[Senate Hearing 112-76]
[From the U.S. Government Publishing Office]



                                                         S. Hrg. 112-76


 THE ROLE OF THE ACCOUNTING PROFESSION IN PREVENTING ANOTHER FINANCIAL 
                                 CRISIS

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

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

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

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

 EXAMINING THE ROLE OF THE ACCOUNTING PROFESSION IN PREVENTING ANOTHER 
                            FINANCIAL CRISIS

                               __________

                             APRIL 6, 2011

                               __________

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










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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     William Fields, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

CHARLES E. SCHUMER, New York         PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey          MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
HERB KOHL, Wisconsin                 JIM DeMINT, South Carolina
MARK R. WARNER, Virginia             DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota

                Kara Stein, Subcommittee Staff Director

         Gregg Richard, Republican Subcommittee Staff Director

                 Robert Peak, SEC Congressional Fellow

                                  (ii)
















                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, APRIL 6, 2011

                                                                   Page

Opening statement of Chairman Reed...............................     1

                               WITNESSES

James R. Doty, Chairman, Public Company Accounting Oversight 
  Board..........................................................     3
    Prepared statement...........................................    35
    Responses to written questions of:
        Chairman Reed............................................   104
        Senator Crapo............................................   109
Leslie F. Seidman, Chairman, Financial Accounting Standards Board     4
    Prepared statement...........................................    44
    Responses to written questions of:
        Chairman Johnson.........................................   111
        Chairman Reed............................................   113
James L. Kroeker, Chief Accountant, Securities and Exchange 
  Commission.....................................................     6
    Prepared statement...........................................    51
    Responses to written questions of:
        Chairman Johnson.........................................   241
        Chairman Reed............................................   242
        Senator Crapo............................................   249
Anton R. Valukas, Chairman, Jenner & Block LLP...................    21
    Prepared statement...........................................    55
    Responses to written questions of:
        Chairman Reed............................................   250
 Cynthia M. Fornelli, Executive Director, Center for Audit 
  Quality........................................................    23
    Prepared statement...........................................    60
    Responses to written questions of:
        Chairman Reed............................................   251
Thomas Quaadman, Vice President, Center for Capital Markets 
  Competitiveness, U.S. Chamber of Commerce......................    24
    Prepared statement...........................................    67
    Responses to written questions of:
        Chairman Reed............................................   255
Lynn E. Turner, Former Chief Accountant, Securities and Exchange 
  Commission.....................................................    26
    Prepared statement...........................................    71
    Responses to written questions of:
        Chairman Reed............................................   255

                                 (iii)

 
 THE ROLE OF THE ACCOUNTING PROFESSION IN PREVENTING ANOTHER FINANCIAL 
                                 CRISIS

                              ----------                              


                        WEDNESDAY, APRIL 6, 2011

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 9:34 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Jack Reed, Chairman of the 
Subcommittee, presiding.

            OPENING STATEMENT OF CHAIRMAN JACK REED

    Chairman Reed. Let me call the hearing to order.
    First, my colleague and Ranking Member, Senator Crapo, very 
much wanted to be here. He is not 100 percent today physically, 
so just some minor sort of setback. But, unfortunately, he is 
not likely to join us. Other colleagues will arrive, but given 
the time of our witnesses and the importance of the topic, I 
think it is appropriate to begin.
    Let me make an opening statement and then recognize my 
colleagues when they arrive, if we have not recognized 
witnesses for their statements. And I want to thank, obviously, 
the witnesses, both panels, for attending.
    In the wake of the financial crisis of 2008, many have 
decried too big to fail, but there may be a more immediate 
problem: too big or too complicated or too powerful to be 
audited. And without effective auditing, directors, creditors, 
and shareholders are all flying blind, and failure could be 
just ahead and unavoidable.
    Prior to the collapse or rescue of nine major financial 
institutions in 2007 and 2008, they each received unqualified 
audit reports within months of their demise from various major 
accounting firms. So this hearing is not about one company or 
one auditor. This is about systemic weaknesses in the audit 
process that may continue to impair investor confidence and 
provide inadequate information to the investing public and to 
directors of public companies and to the markets in general.
    The costs of these problems are staggering. The Financial 
Crisis Inquiry Commission estimated that nearly $11 trillion in 
household wealth was lost through retirement accounts and life 
savings being diminished in the crisis. Auditors who have the 
responsibility for examining and reporting on the companies' 
books and records in the cases I have cited sounded no 
distinctive and helpful alarms prior to the demise of these 
companies.
    As such, serious questions have been raised about the 
quality of financial reporting practices and about the quality 
of audits that should have revealed key financial 
irregularities or the poor status of these companies. Auditors 
have a special responsibility--not a unique or sole 
responsibility but a special responsibility--a public trust, as 
defined by the Supreme Court, to protect participants by 
certifying that information companies prepare and publish is 
accurate and transparent.
    Without question, there seems to be a systemic lack of this 
transparency in the last several years. Investors never knew 
the risks and uncertainties embedded in certain of the 
securities they purchased. Huge financial firms used accounting 
gimmickry and financial engineering to obscure their financial 
health. And this leads us to important considerations.
    Did the accounting profession contribute to the lack of 
transparency either in promulgating rules that allowed for 
financial engineering and a lack of transparency? Or were 
appropriate rules ignored by the companies? Why were there no 
alarms sounded in a meaningful and timely way to perhaps avoid 
or mitigate some of the consequences of these failures?
    Regulators from around the world have undertaken inquiries 
regarding the sufficiency of audit firms and accounting 
methodologies. The European Commission has undertaken a number 
of inquiries. The British Parliament recently released a report 
on their examination recommending a number of detailed actions 
in addition to a call for further review. That report included 
findings that questioned both the audit profession and whether 
international financial reporting standards were sufficiently 
robust.
    The purpose of this hearing is to examine the role of 
accounting professionals in preventing another financial 
crisis. The financial crisis that we endured may have been 
avoidable, and there were key missteps by many participants, 
including regulators and supervisors. And while I am interested 
in learning about the failings during the financial crisis, I 
want to emphasize again this is more about what we have to do 
now to protect ourselves in the future, to return our financial 
reporting in the United States to the world standard it once 
was and must be.
    The accounting profession is one of the bedrocks of our 
financial marketplace. A robust and transparent financial 
reporting system is the key to establishing credibility and 
confidence in our markets, which in the end protects investors 
and lowers the cost of capital. And I look forward, again, to 
the testimony of the witnesses that are here today.
    Let me now recognize and introduce the first panel.
    James Doty is Chairman of the Public Company Accounting 
Oversight Board. Mr. Doty was appointed by the Securities and 
Exchange Commission as the Chairman of the Public Company 
Accounting Oversight Board in January 2011. Prior to his 
appointment, he served as a partner at the law firm of Baker 
Botts. Welcome, sir.
    Leslie Seidman is Chairman of the Financial Accounting 
Standards Board, FASB. She was appointed to this position by 
the Financial Accounting Foundation effective December 23, 
2010. She was originally appointed to the FASB in July 2003 and 
reappointed to a second term in July of 2006.
    James Kroeker is the Chief Accountant of the Securities and 
Exchange Commission. He first joined the Commission as Deputy 
Chief Accountant in February 2007. Prior to joining the SEC, 
Mr. Kroeker was a partner at Deloitte & Touche LLP, and he has 
already assured me that he is an essential person at the SEC.
    Mr. Doty.

