highly concerned about a common practice of
his era--that people would purchase purported medicines with no
verification of safety or effectiveness. In response to that state of
affairs, Colonel Lilly chose to start his own small company. His goal
was to produce medicines that passed high standards and protected the
public's health, safety, and interest. He further believed that
medicine should most properly be purchased on the advice of doctors,
not from traveling salesmen.
From this beginning, quality control and its counterpart, internal
control, have always been a part of Lilly's tradition. And it is the
same way for my counterparts in FEI.
But in addition to its emphasis on quality control, Eli Lilly & Co.
is also known for another major tradition: innovation. As with so many
organizations, the pursuit of quality improvement led directly to the
quest for major advances that would be new and better. Our products, as
those of our peer companies in FEI and beyond, help raise the quality
of life and standard of living in the United States and around the
world.
If Colonel Eli Lilly were here today, my guess is he would probably
applaud the Sarbanes-Oxley Act for its emphasis on internal controls in
providing quality assurance in financial reporting. He would recognize
the role of the external auditor in providing third party, independent
attestations on these financial reports. But he would also remind
people of the importance of innovation. We cannot lose sight of the
forest for the trees. We must not let internal control testing and
related documentation take over so much of our time that we lose focus
on the operational and strategic planning on which our companies and
the stakeholders depend.
That concludes my remarks. I would like to thank the Chairman and
the Members of the Committee for allowing FEI the opportunity to
testify.
PREPARED STATEMENT OF JAMES S. TURLEY
Chairman and Chief Executive Officer, Ernst & Young LLP
September 9, 2004
Mr. Chairman, Senator Sarbanes and Members of the Committee, I am
Jim Turley, Chairman and CEO of Ernst & Young, one of the largest
accounting organizations in the world. We have 103,000 people in more
than 140 countries working in our global network of firms. Two years
after the enactment of the landmark Sarbanes-Oxley Act (Act), it is
appropriate to reflect on what we have been through, assess where we
are today, and look ahead to new and remaining challenges. We should
conduct this examination through the perspective of what is good for
the economy and investors in the long-run.
But first, let me tell you that from what I see in the marketplace
everyday, the Sarbanes-Oxley Act is working. In my opinion, the Act has
brought about the most significant change in securities law and our
profession since passage of the Securities Exchange Act of 1934. It has
allowed investors to put a wall between the corporate and accounting
scandals of the past several years and the future. It is
encouraging and enabling our profession to move forward and make
necessary changes and it is restoring investors' confidence in the
financial markets.
The Accounting Profession's World Has Changed
The accounting profession has undergone historic change.
I became Chairman of Ernst & Young in the summer of 2001. Since
that time, our relationships with the companies we audit and their
audit committees have unalterably changed. The profession's regulatory
structure is fundamentally different. After one hundred years, self-
regulation of the accounting profession is over. The Public Company
Accounting Oversight Board (PCAOB) now inspects, investigates,
disciplines, and sets standards for auditors of public companies.
I believe that the formation of the PCAOB will prove over time to
be one of the best things that ever happened to the accounting
profession. A tough, but fair and independent regulator will make our
profession and Ernst & Young better, while helping to restore the
confidence of the investing public. The PCAOB provides a credible voice
to judge how well the accounting profession is living up to our
commitment to quality, and how effective we are in delivering on
investors' expectations. PCAOB Chairman Bill McDonough and other Board
members clearly are not afraid to challenge us. As a result, the entire
profession is improving.
Ernst & Young Has Changed
At Ernst & Young we are committed to cooperating with our new
regulator and to being more transparent so that the investing public
feels more confident about what we do, and so that the regulators
understand our challenges and our commitment to doing quality work. I
know this is true for other firms within the accounting profession as
well.
Just as important, and perhaps not as obvious, are the changes
taking place
inside the accounting firms. At Ernst & Young we have completed a top-
to-bottom review of our business practices. In Fall 2002, I appointed
one of our most senior client serving partners to the position of Vice
Chair-Quality, reporting directly to me. Importantly, this post was
established to be independent of our audit, tax, and transaction
service lines and the charge was to leave no stone unturned. As a
result, every policy, every practice, every performance system, and
every training system has been reexamined and positive changes made.
All our personnel have been challenged to do the right thing.
As Chairman, I have tried to make it very explicit to every one of
our people around the world that our strategy is to have the best
people providing absolutely the best quality to the marketplace.
Setting the tone for our firm's culture and direction is one of the
most important responsibilities I have. When I talk with our personnel
about our strategic approach, it is really quite simple. I try to paint
a mental picture of three pillars--people, quality, and growth. Having
the best people delivering the best quality is the way to achieve the
growth we need to reinvest in our firm and provide opportunities for
our people. As we consider those three pillars, it only works from the
left to the right. It does not work starting at the end and chasing
growth for growth's sake, and then trying to find the people to do the
work in a quality manner.
Quality is the key driver for everything we do. We are very mindful
that maintaining this quality is key to the successful execution of the
public-interest role we play in the capital markets.
Where We Are Today
Today, because of the Act and similar efforts around the globe,
investors have good reason to be increasingly confident in capital
markets and financial reporting. The Act has had a significant impact
on audit committees, corporate management, and auditors, including the
regulation of the profession.
