[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


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


                                 ______

                    U.S. GOVERNMENT PRINTING OFFICE
22-425                      WASHINGTON : 2005
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092250 Mail: Stop SSOP, Washington, DC 20402ï¿½090001


            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

                              ----------                              

                       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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    \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.

                              ------------
                  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\
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \2\ See Attachments 2 and 3 for results of the January 2004 and 
July 2004 FEI surveys, respectively.
---------------------------------------------------------------------------
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.