STATEMENT OF JAMES R. DOTY, CHAIRMAN, PUBLIC COMPANY ACCOUNTING 
                        OVERSIGHT BOARD

    Mr. Doty. Thank you, Chairman Reed. I appreciate, and on 
behalf of the Public Company Accounting Oversight Board we 
appreciate, the opportunity that you and Ranking Member Crapo 
and Members of your Subcommittee have extended to us to appear 
here.
    I joined the Board, as you mentioned, on February 1, 2011. 
Many of the achievements and the initiatives I describe in our 
written testimony or refer to here today were the work of, or 
begun by, my predecessors on the Board as well as the PCAOB 
staff, and that work sometimes extended over several years.
    The PCAOB is committed to applying lessons from the 
financial crisis through inspections, standard setting, and 
enforcement. We garnered those lessons from our inspections of 
audits conducted during the financial crisis and from dialog 
with investors and other users and preparers of audit reports.
    Last fall, the PCAOB issued a report describing the kinds 
of audit deficiencies our inspectors identified in audits 
affected by the financial crisis. As described in that public 
report, the inspectors identified multiple instances where 
auditors failed to perform the work mandated by PCAOB 
standards.
    In short, accounting firms must do a better job in 
adjusting to emerging audit risks as economic conditions 
change. They must adjust so that investors will have reliable 
information about the performance and financial position of 
public companies during periods of economic volatility.
    Many investors were left wondering whether auditors could 
have done more during the recent crisis to highlight risks in 
our financial system, which raises questions about the 
reporting model. The Board has undertaken a comprehensive 
project to look at the very nature of the auditors' reporting 
model, which has not significantly changed in more than 60 
years.
    In addition, in 2011, the PCAOB will continue to focus on 
high-risk audit areas posed by the ongoing effects of the 
crisis. These areas may include, for example, the financial 
statement effect of an obligation to repurchase mortgages 
previously sold or mandated modifications to certain mortgages 
at financial institutions.
    PCAOB inspectors will also look closely at corrective 
actions taken by accounting firms in areas where inspectors 
identify problems. A firm's failure to obtain sufficient 
evidence to support its opinion does not mean that the 
financial statements themselves are necessarily misstated. But 
it does mean that corrective actions are required, both to 
shore up the deficient audit as well as to better plan and 
perform future audits. Inspections can only protect investors 
from audit failures if firms act on inspection results.
    Neither the financial statements, audits, nor the PCAOB 
oversight are intended to assess a company's liquidity 
structure, capital adequacy, or risk management. Nor does the 
PCAOB set accounting and disclosure requirements.
    Rather, the PCAOB evaluates whether auditors have done 
their job, which is to make sure an institution's financial 
statements and related disclosures fairly present the results--
good or bad--in conformity with applicable accounting and 
disclosure standards.
    When we find that auditors did not do their jobs, we seek 
remediation through inspections. We examine existing standards. 
We issue staff alerts on key issues, in addition to considering 
whether new standards may improve the quality of audits and 
audit reports. And, the details of that are reflected in our 
written testimony. When appropriate, we discipline firms 
through our enforcement program.
    The PCAOB is engaged in several investigations relating to 
audits of financial institutions and other public companies 
affected by the crisis. These investigations, and any contested 
disciplinary proceedings that may result, are confidential 
under the Sarbanes-Oxley Act.
    This secrecy has a variety of unfortunate consequences. 
Interested parties, including investors, audit committees, 
issuers, and other auditors, are kept in the dark about alleged 
misconduct, even after a hearing and after adverse findings by 
us. Investors are not aware that the companies in which they 
have invested are being audited by accountants who have been 
charged by the PCAOB.
    As my colleagues on the Board have previously suggested, 
only Congress has the power to lift this veil. The PCAOB stands 
ready to work with Members of this Subcommittee and the full 
Banking Committee to further the protection of investors that 
has been the hallmark of the Committee's work from its earliest 
days.
    Thank you, and I look forward to your questions.
    Chairman Reed. Well, thank you very much, sir, and 
obviously the full text of your statement will be made part of 
the record, and not only you, sir, but the other witnesses may 
summarize, and your full text will be part of the record.
    Mr. Doty. Thank you.
    Chairman Reed. Ms. Seidman.

STATEMENT OF LESLIE F. SEIDMAN, CHAIRMAN, FINANCIAL ACCOUNTING 
                        STANDARDS BOARD

    Ms. Seidman. Chairman Reed, my name is Leslie Seidman, and 
I am the Chairman of the Financial Accounting Standards Board. 
I would like to thank you for the opportunity to participate in 
this important hearing today.
    As the Subcommittee examines the role of auditors and 
accountants in helping to prevent another financial crisis, I 
thought it would be helpful to outline for you the manner in 
which accounting standards are developed. In doing so, I would 
like to begin by providing a brief overview of the FASB and its 
parent organization, the Financial Accounting Foundation. I 
also want to be sure that this Subcommittee understands both 
the FASB's robust due process and how we remain accountable to 
our stakeholders. Finally, I want to update you on some 
convergence projects with the International Accounting 
Standards Board, many of which address issues related to the 
financial crisis. My written testimony provides more expansive 
information about our technical activities.
    The FASB is an independent private sector organization that 
operates under the oversight of the Financial Accounting 
Foundation and the Securities and Exchange Commission. For 
nearly 40 years, the FASB has established standards of 
financial accounting and reporting for nongovernmental 
entities, including both private and public businesses and not-
for-profit organizations. Those standards are recognized as 
authoritative, Generally Accepted Accounting Principles, or 
GAAP, by the SEC for public companies and by the American 
Institute of Certified Public Accountants for other 
nongovernmental entities.
    GAAP is essential to the efficient functioning of the U.S. 
economy. Investors, creditors, donors, and other users of 
financial reports rely heavily on credible, transparent, 
comparable, and unbiased financial information. Accounting 
standards are not intended to drive behavior in a particular 
way; rather, they seek to present financial information so that 
financial statement users can make informed decisions about how 
best to deploy their capital.
    An independent standard-setting process is the best means 
of ensuring high-quality accounting standards since it relies 
on the collective judgment and input of all interested parties 
through a thorough, open, and deliberative process. Our process 
is similar to the Administrative Procedures Act process used by 
Federal agencies for rulemakings but provides far more 
opportunities for interaction with all interested parties.
    Our process involves public meetings, roundtables, 
workshops, surveys, field visits, and the exposure of our 
proposed standards for formal public comment. We meet regularly 
with the staff of the SEC and the PCAOB and with banking 
regulators.
    In recent years we have significantly improved our ability 
to engage with interested parties in a variety of ways so that 
we can obtain the feedback we need to make informed decisions 
about how to improve financial reporting standards. We 
videocast our Board meetings and have created podcasts and 
webcasts to provide short summaries of our proposals and new 
standards so that people can quickly assess whether they have 
an interest and want to weigh in. We have also been reaching 
out proactively to a wide range of investors and reporting 
entities. I particularly like these interactive meetings 
because we can ask questions to better understand why a person 
holds a particular view, which can accelerate the 
identification of issues and possible solutions. In short, the 
FASB actively seeks input from all of its stakeholders on 
proposals and processes, and we are listening to them.
    Finally, we continue our work on convergence of U.S. and 
international accounting standards in several key areas. We 
developed improved accounting and disclosure standards relating 
to securitizations and consolidation of special purpose 
entities, and we plan to issue this month a converged standard 
on how to measure fair value when it is required by another 
standard.
    We recently exposed a revised joint proposal on the 
accounting for loan losses and plan to discuss the feedback on 
it with the IASB starting next week. These are the key topics 
identified by the FASB's Financial Crisis Advisory Group and 
the Financial Stability Board, and we have made significant 
progress on them.
    Mr. Chairman, that concludes my remarks, and I would be 
pleased to answer any questions.
    Chairman Reed. Thank you very much.
    Mr. Kroeker, please.