Changed Behavior of Audit Committees
As you know, issuing a set of financial statements involves three
key players and a system of checks and balances. Management works with
the company's internal accountants year round to maintain the company's
financial information and, in doing so, prepare the financial
statements. The audit committee, pursuant to the Act, oversees the
company's financial reporting process and hires the independent
auditors. And, the independent auditors audit the company's financial
statements to test management's assertions as to the accuracy and fair
presentation of the financial statements before they are issued.
As part of this three-way relationship, auditors meet with
management and the audit committee to discuss the financial statements.
Before Sarbanes-Oxley, the conversations would regularly be a dialogue
between management and the auditors, which the audit committee
observed. Today, that triangle has been totally changed and turned on
its head. Conversations are now between the auditor and the audit
committee as they critically examine the judgments and estimates
underlying management's decisions affecting various components of the
financial statements. Management at times is not even in the room.
Audit committees, as surrogates for investors, are in charge today.
They hire and fire auditors and evaluate the audit firms on an annual
basis. Audit committees scrutinize the appropriateness of each service
we deliver before we are retained to deliver it and before we deliver
it. This is the audit committee preapproval process that Sarbanes-Oxley
demanded.
Audit committees are taking the preapproval process very seriously.
While some commentators would choose to further restrict the services
that accounting firms can render to companies we audit, I think audit
committees are appropriately restricting and preapproving services
based on what is in investors' best interests. The proxy data
demonstrate that companies are, in fact, implementing the law. We
should give Sarbanes-Oxley time to work before contemplating any
further change that might reduce the flexibility afforded audit
committees to promote audit quality and investors' interests.
In executing their new oversight responsibilities, audit committees
that used to meet three or four times a year for an hour or so are
today meeting eight, or even ten times a year, sometimes for upwards of
six to eight hours at a time. However, what gives me greatest
confidence in the new enhanced audit committee is the quality of their
focus and not just the quantity of their meetings.
Audit committees are increasingly and properly focused on what I
call the five ``C's.'' They are focused on understanding the complexity
of the businesses they are serving and how that complexity translates
into risk. Overly creative transactions are being exposed and more
closely examined or eliminated. Sarbanes-Oxley's emphasis on the
importance of internal controls is understood and embraced as a tool
for helping to prevent and detect problems within companies. Coziness,
not just between the auditor and management but also between the Board
and CEO is not tolerated. And finally, the audit committees are focused
on drilling into the choices that management is making. Day in and day
out, CEO's and CFO's have to make choices related to accounting
policies, estimates, judgments and everything else, and it is those
choices that dictate whether the financial statements they prepare are
conservative, appropriately so, or not.
It is an amazing change. In the past 18 months, I have attended
many audit committee meetings and I wish that investors, and frankly
anyone who is skeptical about the changes that are occurring, could see
the positive changes taking place inside audit committees and the
profession.
I know of many instances in the last 2 years where a company had to
find a new auditor and the audit committee rejected management's
recommendation and hired a different firm instead. That almost never
happened before passage of the Sarbanes-Oxley Act. Audit committees are
engaged in a very real way and are making decisions based on what is
best for investors. We should give them and the Act time to work.
Changed Behavior of Management
Not to be overlooked in a discussion of the positive changes
brought about by the Act is the strengthened accountability of
corporate officers to investors.
The challenges posed to corporate management by the Act have been
significant. While some have chafed at the new requirements and burdens
of the law, the overwhelming majority of corporate executives are
embracing it. Every day they are working to create value for investors,
generate growth, and steer their companies forward within the
boundaries set by the securities laws.
Nonetheless, it is clear that, in some cases, insufficient
management oversight and inadequate financial controls were at the
heart of the string of U.S. corporate failures that led to passage of
the Act. Something needed to be done.
In this regard, I believe that the CEO and CFO certification
requirement is one of the most important aspects of the Act in terms of
driving management behavior. It requires CEO's and CFO's of public
companies to sign their names to certify the accuracy of financial
statements and the effectiveness of internal controls. This demand on
the top has led to a process underneath that is realigning behavior.
The certification requirement has helped drive change throughout all
ranks of the corporate structure.
Let me give you an example. Not long ago, I was discussing
Sarbanes-Oxley with the CFO of one of the world's largest companies,
one that is based here in the United States. When asked about his
perception of the Sarbanes-Oxley Act his response surprised me.
``Jim,'' he told me, ``in the old days I had to take out my hammer''-
that is the word he used -``and beat down crazy ideas that my own
people were bringing to me on a quarterly basis, ideas for recognizing
revenues before we would really earned them . . . ideas for deferring
expenses that should have been reported. But today, all of our people
around the world recognize that we have to make money the old-fashioned
way, by shipping product and billing and collecting for it.''
What this CFO described is a real change in behavior that has
resulted in an exponential increase in dialogue within company
hierarchies. Today, corporate management is more interested in
transparency and accuracy and less interested in overly creative ideas.
Accountability is cascading through every business unit of every
company. This change is a direct result of the Sarbanes-Oxley Act.
Changed Behavior of Auditors
As I stated earlier, at Ernst & Young, we are reexamining every
policy, every practice, every performance system, and all of our
training routines and challenging ourselves to do better. Our
communications, the tone from the top, and even our business strategy
make it clear that quality is our key objective.