STATEMENT OF JAMES L. KROEKER, CHIEF ACCOUNTANT, SECURITIES AND 
                      EXCHANGE COMMISSION

    Mr. Kroeker. Chairman Reed, thank you, thanks to Ranking 
Member Crapo and to the Members of the Subcommittee.
    Let me apologize in advance for my voice. It is 90 percent 
better than yesterday, but as you might notice, I am having 
some throat issues.
    I am Jim Kroeker, Chief Accountant of the Securities and 
Exchange Commission, and I serve as the principal adviser to 
the Commission on accounting and auditing matters. I appreciate 
the opportunity to testify today on behalf of the Commission 
regarding the role of the accounting profession in preventing 
another crisis.
    Financial reporting plays a critical role in establishing 
and maintaining the confidence of the investing public. 
Information provided to participants in our capital markets 
must be neutral, reliable, and portray economic results in an 
accurate and faithful manner. An audit by an independent public 
accountant has long been recognized as important to reliable 
financial reporting.
    The recent crisis resulted in the deepest economic 
recession since perhaps the Great Depression. As the crisis 
unfolded, regulators responded in various ways to financial 
reporting issues and auditing developments. Now, as our Nation 
emerges from this crisis, we have both the opportunity and the 
responsibility to consider the lessons and what can be learned 
to improve auditing and accounting going forward.
    First, we must consider the current role of auditors and 
the audit work performed during the crisis. A financial 
statement audit is designed to provide reasonable assurance 
that a company's financial statements are presented fairly in 
all material respects in conformity with U.S. generally 
accepted accounting principles. In exercising this vital 
function, auditors seek to address the risk of material 
misstatement in financial statements reported to investors or 
``financial reporting risk.'' An audit is not designed to 
address other risks, such as business or operational risk, 
which may affect the company's results and impact investor 
decisions.
    Focusing on financial reporting risk, there is reason to 
consider the extent to which improper, fraudulent, or 
inadequate financial reporting played a role in the crisis. 
When poorly performed audits contributed to or failed to detect 
financial reporting abuses, there are existing mechanisms for 
dealing with such misconduct, including SEC and PCAOB 
enforcement actions. We have and will continue to prosecute 
those who fail to comply with their obligations.
    Second, in addition to considering whether audits performed 
during the crisis complied with the current standards, we and 
the PCAOB are actively working to determine how standards and 
even the role of the auditor itself can be improved, and I 
would like to highlight just three of those projects.
    First, each PCAOB inspection results in a report that 
details audit deficiencies noted during the inspection. We 
continue to support the PCAOB's efforts to identify and 
consider root causes of recurring audit deficiencies.
    Second, the PCAOB actively has been seeking input from 
investors, preparers, and auditors on a variety of topics, 
including its standard-setting activities. That outreach was 
considered by the Board in adopting its recently issued 
standards that deal with the auditor's assessment of and 
response to risks of material misstatement.
    Third, some investors have questioned the sufficiency of 
the information they receive from auditors, including whether 
investors could benefit from additional early warnings. In 
response, the PCAOB is actively working on an important project 
related to what should appear in the auditor's report.
    The crisis also made clear how interconnected global 
financial markets are. We have been working with the PCAOB in 
their ongoing efforts to reach agreement with regulatory bodies 
in other jurisdictions to conduct inspections.
    Turning now to accounting, the recent crisis also provided 
us with the opportunity to examine whether accounting standards 
could be improved. The crisis highlighted the types of 
information that investors, regulators, and other users of 
financial reports need to see in a company's financial 
statements. Consistent with input from my office, this 
Subcommittee, and the President's Working Group on Financial 
Markets, the FASB completed a major standard-setting initiative 
to improve financial reporting for many financings, 
securitizations, and other transactions that had previously not 
been consolidated on a company's balance sheet.
    These new standards are effective for financial reporting 
results in 2010 and should enhance financial reporting 
transparency. We will continue to monitor their effectiveness.
    In addition to these crisis-specific initiatives, the FASB 
continues to work with the IASB on joint projects to improve 
financial reporting and eliminate unnecessary differences 
between U.S. GAAP and IFRS.
    Thank you for the opportunity to discuss these important 
auditing and accounting developments, and I will be happy to 
answer any questions you may have.
    Chairman Reed. Thank you very much. I want to thank the 
panel for excellent testimony.
    Let me ask what for many people is a threshold question, 
and we are very fortunate today. We have the organization that 
essentially supervises the auditing process, we have the 
organization that prepares the rules for accountants, and then 
we have the Federal agency charged decisively with regulating 
the accounting profession and the reporting of public 
companies.
    And the threshold question is: Why were there no timely 
warnings about companies that within months of an unqualified 
report collapsed or were rescued at taxpayers' expense? Your 
perceptions, Mr. Doty?
    Mr. Doty. Well, Mr. Chairman, I think as our report in 
September of this past year indicates, there are a number of 
areas where auditors should have delved deeper, more deeply 
into issues, valuation issues, the sources of information based 
on which financial instruments were being valued, the issues of 
when going-concern issues arise in a financial institution that 
may be heavily leveraged, being alert to end-of-reporting-
period transactions, significant transactions entered into at 
the end of a financial reporting period that may have had 
principally financial reporting purpose without business 
substance.
    These are, Mr. Chairman, enduring and recurring problems in 
financial reporting and in auditing, and our inspections show, 
if one goes back and beginning in 2006 starts looking at our 
inspection reports, they begin to show and they show with 
increasing frequency, defects and failures in pursuing these 
issues. Our 2011 audit review will do the same. We expect to 
have more deficiencies found in these audits. And, frankly, as 
I indicated, the key here in our mind is whether auditors are 
taking this to heart, going back and seeking to correct those 
audits, taking those defects up the line, and in some cases, 
frankly, whether they are presenting them as deficiencies to 
audit committees or whether they are minimizing them. That is a 
subject we are looking into. We have issued audit practice 
alerts. We will continue to do it. As Chief Accountant Kroeker 
says, we are going to be continuing to work very closely with 
the SEC on these standard-setting proposals in order to be sure 
that we have done what we can do to be sure there is 
transparency in what auditors do and that they have accurately 
talked about what they do and that the public understands it 
and that that's meaningful to them.
    Chairman Reed. You have pointed out some of the issues 
which have been identified by many other people, but there is 
another question, I think, which it raises. You know, why did 
this go on? I mean, if it was being reported to auditing 
companies in 2005 and 2006 that there is a lack of attention to 
these particular things, what were the incentives or 
disincentives that prevented them from dealing adequately with 
all the issues you cited?
    Mr. Doty. Mr. Chairman, that is a penetrating and excellent 
question, and I would defer to the views also of my colleagues 
on the panel. But I think you can see in the building of the 
financial crisis and the approach to it, you can see something 
we have seen before in capital markets called momentum 
investing. There was a certain sense that practices were going 
on that were gaining momentum. Everyone was doing it. It is 
disturbing to us as the regulator of auditors, obviously, that 
auditors were not more self-reliant and did not feel that they 
could go to audit committees and management and start sounding 
an alarm early. We think that comes to rest in very fundamental 
problems of the audit profession, that, in fact, the auditors 
themselves are recognizing has to change, that the audit 
profession knows that it is standing on the edge of a period of 
real change.
    Chairman Reed. Ms. Seidman, your comments.
    Ms. Seidman. Thank you, Mr. Chairman. Focusing on the role 
of the FASB in the financial system and our role being to 
establish financial reporting standards that provide investors 
with complete and neutral information with which to make 
informed investing decisions, we have procedures in place that 
we use to monitor whether standards are producing complete and 
neutral information or are perhaps resulting in unintended 
consequences, as well as cases where perhaps there is a lack of 
a standard and, therefore, a standard-setting implication for a 
financial reporting issue.
    We have a number of standing advisory committees, and a 
regular agenda item is to ask them: Are there issues out there 
that the FASB or another party should be working on so that we 
can quickly respond and provide guidance to help improve 
financial reporting?
    We also have regular meetings with the staff of the 
Securities and Exchange Commission, the PCAOB. We have an 
emerging issues task force. All of these outreach activities 
are designed to have timely identification of financial 
reporting issues from the people who are out in practice and 
closest to the businesses and the transaction so that we know 
if problems are emerging.
    On a going-forward basis, we have some improvements in 
place to try and do an even better job of identifying those 
issues on a timely basis. With my colleagues, Mr. Doty and also 
Mr. Kroeker, we are planning to initiate a new financial 
reporting series that we plan to start in July the purpose of 
which is to convene regular meetings with interested parties to 
discuss what issues are emerging in the financial markets and 
among financial reporting professionals so that we can have a 
mechanism for surfacing those issues from informed constituents 
and then determining what is the nature of the issue. Is it a 
financial reporting matter, is it an auditing matter or 
possibly an enforcement matter? And then assigning 
accountability to the right party.
    Getting back to the situation that unfolded in recent years 
with the crisis, the processes that we had in place we felt, 
given the global nature of the issues, warranted extra 
measures. And so together with our counterpart internationally, 
the International Accounting Standards Board, we convened a 
special advisory group to help us identify which accounting 
standards might be in need of improvement during the times of 
crisis as well as other parties were certainly weighing in at 
the time and providing feedback to us as well.
    Those issues really came down to concerns about adequacy of 
guidance with respect to fair value measurement, the standards 
relating to securitizations and consolidations, as well as 
particularly the accounting for loan losses or impairments. And 
that is where we have been focusing our efforts in recent 
years. We have issued revised standards on fair value 
measurement as well as consolidations and securitizations, and 
we are working very diligently on that last item, the 
accounting for financial instruments, specifically with respect 
to impairment, and we are hoping to make progress on that 
standard this year.
    So with all of these changes and enhancements that we have 
made and are continuing to make, we are hoping that those 
efforts will provide the accurate and neutral information that 
investors need to evaluate the risks inherent in companies on a 
going-forward basis.
    Chairman Reed. Thank you for that. Before I recognize Mr. 