I know that our partners and other executives at our firm are
renewing their commitment to ``the basics'' of the audit function. We
are digging deeper, looking at more evidence to support
representations, and documenting our work more thoroughly. We have
expanded the responsibilities of the independent review partner. We
have added more rigor to our audit process, but by far the most
significant changes are in the mindset and behavior of our
professionals. They understand that performing audits of the highest
quality is their most important day-to-day responsibility.
At Ernst & Young, we also have taken many other steps over the past
2 years to align our organization, policies, and processes to enhance
the quality of our services. Let me provide you with just a few
examples of what we have accomplished.
We have reinforced the tone at the top by refocusing our processes
for evaluating and compensating our audit partners. We adopted a year
in advance the new SEC rule prohibiting the evaluation and compensation
of audit partners based on the sale of nonaudit services to their audit
clients. To drive further improvements in audit quality, we are
rewarding our best auditors, we are rewarding actions that enhance
quality, and we are imposing sanctions where necessary.
We have significantly increased the number of technical resources
who are consulted by our people and who make the firm's final decisions
on accounting, auditing, and reporting matters. In addition, we have
established new networks, such as a senior client service partner
network to mentor and share best practices with our people on client-
related matters.
We have redesigned and significantly increased the amount of
training provided to our audit professionals. Since December 2002, our
people have participated in 460,000 hours of training in the specific
areas of Section 404 and internal controls and audit risk assessment.
During the same period, our people participated in an additional 60,000
hours of training focused solely on fraud and lessons learned.
We have realigned and expanded the resources devoted to our quality
controls over our independence from our audit clients and have
implemented many new policies, procedures, and processes, including new
ones regarding business relationships with audit clients. And we are
taking measures to ensure we have best-in-class procedures to verify
our independence from audit clients.
We established an ethics hotline and Ethics Oversight Board to
provide an environment and culture where our people can speak up, raise
any concerns they may have, and get action.
Our client acceptance and reacceptance processes have been
reengineered with an increased focus on determining which companies we
really want as audit clients and culling out those that we do not
believe have adapted to the new environment and demands on a public
company.
Clearly, much of the change in the behavior of auditors comes from
their own individual sense of professionalism and the changes that are
being made inside firms like ours. However, as I noted earlier, the
significance of the creation of the PCAOB must not be overlooked and
the PCAOB's impact in driving future auditor behavior should not be
underestimated. New requirements in PCAOB standards and the close
scrutiny of PCAOB inspections already demonstrate how its actions will
drive auditor behavior with lasting and controlling effect across the
profession.
As we look at where we are today, there is enormous and, I think,
sustainable change in the behaviors of boards of directors, audit
committees, corporate management, and firms like ours. From an
insider's view, there is real reason for investors to regain faith in
the integrity of financial information and the capital markets.
Remaining Challenges
Finally, I would like to focus on the road ahead. The integrity and
reliability of financial reporting is fundamental to the capital
markets. Even with Sarbanes-Oxley in place, there are some lingering
issues that the accounting profession is focused on addressing.
Some of the remaining challenges relate to what is commonly known
as an ``expectation gap.'' Our profession has struggled for years with
an expectation gap between the amount of fraud detection that the
public has expected and the level of assurance that a properly
conducted audit is designed to reasonably deliver. Additionally, there
is a break between expectations and reality as it relates to the
precision of financial reporting and the exactness that results from an
audit. Both of these expectation gaps, one dealing with fraud and the
other with precision or exactness, must be attacked from both ends,
through education on one hand and more robust audits and financial
reporting on the other.
Fraud Expectation Gap
The accounting profession has spent decades grappling with closing
the expectation gap around fraud detection. From the Cohen Commission
in the 1970's, to the Treadway Commission in the 1980's, and then the
Professional Oversight Board's Panel on Audit Effectiveness in the
1990's, policymakers, academics, and the profession have examined the
issue and sought to educate the public as to the inherent limitations
of an audit that relies in many ways on management representations and
sampling. But simply trying to explain what an audit does and does not
do, on its own, has never been successful and is simply not enough.
More is required. We must do better.
We are committed to working with the PCAOB to address auditing
standards around fraud to do all we reasonably can in light of costs
and benefits to investors. The Sarbanes-Oxley Act has already given
management, auditors, and investors a new tool against fraud with the
strengthened effectiveness of internal controls that will result from
the Section 404 requirements. And as I mentioned earlier, we are
spending many more resources training our professionals on fraud
detection. In conjunction with the PCAOB, we have to be more focused on
deterring and detecting fraud. Yet, the investing public will have to
try to understand the reality that well-conceived criminal acts may go
undetected even if an audit is performed fully consistent with
standards.
Precision of Financial Information
The second expectation gap, related to the precision of financial
reporting, was described as a ``brittle illusion of exactitude'' in a
report by the American Assembly Project, a nonpartisan public policy
think tank affiliated with Columbia University.
The February 2004 report, entitled ``The Future of the Accounting
Profession,'' noted the pervasive disconnect between financial
statements that are, by necessity, based on educated estimates and
judgments, and the expectation that financial reporting is a precise
science in which a ``right number'' can be accurately derived. To
manage expectations, the Assembly report urged auditors, and the
investing public, to recognize that nearly every number on a balance
sheet or income statement is the result of a series of estimates,
assumptions, and accounting choices by managers that are reviewed and
tested only to a degree by auditors.