Kroeker, I want to follow up with a specific issue and that is, 
in 2002, in the wake of Enron, we passed Sarbanes-Oxley, and 
one of the provisions, Section 401, was, we thought, 
specifically designed to address what we found to be one of the 
fundamental accounting issues with Enron, which was off-balance 
sheet transactions which were not appropriately recognized by 
the profession.
    The scope was very broad about what we assumed that the 
rules would cover. That is 2002. In fact, our presumption was 
we had taken the effective legislative action to sort of 
finally sort of clarify, fix, if you will, the abuse of off-
accounting transactions. It turns out that as we all now 
recognize, one of the major problems with some of these 
entities was off-balance sheet transactions, special investment 
vehicles, all sorts of other exotics.
    In February of 2008, I wrote your predecessor, Mr. Herz, 
and said, essentially, Where are the rules and the guidance on 
these off-balance sheet transactions? Why has not Section 401 
been fully implemented so that accountants know precisely what 
they have to recognize?
    And as I read your testimony today, which was excellent 
testimony, it appears that by May of 2011, there will be a 
final kind of determination. I guess the point is, is that one 
could argue, or at least hypothesize, that had this regulation, 
this statute been effectively implemented by regulations, that 
some of the problems we saw in 2008 with some of these 
companies--in fact, I think we were all sort of taken aback 
when very eminent directors of some of these companies said 
they had never heard of a liquidity put, they had no idea that 
they had the responsibility to buy back, in an illiquid market, 
these things because they were totally off the books.
    So in that regard, can you explain why it took so long to 
do something that we thought was central and obvious and 
necessary?
    Ms. Seidman. Thank you, Mr. Chairman. We have, in the last 
several years, been approaching a number of issues with respect 
to off-balance sheet financing, and that term is a very broad 
term that can include things like the accounting for 
derivatives. It can include things like repurchase agreements 
as well as securitizations and off-balance sheet special 
purpose entities.
    And so, in a number of those areas over recent years the 
FASB has issued standards to improve the accounting and the 
disclosure relating to off-balance sheet transactions. 
Immediately following the Enron scandal, the FASB did issue a 
revised standard on off-balance sheet financing with respect to 
variable interest entities or special purpose entities. And 
that standard went into effect.
    Chairman Reed. When did it go into effect?
    Ms. Seidman. That standard, I believe, went--I am going to 
have to check specifically.
    Chairman Reed. Page seven of your testimony?
    Ms. Seidman. Sorry. I was looking at a list. Chairman, I 
apologize. That section refers to later standards that were 
issued, so I was referring to an earlier effort so I will get 
that information to you.
    Chairman Reed. Thank you.
    Ms. Seidman. That approach was based on a quantitative 
evaluation of the risks and rewards that an entity held, and we 
later became aware of practice issues related to that standard, 
which we immediately undertook to remedy, which is more in the 
timeframe of 2008 and 2009. At the same time, we were working 
with our international counterpart to determine what the 
appropriate standard would be on a global basis for the 
consolidation of these special purpose entities.
    At that time, we decided to pursue a more principle-based 
approach, which was based on who had control of the entity and 
who would have the majority of the benefits and exposures to 
risk, and that is the standard that we issued in 2009 and it 
became effective in 2010. So we, I do believe, have a more 
principle-based standard, which is going to require all 
practitioners to use judgment in determining whether to 
consolidate these entities that they have involvement with or 
have significant investments in.
    Prior to issuing that standard, we had also developed some 
significantly improved disclosures. So regardless of whether 
the accounting was to consolidate or not consolidate, we 
provided the information to investors for any situations where 
there was involvement with the entity so that it was less 
dependent on the particular evaluation of whether it was on or 
off-balance sheet, but it provided both views.
    This is one of those matters where there are questions 
about whose assets and liabilities they are. Everybody wants to 
report all of the assets and liabilities of an entity, but in 
some of these very complex transactions, it requires a very 
detailed analysis of the specific forms of involvement and 
provisions, so that we wanted to provide disclosures so that 
regardless of those very close calls and whether it ended up on 
the balance sheet or not on the balance sheet, the investor had 
all of the information in order to make that determination.
    There are a couple of other standards that we have issued 
in recent years relating to off-balance sheet financing that I 
thought would be important to emphasize as well. One of the key 
players in the financial crisis were the monoline insurers, in 
other words, the ones who would guarantee the bond offerings, 
et cetera, and we issued a standard in, I believe it was in, 
2009, to require significantly improved disclosures for the 
monoline insurers as well as a more robust approach to the 
measurement of their liabilities.
    So we have undertaken a number of efforts to try and 
present more complete and neutral information about the 
financing activities of an entity. We do have one active 
project with respect to lease accounting, which is another form 
of off-balance sheet financing, and we are working diligently 
to conclude on those matters this year with the IASB.
    Chairman Reed. Thank you. I am going to recognize Mr. 
Kroeker and then I am going to recognize Senator Hagan for any 
comments or questions she might have, and then I have 
additional questions. Mr. Kroeker, please. The basic question 
is, why no alarms adequately and timely enough to warn the 
investing public about the demise of these companies?
    Mr. Kroeker. First, I think in those examples where 
management, auditors, or accountants were aware of risk--aware 
of a significant buildup and it went undisclosed--the important 
step to take is vigorous enforcement action. We have been doing 
that and that will continue. So I think a very important first 
step is where people failed to comply with their obligations, 
holding them accountable.
    Second, the issue of why not broader early warning signals 
from either the auditors or the accounting profession, I think 
as Chairman Doty outlined, there are some serious questions 
about performance of audits. They see that in PCAOB inspection 
reports. But the issue of an auditor's responsibility with 
respect to going concern--and they do have a responsibility to 
highlight whether there is substantial doubt about going 
concern--and that is an active project at the FASB as well.
    Interestingly enough, it is an area where going back four 
or five, maybe even 6 years, an observation that management 
does not have, at least in the base financials themselves, a 
similar obligation or responsibility as clearly outlined as 
that which there is for the auditor with respect to going 
concern. And FASB has an active project on that.
    Of course, the way it is designed today, that is, in some 
people's view, a very binary determination. There either is or 
there is not substantial doubt about a going concern and 
whether or not a reduction in the binary nature of that--more 
early warning signaling than just we have got to the point 
where there is now substantial doubt about going concern--but 
earlier warning even than the point where you say, ``The doubt 
is so high, is that really enough for investors?'' So I think 
that is an extremely important project that the PCAOB has on 
its agenda as well.
    Chairman Reed. Thank you very much. Again, I have 
additional questions. Let me recognize Senator Hagan for any 
comments or questions she might have, then Senator Merkley, and 
then I will reclaim. Senator Hagan.
    Senator Hagan. Thank you, Mr. Chairman, and thank you for 
holding this hearing.
    Ms. Seidman, in your testimony, you mentioned that FASB 
acts to consider promptly any significant areas of deficiency 
in financial reporting, and one of the things that became 
apparent following the collapse of Lehman Brothers was that the 
firms would forum shop to arbitrage regulatory standards in 
various jurisdictions.
    First off, I would like to understand to what extent the 
accounting standards were and continue to be gamed by the 
international financial institutions. It seems to me that 
Lehman's ability to obscure its balance sheet, helped by 
booking transactions through affiliates under British law and 
then accounting for them in the U.S. using GAAP, would be 
considered a significant area of deficiency.
    Ms. Seidman. Thank you, Senator. The accounting issues 
relating to the Repo 105 transactions that you are referring to 
relate to an accounting standard that was issued in 1996 that 
provides guidance for how to distinguish between a sale and a 
financing on a repurchase agreement.
    There are two key considerations in that evaluation. One is 
the legal analysis that you referred to. The entity has to 
satisfy itself that it has been transferred beyond the reach of 
the entity. And then the second is an evaluation of whether the 
entity, notwithstanding the surrender of legal control, has 
retained effective control through the repurchase agreement and 
through other means. So both of those aspects come into play in 
evaluating the Repo 105 transactions.
    The FASB was not aware of any practice issues with respect 
to those particular provisions of the standard. As I say, it 
had been in effect for quite some time, and we first became 
aware of this issue with the release of the Bankruptcy 
Examiner's report with respect to Lehman Brothers.
    And so, at that time, the SEC issued some Dear CFO letters 
to evaluate the pervasiveness of the issue. When those letters 
came in and through discussions with the staff of the SEC and 
others, we did determine that it would be appropriate for us to 
review whether those particular provisions continued to be 
relevant in evaluating whether repurchase agreements should be 
accounted for as sales or borrowings.
    We did two things to respond to that. First, with respect 
to the legal analysis, when we issued Statement 166, which was 
a revision of the standard that does provide a requirement to 
evaluate legal isolation, we clarified that that analysis 
should take place at the consolidated level.
    So in other words, if you are a U.S.-based entity, you 
ultimately need to consider whether the transaction is beyond 
the reach of the entity in the U.S.; whereas, previously, 
perhaps there was some ambiguity about at what level. In other 
words, could it be done at the subsidiary level or must you 
satisfy that threshold at the consolidated level? So that 
standard was put in place without repos particularly in mind, 
but, in fact, it does address a particular aspect of this 
issue.
    The second had to do with whether the specific collateral 
provisions, in other words, the requirement to maintain 
collateral, really remained relevant in today's environment. 
When those provisions were included, they were intended to 
describe market practices at the time. In other words, if you 
were doing a repurchase agreement with treasury securities, 
then entities were typically maintaining a high level of 
collateral. But elsewhere in the world, perhaps that was not 
true, and there was thought at the time that that should 
matter.
    Our board undertook an effort to review those provisions 
and has concluded that we do not believe that those technical 
provisions should be determinative in evaluating whether a 
repurchase agreement should be accounted for as a purchase or a 
sale. We are actually finalizing our balloting process on that 
improvement right now as we speak, and we hope to issue that 
clarification by the end of the month or early in May.
    Senator Hagan. What about actual forum shopping concerning 
arbitrage regulatory standards in various jurisdictions? Is 
that something that you are actually looking into?