It concluded, among other things, that the investing public must
accustom itself to a new reality, one which it may find unpalatable:
That the complex economy in which companies do business today makes it
difficult for even the most competent of accountants, internal or
external, to ascribe a precise value to many corporate assets or
transactions. Demanding that degree of precision, the report concluded,
is simply unrealistic. However, the need for appropriate disclosure and
broader acknowledgement of such imprecision should be examined.
Addressing the expectation gaps around fraud and precision is an
important step in restoring the public trust in our integrity and
objectivity. The creation of the PCAOB presents an historic opportunity
for the accounting profession, the PCAOB, other policymakers,
academics, and the public to work together to close the expectation
gaps and make sure that the investing public is best served by our
profession.
Internal Controls Reporting
While I embrace the emphasis on internal controls set forth in
Section 404 as a valuable tool for helping to prevent and detect
problems within companies, I am concerned that most investors, the
general public, analysts, and the media know little about the 404
reporting process and what potential findings may mean. So far, much of
what they have heard is concern about cost of compliance from some in
the issuer community.
With the reports required under Section 404 of the Sarbanes-Oxley
Act first due in early 2005, it is time to move past arguments against
404 requirements and get into educating and informing around the
results. Without such an effort, there is a significant risk that the
public will misinterpret, and overreact to, an assessment that a public
company's internal controls are deficient and warrant improvement.
Without sufficient understanding, some may wrongly equate an internal
control weakness with financial statement inaccuracy.
Let me cite two aspects that will need to be addressed through
communication and education. First, it appears there is the potential
for many more material weaknesses to be reported and adverse opinions
issued than perhaps anyone imagined. This is due to many factors other
than the Act itself. For most companies, this will be the first time
that internal controls have been scrutinized to the degree that 404 and
the resulting SEC rules and PCAOB standards require. Scrutiny will come
from both management and the independent auditor.
Although some leading companies got started before the rules and
standards were even finalized, many companies have been slow to start
the assessment process and may not have time before year-end to remedy
any deficiencies noted during the process.
In addition, the PCAOB auditing standard is rigorous and sets a
high bar for companies to achieve a passing grade. How will the public
react to a potential proliferation of material weaknesses and adverse
opinions? How will the capital markets react? Is it enough to say the
numbers of such findings will decrease over time as weaknesses are
identified and subsequently remedied? There should be an informed
reaction and response when internal control problems are surfaced, but
not an uninformed overreaction that undermines investor confidence in
reported financial information. This is a concern that can be managed
but warrants a focused and shared effort.
Second, there is the potential for a new expectation gap, a gap
between the comfort that some might derive from a company and its
independent auditors reporting a passing grade on internal controls and
their later dissatisfaction when the company does not meet its
financial goals, makes significant changes to its critical accounting
estimates, or based on subsequently discovered information is required
to restate previously issued financial information. The profession will
conduct thorough audits of internal controls over financial reporting,
but as set forth in the standards the scope of these audits will be
based on the concept of providing reasonable, not absolute, assurance.
Let me be clear. The benefits to investors from the implementation
of Section 404 are significant in terms of improvements in the
reliability of periodic financial reports, including quarterly reports
and not just annual reports subject to a financial statement audit. But
along the journey of achieving these improvements in financial
reporting, we cannot allow each incidence of subsequently discovered
information to shake investor confidence in financial reporting through
an uninformed overreaction.
We, the profession, policymakers, issuers, directors and investor
leaders, need to collectively engage in a public dialogue to educate
others regarding the new internal control reporting process and how to
interpret potential findings and responses. In conjunction with the
other major firms, we are beginning that effort and look forward to
working with others in this effort.
Continued Implementation of the Act
It also is clear some people outside of our profession are
concerned with the rigorous requirements of the Act, the strength and
scope of the processes imposed, and the increased work auditors are
required to perform. Some of this relates to the new internal control
reporting requirements. Many of you have told me about the complaints
you have heard. I have heard many of the same concerns. It is important
to find the point where good corporate governance and economic
performance and protection complement rather than conflict with each
other. I think that is important to keep in mind as the Act is being
implemented.
However, as implementation continues on many fronts, I would
encourage refraining from change to the direction set forth in the Act
itself. Instead, give boards, audit committees, management, auditors,
and others time to fully implement existing requirements.
Let me directly address this issue of implementation as it relates
to our work as auditors. Yes, we are being tough. The law requires it,
the PCAOB is inspecting our work every step of the way, and investors
expect nothing less from us. And as we adapt to address heightened
auditing standards, fraud detection expectations, internal control
reporting demands, and other new requirements, the amount of work we do
will surely increase and, as a result, costs will surely rise. Such new
requirements are part of our professional obligations for which we are
increasingly held
accountable if we fail to uphold them. In this process, Congressional
leaders and regulators have stood behind the law's requirements and the
accounting profession's efforts to carry them out faithfully, and for
that we are appreciative.
Sustainability of the Accounting Profession
Finally, I would like to address two issues on the horizon that
will affect the long-term sustainability of the private sector audit
function.
Unless our profession can continue to attract and retain the best
people, and deal with the economic risks our people face as partners,
the public accounting firms as we know them today could be in jeopardy.
While we have experienced a recent surge in entrants to the
accounting profession, the long-term trends have been headed down. We
face real challenges in sustaining the pipeline of quality people into
the accounting profession. We need to attract highly competent people
to the profession who are not only good with numbers, but who are also
able to communicate with audit committees and management. They need to
understand our values and that what they do is incredibly important to
the free-market system.