    Ms. Seidman. That is not something I am in a position to 
evaluate, but I do believe that the clarification of the 
requirement, in other words, that this analysis must be passed 
at the consolidated level, would seem to limit the ability to 
do that.
    Senator Hagan. Mr.--is it Kroeker?
    Mr. Kroeker. Yes.
    Senator Hagan. Thank you. I know that the efforts being 
undertaken by FASB are extremely important to the SEC. Can you 
describe what the SEC's involvement has been in the effort to 
streamline standards across jurisdictions and what you see as 
challenges to success in this effort?
    Mr. Kroeker. Yes. We are highly involved in the standard-
setting process, both in the U.S. and abroad, and we have 
active day-to-day work in our oversight capacity over the FASB 
having, on a day-to-day basis, project managers of the FASB 
work closely with accountants on our staff as we identify 
issues in practice, making the FASB aware of those, following 
their deliberations, importantly pointing out, for example, in 
2008 the strong need for further improvement to off-balance 
sheet accounting. So we play a very active role in working with 
the FASB.
    As it relates to, I think, the second part of your 
question, both challenges and opportunities with the FASB and 
standards around the world, we have, for the better part of 
three decades, recognized the desire or the need for a high 
quality set of accounting standards that is implemented not 
just in the U.S., but around the world, and have been very 
supportive of the IASB, the International Accounting Standards 
Board, in developing a high quality set of standards.
    It has become increasingly a set of standards that is used 
around the world and has increased significantly in its 
quality. The opportunities and the challenges that exist, both 
on the FASB's and the IASB's agenda, many of which were 
highlighted by the financial crisis, let me highlight just a 
couple.
    Their standard on accounting for financial instruments, 
whether or not we can do a better job of providing forward-
looking information as it relates to credit impairment of 
loans. Right now, we have a model that is very much based on 
identification once a loan has an incurred loss. Investors and 
those charged with oversight of the financial reporting process 
have observed that may be too late in terms of the credit 
cycle.
    The FASB and the IASB have a joint project and it is 
imperative that they continue to work together and deliberate 
those issues jointly. Improvements to hedge accounting: The 
IASB has an exposure draft on improvements to hedge accounting 
and derivative accounting. The U.S. model is, some have 
described and depending on what book you look at, somewhere 
around 800 pages of guidance dealing with derivatives and hedge 
accounting.
    It is a very complex, rules-driven model and there is room 
for significant improvement. The IASB model is largely based 
upon that U.S. model. The IASB has an exposure draft, the 
intent of which is to simplify that depth of rules to have 
derivatives and hedge accounting match up with an entity's risk 
management strategy, and in concept that sounds great.
    Their proposal has a number of areas where there, I 
believe, will need to be significant greater clarity as to the 
objective and how to achieve the objective. But my point being 
that it is imperative that the FASB work together with the 
IASB, that they do not leapfrog each other, that they 
deliberate those issues jointly. I think it is one of the 
biggest challenges we face going forward.
    Senator Hagan. Thank you, Mr. Chairman.
    Chairman Reed. Thank you. Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chairman. Thank 
you to the panel for your testimony and I just want to thank 
Chairman Reed for calling this conversation together, about 
understanding the better the role of the accounting world in 
the crisis that we have all gone through and what issues we 
should be focusing on and what we should be considering doing 
differently down the road.
    In the second panel today, Mr. Valukas has testimony that I 
thought I would quote a passage of and ask for a response. He 
notes, Lehman's executives, not regulators or auditors, made 
the decision to load up on illiquid assets. Lehman's 
executives, not regulators or auditors, were responsible in the 
first instance for preparing fair and accurate financial 
reports.
    He continues, I found that Lehman's decision not to 
disclose to the public a fair and accurate picture of its 
financial condition gave rise to colorable claims against 
senior officers who oversaw and certified misleading financial 
statements. And he later says in his testimony, I found that 
colorable claims exist against Lehman's external auditor in 
connection with Lehman's issuance of materially misleading 
financial reports.
    Now, there is a lot of conversation, attention being paid 
these days to Barry Bonds and his accountability for truth 
under oath. In town halls that I am holding, I am often asked 
the question, perhaps one of the most common questions I am 
asked is, why have not high members of the financial community 
been held accountable for accuracy or truth in financial 
statements, or to put it differently, why have so few 
executives at major institutions been prosecuted by the SEC or 
by the Department of Justice? Now I have a chance to get 
experts' insights on that, so please share with me.
    Mr. Kroeker. Let me start. One, and as I also address in my 
testimony, we have taken action against a number of actors in 
the financial crisis. Of course, investigations and enforcement 
activity continues, and I think it is important to hold those 
accountable where they have not lived up their obligations.
    Without commenting specifically on individual cases, 
because I do not want to get into the nonpublic aspects of 
where and what we are investigating, I can tell you that we 
have taken the Bankruptcy Examiner's report extremely 
seriously. It is a detailed and chilling report. Our staff, our 
chairman and others, have spent time with Mr. Valukas to 
understand the nature of that report.
    We took immediate action to determine the pervasiveness or 
the lack thereof of transactions, so-called Repo 105s, and 
immediately issued interpretative guidance to MD&A that would 
clarify for anyone that, of course, you need to disclose your 
liquidity position, those things that have a tremendous impact 
on capital. We are also, again, continuing investigative and 
enforcement activity promptly.
    Senator Merkley. Well, thank you. I thought maybe you were 
going to say to me something along the lines of, ``Well, 
actually, there are three dozen executives in jail and we have 
this many prosecutions underway,'' and something that I can 
relay back to folks back home.
    Mr. Kroeker. With respect to people in jail, the SEC has 
civil authority. We do not have criminal authority, but I can 
certainly work with our enforcement division to get a more 
detailed list of what we can provide with respect to cases to 
date, and then see what we can provide with respect to what is 
ongoing, of course, in the nature of, many of those are 
nonpublic proceedings.
    Senator Merkley. Well, thank you. Because I think the 
public wants to understand this better; that is, was it 
essentially deregulation that made activities permissible, that 
by taking away the traffic signals, if you will, we caused a 
major crash or traffic paralysis in the financial markets. Or 
did things seriously go awry in terms of integrity and have 
those issues been adequately dealt with as they should be in 
all areas where integrity--violations of law are involved, 
whether civil or criminal. So thank you.
    I want to go on to a second area here. Is it Mr. Doty?
    Mr. Doty. Yes.
    Senator Merkley. Doty. You have identified in your 
testimony that PCAOB inspectors identified many audit 
deficiencies relating to auditing fair value estimates, 
especially related to insufficient evidence gathered by the 
auditor when using third-party pricing sources, pricing 
services, or broker quotes when valuing financial instruments 
such as investment securities.
    Is this really part of the case to be made for trading 
derivatives on exchanges so that there is a market that 
establishes proper valuation, if you will?
    Mr. Doty. Senator, that is an interesting question. I think 
our focus at the present on the auditing side of this is on the 
difficulty of obtaining valuations when an auditor goes in and 
the issuer being audited has obtained a third-party valuation. 
That comes often in the form of proprietary information from a 
firm that has an actual adverse interest.
    You are pointing to a clouded area of the market function, 
and we would have to acknowledge to you that we think--we are 
working with our colleagues at the SEC on rule proposals, 
standard-setting proposals that go to the issues of how you 
value. We have a task force at the PCAOB. This, I think, is a 
knotty, difficult issue of knowing what value is.
    I can't tell you as an audit regulator what the collateral 
effects would be on market activity if you did this. I can 
agree with you, though--and there is always a collateral 
problem with whatever you do in this area, the market as being 
a mechanism, but I can certainly agree with you that one of the 
most difficult problems we face, as an audit regulator in 
framing standards and will face going forward, is the fact that 
valuation is hard to come by. Auditors are having to do more 
work themselves, which one would hope the issuer would have 
done, and that that work is not always sufficient to establish 
value.
    Senator Merkley. Thank you. Thank you, that was very 
helpful, Mr. Chair.
    Chairman Reed. Thank you very much, Senator Merkley. Let me 
pose a few more questions, and again, I think this is in the 
order of one of these threshold questions, which I will address 
to the whole panel. Is auditing today a loss leader for these 
accounting agencies, i.e., the pricing of the services, given 
all of the complexity and everything else, provides maybe 
implicitly, not explicitly, a disincentive to do extra, to do 
more, because the compensation is not adequate?
    Or, alternatively, is there, because of the limited nature 
of major auditing firms--it is a small group, the British 
describe it as an oligopoly, the fear that telling the truth to 
power will find yourself out on the street. So these are issues 
that are not measurable by charts, but I think they profoundly 
or may profoundly influence the behavior of companies and 
auditors. So your thoughts would be appreciated, Mr. Doty and 
Ms. Seidman and all.
    Mr. Doty. Mr. Chairman, I think it is a significant 
problem, the most significant problem today and that is how do 
we restore and buttress the counterweight, which the auditor 
is, to management expediency. And there are rule proposals, 
thoughts of doing that. If you take the collection of proposals 
we have now with the SEC as joint projects, you will see some 
of them.
    But it is clear that the audit firms get most of their 
money from auditing. The global firms are large enough to audit 
the multinational corporations. Therefore, it is a serious 
question in my mind as to whether size is the problem. I think 
size is not the problem. Coordination among the networks and 
the establishment and enforcement of quality control within the 
network, I think, is the achievement that we have to seek.
    So in order to have what we want, we have to have auditors 
who will say what has to be said and will challenge management 
without regard to the fact that the audit committee may seek 
lower audit fees or the management may have questions about 
retaining them. It is the audit committee that retains the 
auditors. We have a project on communication with the audit 
committee. We are going to be looking at this hard to be sure 
that audit committees do not fall into the trap of judging the 
cheapest audit to be the best audit.
    Chairman Reed. Ms. Seidman, your comments?
    Ms. Seidman. Mr. Chairman, with respect, this is not an 
area that I am knowledgeable about, so I am going to defer to 
Mr. Kroeker.
    Chairman Reed. OK. Mr. Kroeker.
    Mr. Kroeker. Yes, with respect to the first piece of your 
question, are audits today loss leaders, I certainly hope that 
is not the case. I think we saw that in an earlier crisis, the 
Enron crisis, where there was much concern about whether an 