In addition to new entrants to the accounting profession, it is
just as important that we retain the extraordinary talent that we
already have. The Sarbanes-Oxley Act's requirements and pressures put a
great strain on our ability to retain sufficient personnel of the
caliber we need at various experience levels to meet the demands we
face. The demands of not only auditing financial statements but now
also auditing internal controls have strained resources across the
profession. These resource constraints cannot be allowed to put the
quality of any of our work in jeopardy. In addition to the impact of
tougher client acceptance and retention practices, all the larger firms
are resigning from significant amounts of work in order to make
available resources to do the necessary audit work in a quality manner.
Even with that, the demands on our people are intense. The second risk
to our sustainability is the ever-increasing cost we bear to simply
stay in business. Practice protection costs weigh heavily on our firm
and the profession. Insurance premiums have soared, both absolutely and
relatively as a percentage of our revenues. For our U.S. firm, practice
protection has become one of our largest costs, second only to our
personnel costs.
In our very litigious environment where class-action lawsuits are
filed at the drop of a hat and the cost to defend against them is so
high, public accounting firms face significant financial risk. While we
try to minimize these costs by performing in a manner that strictly
adheres to professional standards and regulatory requirements,
unfortunately good auditing is all too often not a sufficient defense.
Conclusion
All of us--accounting firms, Congress, the SEC, the PCAOB, and
other capital market participants--must do a better job educating the
public on the reforms that have been put in place.
Recent research among investors commissioned by the four major
accounting firms shows that the investors who are most aware of the
reforms that have been put in place by the Sarbanes-Oxley Act have far
greater confidence that what needed to be done is being done.
This research points to the need for broader education of the
investing public on their new protections under the law. We should all
be more proactive in highlighting the whistleblower provisions, the CEO
certifications, the nonaudit service restrictions, and the fact that
you created a new regulator for the profession. We should be talking
more about the internal control requirements to curb fraud and how
Congress made it a crime to lie to the auditor and people can go to
jail because of it.
Investors need to come to appreciate how audit committees with
strengthened oversight are clearly acting as surrogates for investors'
interests. There is a lot in the law and I touched on a few things.
This is something all of us should give voice to every chance we get
until investors better understand what has been done.
Finally, I would like to address the recently released PCAOB
inspection reports. The inspections underscore the PCAOB's commitment,
on behalf of the investing public, to review our auditing policies and
processes; and our cooperative participation underscores our commitment
to be transparent with our regulator.
While nobody likes to be inspected by their regulator, I truly
believe that Ernst & Young and the entire profession will be better for
it. Without question, in this process we will come to understand that
there are things that some of the other firms might be doing better
than us and the other firms will learn of things that we at Ernst &
Young do better than them. I embrace the process because I think the
whole profession, and investors' confidence in us, will improve
markedly.
In closing, I would like to thank this Committee, the Congress, the
President, the Securities and Exchange Commission, and the Public
Company Accounting Oversight Board for your work in creating and
furthering the implementation of the Sarbanes-Oxley Act of 2002.
----------
PREPARED STATEMENT OF GREG BENTLEY
CEO, Bentley Systems, Inc.
September 9, 2004
Good afternoon, Mr. Chairman and Members of the Committee. My name
is Greg Bentley and I serve as the Chairman, President, and CEO of
Bentley Systems, Inc., which is headquartered in Exton, Pennsylvania,
near Philadelphia. I note the presence of Senator Santorum on this
Committee and offer our sincere thanks for his service to the citizens
of the Commonwealth and our Nation.
As a member of the American Business Conference, founded by Arthur
Levitt almost 25 years ago, I am honored to represent a growing
majority of our economy--privately held companies, and businesses
smaller that you hear from most--regarding the Sarbanes-Oxley Act.
Significantly, Bentley Systems remains a private company today, despite
having filed our preliminary registration statement for an initial
public offering in April 2002. We stayed the course in registration
despite the seven-figure cost of hiring a second firm to reaudit our
financials, replacing Arthur Andersen, our longtime auditors. In
retrospect, the delay turned out to be fortuitous, as it coincided with
the promulgation of Sarbanes-Oxley, whereupon we withdrew our offering.
I believe our experiences in this regard are relevant to your
assessment of policy formulations to stimulate continued
entrepreneurship, growth in the private sector, and a robust national
economy. To us, this is so critical that in return, I will divulge what
I have referred to as the ``secret sauce'' behind our business success
to date. Last week, I heard a compelling articulation of an ``ownership
society,'' within which I want to advocate the importance and
preservation of our company's ``ownership culture.''
Our 1,600 colleagues at Bentley Systems last weekend observed the
company's 20th birthday. During this lifetime we have grown from
(literally) a ``band of brothers'' to about $300 million of annual
revenues, profitably and primarily self-financed. We rank among the
larger firms within the global applications software industry, and
among the very largest of those that have remained private companies.
Our software supports the architecture, engineering, construction, and
operations of the world's physical infrastructure. Our products are
used, by way of example, to design the majority of roadways,
manufacturing plants, and water/utility networks in most major
countries in the world.
In growing tenfold over the past decade, we have created over 700
jobs in the United States, with average annual compensation here of
over $90,000; and our exports contribute over $150 million per year to
the U.S. trade balance.