audit was being used as a loss leader to higher value--not 
higher value, certainly not higher importance--but the ability 
to earn higher fees on consultancy or other services.
    And I think with respect to the company under audit, that 
has been addressed by independence rules that prohibit many of 
those types of services, and so I am hopeful that audits are 
not being priced as loss leaders because that other revenue 
stream does not--should not exist, in any case. Whether or not 
there is enough focus on auditors being selected because of 
quality as opposed to other means--and Chairman Doty outlined 
in some remarks earlier this week troubling examples that they 
had seen either in engagement letters or proposals, things 
like, ``If you choose us, we will have a reduced audit 
footprint.'' Asking the question of what is, in fact, a reduced 
audit footprint, that could sound like ``we will not be as 
rigorous.'' And to the extent that that exists, strengthening--
audit committees having a stronger role in selecting auditors 
because of quality as opposed to fee pressures or other things 
that are very real but may get in the way of quality. And I 
think that is a very real concern, something that we are 
actively in discussions with the PCAOB about.
    As it relates to the number of firms that might audit a 
large percentage of the capital market, whether that is the 
largest of four or the largest of six or the largest of eight, 
the GAO has studied that on a couple of occasions recently, 
once in 2003 and again in 2008, and has not necessarily found 
the same types of issues that might exist in other markets, for 
example, in Europe, where auditor selection may be even more 
constrained in an individual country or within an individual 
sector; that is, there may be only one or two auditors of 
choice. So there are some differences in the marketplace as 
well.
    Chairman Reed. Thank you very much.
    Let me turn to another question. There have been some 
studies, recently a October 2009 study, ``Did Fair Value 
Accounting Contribute to the Financial Crisis?'' And the 
conclusion of this study was that there is little support for 
claims that fair value accounting leads to excessive writedowns 
of banks' assets. In 2008, the SEC studied this. More recent 
academic studies noted, perhaps suggested--or the debate is 
still large--that the overvaluation of bank assets--Mr. 
Kroeker, what is your sort of sense now? And then I will ask 
your other colleagues about fair value accounting. Did it 
overvalue assets? Is it accurate? Is it something that you have 
adjusted so that it is more finely tuned?
    Mr. Kroeker. I participated intimately in that 2008 study. 
I think part of the reason for a statement that says fair value 
was not a significant contributor was taking a look at the 
financial institutions that we looked at in that study. A 
significant percentage of assets are not, in fact, carried at 
fair value. Derivatives are; assets in a trading portfolio are. 
But large percentages of financial institutions' assets--loans 
and other investments that it holds for long-term cash 
collection--are, in fact, not marked down on a daily basis or 
even a quarterly basis based on fair value. They are supposed 
to be marked down when there are credit impairments or longer-
term impairment. But we do have--continuing through this day--
that loans are marked down for credit impairments, not daily or 
quarterly fluctuations in value. And it is an area where I 
think it is important to determine whether those assets, 
because we wait until we can identify an incurred credit loss, 
whether those assets are, in fact, written down effectively too 
late. And the FASB has a project jointly with the IASB and has 
made significant progress. I think they are encouraged that 
they will be near final in the short term.
    Chairman Reed. Ms. Seidman.
    Ms. Seidman. Thank you. I completely agree with all the 
comments that Mr. Kroeker just made. Let me just elaborate that 
in the course of the crisis, the FASB was asked to provide 
additional guidance to help practitioners determine fair value, 
especially in the cases where the market was very illiquid and 
disrupted, which we did provide, and I do believe that it 
reinforced the basic principle of fair value measurement, but 
it provided some guidance to help people exercise judgment and 
come to a conclusion of how to estimate fair value during those 
difficult times.
    Those interim pieces of guidance that we developed have now 
been incorporated into a standard that we are finalizing with 
the International Accounting Standards Board and plan to 
release in the short term.
    Part of that was also to provide much more extensive 
disclosure about the extent to which fair value is actually 
used in the financial statements, and this builds on a point 
that Mr. Kroeker just made. For many financial institutions, it 
is fairly limited as to what is actually carried at fair value. 
But to make that very clear to the investor, these are the 
items that are carried at fair value and also require that 
information to be provided at a much more disaggregated level 
so that investors have a good sense of exactly what is being 
carried at fair value as well as what methods are being used to 
estimate fair value. So there would be a clear distinction 
between cases where fair value is based on actively traded 
items versus cases where there is a very judgmental estimate 
being made, and then in those cases even more information to 
show the reason for the changes in the estimates and the key 
inputs to the measurement. So we are trying to make it much 
clearer to investors what is being carried at fair value and 
how subjective those estimates are.
    Chairman Reed. Thank you.
    Mr. Doty, if you have a comment, please, but I have an 
additional question I would like to address to you and to Mr. 
Kroeker, and this has become a topic of recent reporting. There 
appears to have been an increase in foreign operating companies 
using reverse mergers to access the U.S. capital markets. Does 
this pose a threat to the markets? And are you, both the SEC 
and your organization, beginning to think hard about it? There 
have been a lot of reports about the Chinese companies who are 
acquiring public companies in the United States and essentially 
becoming public companies without a lot of the rigorous hurdles 
that other companies go through? Your comments, Mr. Doty.
    Mr. Doty. It is a priority, Mr. Chairman, for us to get 
access to inspect audits in China and with respect to U.S. 
firms performing audits of Chinese companies in China. We are 
working closely with the SEC. We have initiatives underway. 
Clearly, if Chinese auditors are auditing companies who are 
then by reverse merger and without full SEC disclosure becoming 
the firms whose securities are held by U.S. shareholders, that 
is of concern to us. Without regard to its percentage of the 
capitalization of our securities market, it is of concern to 
us. And we will continue to pursue that vigorously, working 
with the SEC, and I think you can expect some initiatives 
coming out in the course of the summer and the fall.
    Chairman Reed. Mr. Kroeker, please.
    Mr. Kroeker. It is extremely important, and I think in part 
people are reading about it because we are taking action. We 
have an internal task force, cross-office, cross-divisional, 
involving enforcement, the Division of Corporation Finance, our 
office, and others. We have been asking through filing reviews 
questions about preparers' understanding--particularly if there 
are language barriers anywhere around the world--their 
understanding of U.S. GAAP and U.S. GAAS. Does that lead to 
questions about the integrity of internal controls if you do 
not have an understanding of U.S. GAAP? Asking serious 
questions to auditors, and anecdotally, I have heard from a 
number of auditors that they are asking more serious questions 
because we are asking, and I think that is resulting in 
increased press accounts. We have seen a number of auditor 
resignations, which are publicly filed with us. The PCAOB is 
highlighting the issue, so it is something we take very 
seriously. It is a very important issue to continue asking 
about.
    Chairman Reed. Thank you.
    Just a final question, Mr. Kroeker. My colleague Senator 
Merkley referred to Mr. Valukas' testimony about the management 
deficiencies or apparent deficiencies there. But there was also 
something I found quite interesting and in a way disturbing, 
and let me read it. ``The SEC and the Fed each knew that 
significant amounts counted as liquidity were in fact posted as 
comfort deposits in order for Lehman to do business; the Fed 
knew that significant amounts counted as liquidity were, in 
fact, actually pledges to lenders. The agencies internally 
disagreed with Lehman's inclusion of these amounts as 
liquidity, yet took no action to require Lehman to adjust its 
public reporting of the numbers.''
    Essentially at the end, the last day, it was a liquidity 
crisis. They had no liquidity. The repo market overnight dried 
up, and that was the death knell of this company. And it 
appears that both the SEC and the Federal Reserve knew about 
it, thought it was bad, and kept their silence.
    Are you aware of that? Is that accurate? And are we doing 
that today?
    Mr. Kroeker. We are not doing that today, and I am aware of 
the bankruptcy examiner's report and that specific section as 
well. And my understanding, it was individuals in our CSE, our 
consolidated supervisory program, that, in fact, were aware of 
concerns about liquidity pools, and those were not being 
communicated broadly across offices and across divisions. And I 
can tell you our Chairman has taken extraordinary measures to 
break down those communication barriers and those silos. We 
have interagency working groups specifically focused on large 
financial institutions, a college of internal regulators that 
address cross-cutting issues. If we are seeing something in one 
area of the building, are the important players in other areas 
of the building deeply involved and aware? So I can tell you it 
is a very serious observation in that report, but it has been 
addressed.
    Chairman Reed. Well, thank you very much. Thank you for 
your testimony. There are numerous other questions. I would ask 
you if you would bear with us. Some of my colleagues might have 
additional written questions which we will provide to you and 
ask for a prompt response, and thank you very much for your 
testimony, and we will call forward the second panel. Thank 
you.
    [Pause.]
    Chairman Reed. Well, thank you all for joining us. We look 
forward to the second panel. I want to thank the first panel 
for their excellent testimony. Let me introduce the members of 
the second panel.
    Anton Valukas is the Chairman of the national law firm 
Jenner & Block. In early 2009, Mr. Valukas was appointed as the 
examiner in Lehman Brothers Holding bankruptcy, reputed to be 
the largest such case in U.S. history, and as you know, we have 
already made reference to your testimony, and the previous 
panel has duly noted your testimony and your report. Thank you, 
Mr. Valukas.
    Cindy Fornelli is the executive director of the Center for 
Audit Quality. Prior to become the center's executive director, 
Ms. Fornelli was the regulatory and conflicts management 
executive at Bank of America. Thank you for joining us.
    Thomas Quaadman is the vice president of the U.S. Chamber 
of Commerce for Capital Markets Competitiveness. Prior to 
joining the chamber, Mr. Quaadman was chief of staff to 
Congressman Vito John Fossella, Jr., from New York, from 1997 
to 2008. Thank you for joining us, Mr. Quaadman.
    And, finally, Lynn Turner served as the Chief Accountant of 
the Securities and Exchange Commission from July 1998 to August 
2001. Mr. Turner has served in a variety of capacities as a 
member of boards and audit committees of public companies, a 
trustee of a mutual fund and a public pension fund, a professor 
of anything, a partner in a major international auditing firm, 
the managing director of a financial research firm, and as a 
chief financial officer. Thank you again, Mr. Turner, for 
joining us.
    Mr. Valukas, please. Your testimony will be made part of 
the record. Feel free to summarize. Thank you very much. You 
have to push the button, I think, sir.
    Mr. Valukas. The one that says ``Talk''?
    Chairman Reed. The one that says ``Talk.''
    [Laughter.]
    Chairman Reed. We do not need any encouragement.

  STATEMENT OF ANTON R. VALUKAS, CHAIRMAN, JENNER & BLOCK LLP

    Mr. Valukas. I am a quick learner. Thank you, Mr. Chairman.
    Let me summarize just a few points that are made in my 
testimony, but that I think are germane to today's activities.
    Lehman's failure was in large part the result of poor 
investment decisions, inadequate liquidity, and ultimately a 
failure of confidence by Lehman's lenders. Lehman's auditors 
did not make the business decisions that caused Lehman to fail, 
but the auditors did play a critical role in the disclosure or 
nondisclosure of information which would have been critical for 
the public to know about and which masked the nature of 
Lehman's crisis.
    The investing public is entitled to believe that a clean 
report from an independent auditor stands for something, and 
whereas in Lehman, the auditors became aware of questions 
practices that were being followed by Lehman, the public has a 
right to expect that the auditors are going to say something 
about that. I have found that there were colorable claims 
against the auditors in connection with their activities. Those 
claims are in litigation, and I really do not want to address 
those today. That would not be appropriate. But I want to point 
to two items which were discussed previously.
    Two metrics were of critical importance to Lehman Brothers 
in the last year of its existence: leverage and liquidity. In 
both instances Lehman reported these metrics in misleading 
ways. The significance of them cannot be underestimated. The 
global treasurer recognized in 2007, the global treasurer of 
Lehman Brothers said that ratings agencies were ``most 
interested and focused on leverage.'' It was a critical point. 
They looked at leverage as being an issue that if leverage was 
not considered to be appropriate, they might get a downgrade in 
their rating, which, of course, would foretell a real problem.
    Lehman opted to create the perception of reducing its net 
leverage through Repo 105, which has been discussed here and 
elsewhere extensively. But let me just point out what Repo 105 
accomplished.
    It removed temporarily--and I mean temporarily--$50 billion 
off the balance sheet right at quarter end, and that was what 
was published in the public documents. Their executives in 
their internal e-mails referred to this as ``a gimmick,'' 
``window dressing,'' and this comes from the president of 
Lehman Brothers, ``a drug we are on.''
    Lehman's former global financial controller stated 
unequivocally in our interview with him that there was ``no 
substance to the transactions.'' Fifty billion dollars worth of 
transactions with no business purpose.
    Lehman's auditors were aware of the use of Repo 105, and 
whether due to gaps in professional audit standards or a 
failure to follow the standards, the results are the same. The 
auditors did not object when Lehman omitted any reference to 
these transactions in their financial statements.
    Liquidity. After Bear Stearns' near collapse in March of 
2008, regulators, lenders, and the investing public looked to 
liquidity as being a critical issue for Lehman Brothers. Lehman 
Brothers was intimately aware of that focus and began to cut 
corners, and clearing banks and overnight lenders sought 
increasing amounts of collateral. By the summer of 2008, Lehman 
began to count in its liquidity pool significant assets which, 
in fact, were pledged or encumbered in those pools.
    On September 12th, 3 days before the bankruptcy, Lehman 
announced that it had over $40 billion in its liquidity pool. 
In point of fact, $40 billion of that liquidity pool was not 
liquid.
    Lehman was able to do this in part because there was no 
definition of what should be included in a liquidity pool. The 
SEC had one definition, looked at the liquidity pool that 
Lehman had, and determined that things should not be in there 
and did nothing about that. The Fed observed billions of 
dollars worth of assets which they did not believe should be in 
the liquidity pool, said nothing to either the SEC or the 
public about that, taking the position that they were not the 
regulator. So the public was not told anything about the fact 
that the pool was significantly impaired. Literally hundreds of 
millions of shares of stock traded without that information 
being public.
    The auditors looked at the pool, but they only looked to 
see what the numbers were, not what was in the pool itself. 
They said that role was the role that the regulators had. So 
among the three of them, no one took any responsibility for 
that pool.
    So what are the lessons to be learned with regard to the 
auditors? Lehman's collapse and misleading disclosures offer a 
tragic example of silo mentality with no one facing 
responsibility. The only consistent story I heard from among 
the regulators and the auditors is it was not their job. 
Lehman's senior executives asserted they were not responsible 
because they relied on the auditors and the auditors' opinion 
and other executives. The auditors said they were not 
responsible because they relied on executives and the lawyers. 
And the lawyers said that they relied on the executives. Who 
did the public get to rely on?
    I have identified several areas--my time is gone here, but 
several areas where we think improvement can be made, but that 
is what we found.
    Chairman Reed. Thank you very much, Mr. Valukas.
    Ms. Fornelli.

 STATEMENT OF CYNTHIA M. FORNELLI, EXECUTIVE DIRECTOR, CENTER 
                       FOR AUDIT QUALITY

    Ms. Fornelli. Thank you, Mr. Chairman. My name is Cindy 
Fornelli, and I am the Executive Director of the Center for 
Audit Quality. I appreciate very much the opportunity to 
testify today on the role of the accounting profession in 
preventing a future financial crisis. This is a very important 
topic for all of us who are committed to protecting investors 
and maintaining confidence in our capital markets.
    The financial crisis fundamentally was an economic and 
liquidity crisis driven by a systemic breakdown in risk 
management practices at many levels. As we heard from the first 
panel in their oral and written testimony, everybody agreed 
that this was not a crisis caused by auditing or anything. 
Nevertheless, auditors, like all participants in the capital 
markets, do have a responsibility to examine the lessons 
learned to see what more they can do to protect investors.
    The financial statement audit is a robust process which 
looks at a point-in-time snapshot of a company's financial 
position and results as of the end of a fiscal year. The audit 
provides reasonable assurance that the financial statements 
taken as a whole are fairly presented in accordance with GAAP.
    Auditors can and do provide warning signs. In October 2007, 
when liquidity began to evaporate, the profession's response 
was to focus even more closely on appropriate fair value 
measures. The CAQ published three white papers on the auditor's 
assessment of fair value measurements in illiquid markets as 
well as other audit issues relating to the fluctuating market 
conditions. It is widely recognized that the papers enhanced 
consistency, skepticism, and professional judgment by auditors 
and clarified the accounting for these instruments. In fact, 
the magnitude of writedowns of asset values at the end of 2007 
generated enormous pressure to suspend fair value accounting. 
And you may well remember that the profession stood shoulder to 
shoulder with investors to defend fair value accounting.
    Investors understand that the true value of the audit likes 
in the extensive amount of work that is performed in order for 
the auditor to issue an opinion. While investors greatly value 
the audit report itself, they increasingly want it to be 
supplemented with information about the quality of financial 
reporting at the company and the scope and quality of the 
audit.
    We support the PCAOB's consideration of changes to the 
auditors' reporting framework. The CAQ has suggested a number 
of areas where the auditor's report could be enhanced. These 
range from providing additional information relating to a 
particular audit's scope and procedures to providing assurance 
in connection with management's discussion and analysis.
    There is still more, though, at issue, and that is the 
broader question of whether and how the role of the auditor can 
evolve. The CAQ convenes and collaborates on key policy issues 
with all stakeholders that have an interest in financial 
reporting. We have done this successfully on a number of 
instances, most recently advancing the deterrence and detection 
of financial reporting fraud.
    Our governing board has been thinking for some time about 
the same questions posed by you and the Subcommittee. So in 
January, it agreed to convene the full range of stakeholders 
again, this time to discuss how the role of the auditor could 
evolve to better serve the needs of investors.
    Some of the issues we plan to raise include identifying the 
information most needed by investors and who can best provide 
that information. We also plan to explore the potential for 
providing early warning signals about business risks, assurance 
around nonfinancial disclosures in annual reports, and 
disclosures made by management outside of the annual report.
    Our hope is that these discussions will expose stakeholders 
to these potentially paradigm-changing issues, encourage hard 
thinking around the cost/benefits of various proposals, whether 
they might require modification to current standards and 
regulatory frameworks, and hopefully to find consensus. 
Certainly today's hearing will help inform our discussions.
    Any changes to the role of the auditor should reinforce, 
not undermine, the responsibilities of auditors, CEOs, CFOs, 
and audit committees to assure the integrity of information 
that is provided to our investors.
    In summary, the public company auditing profession already 
is engaged in a dialog to determine whether more could be done 
with policy makers and regulators here and abroad. I feel 
confident that these efforts will benefit investors and other 
users of financial information and maintain confidence in our 
capital markets.
    Thank you for your time, and I would be happy to answer any 
questions you may have.
    Chairman Reed. Thank you very much.
    Mr. Quaadman, please.