While I and my four brothers (all of them engineers) who founded
and control the company work hard and plan to continue doing so, we
have always recognized that our growth and success is entirely to the
credit of our colleagues, who comprise all the key assets for producing
and vending our software. By 2002, the number of colleagues to whom we
had granted stock options was approaching the limit of 500 (made famous
recently by Google), above which, under current law, formal
disclosures, and consequently now Sarbanes-Oxley adherence, are
required. The motivation for our IPO filing was thus less to achieve
public ownership per se, but rather to make available deserved
liquidity for these option holders, to appropriately reward their
ongoing efforts and results.
At this same time, it happens that I chaired the audit committee of
a large public (S&P 500) IT services firm. As a consequence, my
personal experience with the various emerging costs and burdens of
Sarbanes-Oxley compliance led us to conclude that such costs and
distractions would not be prudent for Bentley Systems at the time.
In summary--because I realize you have other witnesses to present
the perspective of existing public companies--those costs and burdens
are substantial, and are still increasing, and their ultimate extent is
still uncertain, depending on how new audit standards end up getting
put into practice. Most of us are prepared to accept that in the
aggregate these costs are probably justifiable, to preserve confidence
for public investors.
And frankly, many aspects of Sarbanes-Oxley represent sufficiently
worthwhile notions (such as executive attestations, whistle-blower
hotlines, and some degree of explicit and audited internal controls
documentation) that, though we expect to remain private for the
foreseeable future, we have begun a deliberate (hence, relatively
frugal) implementation process at Bentley Systems.
But beyond the new compliance costs, what settled Bentley's IPO
withdrawal was the mismatch between new corporate governance
requirements, and our own ownership culture. In particular, the Act
obliged exchanges to promptly propose new
listing standards, the drafts of which dictated, for the first time, a
majority of independent directors, which we have never contemplated.
It remains especially implausible to me, candidly, that our
founders would relinquish control to such potential new independent
directors as would be willing to expose themselves to the ``perfect
storm'' of liability risks unleashed by Sarbanes-Oxley, especially for
new public companies.
To start with, I am afraid that an appropriately long-term
management horizon to best serve long-term shareholders is inherently
incompatible with infallible short-term earnings visibility. But even
if consistent and predictable fundamental performance could be a given,
I believe that current U.S. GAAP accounting standards make financial
restatements more likely than not. This is because these Byzantine
rules and picayune bureaucratic interpretations change frequently--and
often with retroactive effect--superseding what should be constant and
overriding principles for measuring financial performance with
consistency.
From my lay standpoint, to the extent that convergence with
international accounting standards would reinstate principles-based
accounting rather than ``rules-based'' accounting, every CEO should
favor such a change.
In the meantime, occasional downside earnings surprises are
inevitable, with impact on stock prices. I believe that rational equity
investors can and must (as they once did) take this in stride.
Unfortunately, Sarbanes-Oxley has increased the very real apprehension
that hair-trigger plaintiffs' lawyers will misuse the Act's standards
to exploit these ``gotcha's'' as windfall opportunities, sapping (and,
deterring) competent and well-meaning management and boards, with their
deadweight of expensive distraction.
From a public policy standpoint, in fact, I believe that relatively
simple litigation reform could more immediately and effectively redress
the excessive risk aversion that Sarbanes-Oxley has engendered, than
complicated rework of its complexities.
Otherwise, growing and prospering companies like Bentley Systems
will assuredly remain private indefinitely. Not only will IPO's (other
than perhaps spin-outs) be less prevalent, but also will acquisitions
of private companies by public companies, who would effectively incur
unaddressed Sarbanes-Oxley liabilities.
Are there national interests that may be at risk when a larger
segment of our economy consists of larger private companies? One could
be concerned that investors in public equities will have fewer choices
among smaller growth companies where more investment capital, on the
margin, could provide higher overall returns. On the other hand, there
is presently an abundance of equity funds seeking private-company
investments. Presumably such investors prefer the long-term orientation
of private managements, to the enforced relative fixation of public
companies on short-term earnings.
It is also clear to me that this providential abundance of long-
term equity capital has been fostered by the recent structural tax
reforms. Rolling these back to any degree will reduce growth funding
for our privately-led economy, while making them permanent will even
more substantially increase the ability of firms like Bentley Systems
to invest in faster growth of our exports and employment.
But financial capital, while essential, is far from sufficient for
the United States to maintain and extend its world leadership in
technology--such as the software which is key to growth in all of our
industries, including those we serve at Bentley. In fact, financing
would be useless without the key ingredient in our Bentley recipe--the
ownership culture by which we attract, incent, and reward the
colleagues whose intellectual property creation we are all dependent
upon.
Post-Sarbanes-Oxley, our recipe's potency has been somewhat watered
down, in a respect which I am afraid is representative of American
companies at large. But the good news is that I also think there can be
some simple public-policy changes, within the purview of your
Committee, which could in fact serve even to improve upon the original
recipe.
My first modest proposal would be to exclude equity grants to
employees from the applicable count of ``securities holders,'' so that
larger private companies could extend their ownership culture to more
than 500 colleagues without becoming subject to public-company
regulatory burdens, since such grants are not the result of any
securities purchase decisions.
I would also suggest a policy direction to update the form of
ownership culture, which gets beyond the tedious controversy over
option expensing. As a major shareholder myself, I am well aware of the
costs of option grants, no matter where they are measured in financial
statements.
But, of course, I am equally aware of their benefits, in our
American success recipe. I support the pending legislation which would
delay and circumscribe option expensing, but only because otherwise
most companies are significantly reducing the breadth and scope of
their option programs, without substitute ingredients to sustain their
ownership cultures.
In fact, of greater concern to me, than their expensing, is that
the negative attention to stock options has unfortunately associated
with them the stigma of greed and corruption. On the other hand, this
could open the door to fresh thinking.
Granting outright (or correspondingly restricted) shares instead of
options would even more completely align employee incentives (to the
downside as well as upside) with that of the stockholders at large.
While under option expensing there would not be a relative accounting
bias against this, unfortunately the employee would be subject to
income tax upon vesting, without a source of liquidity other than
prematurely selling the shares (if there is a public market), now that
Sarbanes-Oxley precludes loans from the employer.
An evident solution would be to grant the stock into the employee's
qualified
retirement account, where its value could presumably accumulate
indefinitely, tax-advantaged. The company could then even elect to pay
a dividend on such shares, likewise tax-deferred. That would further
leverage the secret sauce of ownership culture to focus companies on
long-term cashflow generation, while at the same time focusing
employees on long-term, stable career development, and retirement
funds. It happens that company contributions, in stock, to our U.S.
colleagues' profit-sharing accounts are already made annually at
Bentley Systems. These contributions are over and above the company's
cash 401(k) matches of colleagues' own cash contributions, so that this
incentive is always incremental to baseline retirement financing,
rather than a substitute. Also, many other companies take advantage of
ESOP plans, authorized by Congress in acknowledgement that our national
economic interests are served by encouraging broad employee ownership.
The problem with either means, as a candidate to replace broad
employee stock options programs post-Sarbanes-Oxley, is that all such
ERISA-permitted equity contributions must in effect be
``nondiscriminatory''--that is, in essentially the same proportions of
cash compensation to all employees. However, in the United States (and
at Bentley Systems) we have always recognized that our colleagues'
efforts and results are NOT correspondingly distributed equally. The
ownership culture cannot generate its intended incentive leverage, when
it is made into an entitlement.
So, I would ask that you consider creating an exception under ERISA
for discretionary outright grants of stock to employees, for the
purposes traditionally served by option grants. While many of the Enron
abuses have been appropriately curtailed through Sarbanes-Oxley and
related policy developments, our company, colleagues, and country can
least afford to curtail the potent economic force of long-term equity
incentives. This ownership culture secret sauce should be restored and
reinforced as a key ingredient in our corporate and national economic
strategies.
Thank you very much for this opportunity, and I look forward to
questions.
PREPARES STATEMENT OF LEONARD MOODISPAW
President and CEO, Essex Corporation
September 9, 2004
I am the CEO of Essex Corporation, a publicly traded corporation
located in Columbia, MD as well as a number of locations throughout the
United States. We provide solutions to difficult communications and
signal processing problems using our unique optical and signal
processing expertise. Essex has grown from 45 employees and $4.5
million in revenue 2 years ago to 240 employees and estimated revenues
of over $60 million in 2004. Most of that revenue comes from customers
in the Department of Defense and Intelligence communities.
We are listed on Nasdaq as KEYW and have a market cap of
approximately $140 million. Because Essex is a small cap company, we
are not required to comply with many of the provisions of Sarbanes-
Oxley (SOX) until 2005. Yet, we are mindful of the provisions and are
preparing for full implementation.
In a recent commentary in The Wall Street Journal, the President
and CEO of Nasdaq, Bob Greifeld, discussed the positive benefits of
Sarbanes-Oxley. I support his views because I believe the implementing
regulations are forcing companies to assess themselves and expunge
embedded inefficiency that is detrimental to their bottom line and
company culture.
Because Essex is primarily a Government contractor, we are subject
to audits from various Government agencies. That scrutiny is in many
ways as rigorous as those of SOX requirements and the results of
noncompliance are as severe.
For example, the Defense Contract Audit Agency evaluates our
systems and controls as part of their periodic audits. They evaluate
our timekeeping systems, billing processes, and bidding estimation
systems. They annually audit our actual costs against our expected
costs and ensure that those costs are recorded in accordance with the
cost accounting standards and/or generally accepted accounting
standards. In addition, the Defense Logistics Agency reviews purchasing
and inventory control procedures. Inadequate systems and controls can
lead to denial of contracts and disbarment from performing work for the
U.S. Government. If fraud or abuse is suspected, the Defense Criminal
Investigative Service will investigate and criminal sanctions may be
imposed if violations are proven.
Thus, I expect Essex and other companies who work in the Government
arena are better prepared for SOX, mitigating new costs associated with
compliance.
Clearly there are costs associated with complying with SOX and they
will vary with such factors, among others, as the size of the company,
centralization of functions, and geographic dispersion of subordinate
units. However, there is a return on the investment and the costs
should peak during preparation for compliance.
The Y2K (year 2000) experience may also be relevant in evaluating
the cost benefit of SOX. Companies spent significant amounts to analyze
the status of computers and related processes and procedures. As a
result, many nagging documentation issues, needing correction for
systems to operate more efficiently regardless of the date issue, were
identified and corrected.
In a recent study of corporate data integrity, the Seattle-based
Data Warehousing Institute found that nearly half the companies
surveyed had suffered ``losses, problems, or costs'' due to poor data.
The estimated cost of these mistakes was more than $600 billion.
I believe that the net effect of the effort to assure compliance
with SOX will help focus companies on the elimination of erroneous data
embedded in corporate systems by strengthening internal controls to
ensure that such data are accurate and that laws are followed in
carrying out operations.
As to return on investment; there are positive benefits to be
gained, in addition to the well known goal of restoring investor
confidence in public companies after the notorious Enron, WorldCom, and
other debacles.
Strengthening the role of audit committees and involving it is
members more in risk assessment can only help management.
Emphasis on the independence of directors not only adds to
``checks and balances,'' but it also brings new talent to augment
the leadership of companies.
The value of target companies which are SOX compliant will be
greater when considered for merger or acquisition.
Financial institutions will be more likely to lend money to
and invest in companies which are SOX compliant.
Insurance coverage for Errors and Omissions policies for
officers and directors should be less costly for SOX compliant
companies.
Candidates for boards of director posts should insist on SOX
compliance before they serve on boards; thus, such companies are
more likely to attract knowledgeable members.
Executives are likely to demand SOX compliance as a condition
of their employment.
However, these benefits pale by comparison to the expected increase
in efficiency and effectiveness from scrutinizing financial and
information technology processes. Recently, Essex acquired two
companies. In the process of due diligence and integrating operations,
we learned a lot about Essex as well as the two acquired companies as
we shined the light of SOX on them. What are the ``right checks and
balances?'' Who has the authority to make decisions at what level of
expenditure? Who reports to whom in the organization? Are data
protected? Do employees understand their ethical obligations? What
training is necessary to obtain a compliance structure throughout the
company?
These are just a few of the questions which need to be asked--
without being imposed by regulations.
SOX may be relatively more costly for smaller companies who have
such few people involved in some functions that it is difficult to
separate them for internal control purposes. However, the benefits of
having strong internal controls outweighs the costs.
There is a fear that companies will ``go private'' rather than
subject themselves to SOX. I think this is unlikely because the SEC
will properly question the motives of management and investors will
wonder what the company wants to hide. Also, the cost of such an action
can outweigh the cost of SOX compliance.
Another concern is that foreign companies will be reluctant to do
business in the United States; I am working with a public company from
England which is establishing a presence in the United States without
fear of compliance.
SOX cannot be fully examined without commenting on the penalties
for failure to comply. When articles on the subject routinely assert
that CEO's ``can mitigate their jail time'' by certain steps, it gets
one's attention! Also, some fear that audit firms must be tough on
clients to demonstrate their independence. The negative impact on the
price of a stock after such a finding may be significant; hopefully
short-term as the company achieves compliance.
A few years from now, after the costs of compliance have peaked and
the benefits are recognized, we will look back at this period as we do
the Y2K era; the anticipation was worse than the event.
RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY
FROM ANDREW SHENG
Q.1. Mr. Sheng, my staff recently met with banking and
securities officials with the People's Republic of China.
During those discussions it became evident that there are
differences in the way accounting standards are viewed by the
People's Republic of China and Hong Kong. As an emerging
economy, the People's Republic of China believes that it needs
to take a different approach to adopting international
standards. Could you please explain to me how each approach the
establishment of accounting standards?
A.1. Hong Kong's approach toward the adoption of international
accounting standards.
Hong Kong Institute of Certified Public Accountants
(HKlCPA) is the standard-setter for Hong Kong accounting
standards. Its power to set accounting standards comes from the
Professional Accountants Ordinance (Chapter 50) of Hong Kong.
HKlCPA has adopted a policy of convergence with the
International Financial Reporting Standards (IFRS) issued by
the International Accounting Standards Board. Because of the
structure of the legislation in Hong Kong, the HKICPA issues
its own standards rather than adopting IFRS directly. Under the
convergence policy of HKlCPA, Hong Kong reporting standards
will be word for word identical to the IFRS except for minor
additional disclosure requirements.
International Accounting Standards Board has issued a
package of IFRS's for the adoption by EU countries for
accounting periods starting on 1 January 2005. Hong Kong
standards, identical to these IFRS's, will also be effective
for accounting periods starting from 1 January 2005. Hong Kong
standards effective from 1 January 2005 include standards on
financial instruments identical to IAS 39.
China's approach toward the adoption of international
accounting standards.
The following answer was obtained from the China Securities
Regulatory Commission (CSRC).
The Chinese Government, especially the Ministry of Finance
(MOF) and the China Securities Regulatory Commission (CSRC),
has been taking continuous and considerable efforts to
facilitate the internationalization of the mainland accounting
standards. MOF has issued 17 accounting standards for business
enterprises, most of which are based on the IAS. The CSRC has
also issued series of financial information disclosure
standards specifically for the listed companies, and most of
these requirements have absorbed the international practices
from other developed capital market. Therefore, the mainland
accounting standards have been substantially improved to meet
the international accounting standards.
At the specific requirements level, there are a few
differences between these two accounting standards. Currently
most of these differences reflect China unique features as a
transitional economy. Along with further reform and opening up,
we will take substantial actions to facilitate the
internationalization of the mainland accounting standards, as
what we have been doing before. The difference should be
further minimized in the near future.