   STATEMENT OF THOMAS QUAADMAN, VICE PRESIDENT, CENTER FOR 
   CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER OF COMMERCE

    Mr. Quaadman. Thank you, Chairman Reed, and thank you for 
the opportunity to testify before you today.
    Businesses need and want to have strong financial reporting 
policies. In our view, financial reporting has been in crisis 
before, during, and after the financial crisis. What is best 
indicative of this problem is the explosion of restatements 
over the last 10 years. While that number has been going down 
from historic highs, the number of restatements today are still 
far above what has been normal in the past. In fact, at the 
height of the restatement bubble, 10 percent of financial 
statements in the United States had to be restated. In fact, if 
the American industry was to have a 10-percent failure rate, 
the current financial crisis would be merely a walk in the 
park.
    The fair value crisis was actually a microcosm of the 
problems in financial reporting. There was a flaw within the 
fair value standard that did not allow for the appropriate 
valuation of assets in an inactive market. Because of that 
there was a lack of confidence by all parties within financial 
reporting, and it is important to understand as well that 
financial reporting is actually a three-legged stool made up of 
accounting, auditing, as well as regulators.
    There was an inability for FASB to have dialog and broad 
outreach during the fair value crisis with all these 
stakeholders. This allowed for the flawed standard to continue 
for a period of time, and it also provided for an exacerbation 
of the problems that were streaming throughout the economy.
    As a result, we went to FASB to try and seek to have the 
problem corrected. We also went to the PCAOB because the flawed 
financial information on accounting, of course, at some point 
has to be audited. At that point we were told by the PCAOB it 
was effectively not our problem.
    We also went to the regulators because of this because 
obviously that financial information was also being used to 
establish capital standards and requirements, and we received a 
similar reply.
    Simply put, the era of ``not my problem'' has to end.
    As Leslie Seidman talked about, we are engaged in the 
convergence projects of accounting standards. This is the most 
radical and bold rewriting of accounting standards and will set 
our financial reporting policies for the next 25 years or so. 
We have been strong supporters of that, and, in fact, with 
eight other trade associations, we created a coalition called 
FIRCA to ensure that there was appropriate input in those 
projects to avoid the problems that had occurred with fair 
value. That dialog--and I have to say that Leslie and Seidman 
and Jack Brennan, the head of FAF, and Jim Kroeker have gone an 
awful long way to ensuring that there is appropriate dialog 
from all stakeholders in that, and that dialog has actually led 
to very constructive changes that have solved some very serious 
problems. However, we have to ensure that those projects get 
done right and not just done by an arbitrary time deadline.
    Additionally, we have to ensure that those accounting 
standards are auditable before they are implemented. 
Additionally, regulators have to understand what the interplay 
between those accounting standards are with regulatory 
standards. And as we sit here today, as you very well know, our 
financial regulators are engaged in the most drastic rewriting 
of our financial regulations because of Dodd-Frank. We have to 
understand--and I think hedge accounting is the best example of 
that, of how an accounting standard could actually potentially 
undo what those regulators are doing.
    So, with that, we have proposed--which is in our 
testimony--a ten-point plan to shore up financial reporting and 
to put those policies on a strong footing for the next 
generation. We believe that FASB and the PCAOB should abide by 
the Administrative Procedures Act and that their advisory 
committees follow FACA, which is Federal law. We believe that 
the standard setters of transparency should be transparent in 
their processes and also follow an orderly process to establish 
standards. We believe that there should be a formal pre- and 
post-implementation review process, that there should be a 
financial reporting forum made up of regulators, standard 
setters, investors, and businesses to identify and try and 
solve midterm and long-term accounting problems. This was 
actually in the House-passed financial regulatory reform bill. 
It did not make it through Dodd-Frank.
    We believe that materiality for investors, which is a 
recommendation from the CIFiR report, should be a trigger for 
financial restatements. We believe that the PCAOB should have 
business roundtables as well as a business advisory group to 
understand how businesses or investors actually use investment 
products in everyday business activities, such as derivatives; 
that the PCAOB should have an audit advisory group. Judge 
Sporkin at the end of the last Investor Advisory Group meeting 
said that there should be an auditor at the table, and we do 
not think that one-sided conversations are good.
    We believe that there should be--that liability issues 
should be addressed, that there needs to be a mix of auditors, 
both large to small, because--just as we need to have large to 
small financial institutions. We believe that there should be 
global standards for both accounting and auditing.
    And, finally, in closing, we also believe that there should 
be less reliance on prescriptive rulemaking. If we want to have 
the auditors calling balls and strikes, which they should be 
doing, they should be given the judgment to do so.
    With that, I would like to close and welcome any questions 
that you may have.
    Chairman Reed. Thank you very much.
    Mr. Turner, please.

     STATEMENT OF LYNN E. TURNER, FORMER CHIEF ACCOUNTANT, 
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Turner. Thank you, Chairman Reed, and I would like to 
thank Ranking Member Crapo as well for holding this hearing. It 
is an important hearing.
    I have been listening to the dialog, the testimony this 
morning, including your questions, Chairman Reed, and it 
strikes me because the questions you aptly asked about why 
weren't there any warnings or why was this allowed to go on, I 
have been hearing in similar hearings in this building and 
across the way for 26 years now, since 1985, hearings on ZZZZ 
Best, on savings and loans, on derivatives, on the corporate 
scandals, and now this crisis. And the questions have not 
changed. I think Congress has aptly over those two to three 
decades kept asking the questions. And what has also remained 
the same is the problem. We never seem to get the problem 
fixed.
    I have heard the FASB this morning come back and say here 
is how we operate and here are our processes, and the SEC say 
the same. If you had been in the hearings 25 years ago, you 
would have heard almost the same testimony.
    What we are missing, it seems to me, after listening to 
everyone today, is there has been a failure of the groups to 
really go back and do some retrospective look at what in that 
process the FASB or the SEC or the PCAOB has that did not work, 
and that is the piece that we did not hear this morning.
    I would probably disagree with most of the comments the 
chamber made this morning, but they do raise some questions, 
and I think we probably both agree we would like to get to a 
good answer, we would like to get to transparency for 
investors. And I doubt that--I am probably the only investor on 
either panel today serving as a trustee on a $40 billion fund 
that manages assets for about a half billion dollars. I will 
give my remarks of my own today, but it seems that if the 
system had worked as intended, as everyone described it this 
morning, it is even more scarier that we have not heard, you 
know, what was wrong with that system.
    So, with that, I think shortcomings have been exposed at 
the FASB. They consistently over those two to three decades 
have failed to issue timely standards that work. I personally 
do not think the fair value standard was flawed, and I thought 
that the efforts of the Center for Audit Quality and investors 
on that was right on. I do not think it was a problem of 
valuation as much--or the standard as much as it was people 
failing to report to us as investors the losses that they had 
incurred.
    I note the Federal home loan bank, for example, testified 
that the standard was terrible; they were only going to have 
$14 million worth of loses, then later sued people for $3 
billion worth of losses. It seems like it was not the standard. 
It was the internal accounting that was the problem. But 
clearly--and as you have noted in letters in the past, the off-
balance-sheet thing did not work. Congress, as you aptly noted, 
said it was a problem. FASB did a new standard after Enron. 
Shortly after that, at a research firm that I was running, we 
issued a report that said the new standard absolutely would not 
work, and as we now know, it did not work. Yet the FASB did not 
change.
    I think the SEC has probably not done the oversight it 
needed to do. You mentioned some of the lack of disclosure that 
was identified in the Valukas report. That is certainly 
troubling. And there is a role here for audit committees as 
well, as we have seen from some of the FCIC reports coming out 
of the financial institutions. It looks like the audit 
committees were not engaged as they should have been.
    So what do we do about it? I think as Ranking Member Shelby 
has said, and said back in 2009, I think each of these 
institutions, perhaps the GAO, need to be called upon to do an 
in-depth, retrospective review, not unlike what the IMF has 
recently done, and issue a report to the public saying, OK, how 
did we end up where we were and what went wrong. Because the 
one thing we know is something went wrong here, and seriously 
wrong, and cost, as you noted, trillions of dollars to hundreds 
of Americans.
    We also need to turn around and implement recommendations 
that a very distinguished committee put together by Treasury 
Secretary Paulson at the time called the ACAP Committee. They 
issued a number of recommendations to the auditing profession, 
to the PCAOB and the SEC. We have now been sitting on those for 
2-1/2 years without any results whatsoever. They address some 
of the issues in terms of communication that go back to that 
first hearing back in 1985 I was at and have never been 
addressed.
    It seems like after 2-1/2 decades it is reasonable for us--
I know it may be a rush, but it is probably reasonable for us 
to be able to say we would like to see some results here. And 
so I think those ACAP recommendations need to be looked at.
    I think the SEC does need to get serious about enforcement. 
I know the Chamber of Commerce has always been a supporter of 
strong enforcement. And I think when you have strong 
enforcement, you can have a reduction in regulation almost. And 
I do not necessarily think that is a bad thing, but when we 
look at the executives at Lehman, we look at an excellent 
report I have read from Mr. Valukas on the Lehman thing, we see 
no prosecution there. We see no prosecution at Merrill. We see 
no prosecution of the top people at Bear Stearns. And you can 
go on and on.
    I think as the other Senator noted, people in America are 
asking, Where are our watchdogs here? What is the SEC? And is 
the SEC a watchdog or a lapdog?
    To that end, there is the issue out there of funding, and I 
think we have shortchanged the SEC for the last two decades on 
funding. I know that is being debated now. It is not an issue 
of balancing the budget because we as investors pay those fees, 
and we as investors have never said that we were not willing to 
pay those fees. And so I think it is time once and for all to 
finally provide the SEC and Chairman Schapiro with the 
resources she sorely needs to do the job. If we do not do that, 
then the one thing about the watchdog, the law enforcement 
agency, is we know that they will be in handcuffs.
    Thank you.
    Chairman Reed. Thank you very much, Mr. Turner. Thank you 
all for very insightful testimony.
    I am going to begin with Mr. Valukas and pose the same 
question that I posed initially, the threshold question of, you 
know, why was there not an adequate warning. Let me sort of 
preface that by my understanding--this goes back to a very 
brief legal career. An accountant, an auditor that walked into 
a board or management and said, ``We have problems about giving 
you an unqualified opinion,'' had huge leverage in terms of 
producing change, real change. And it appears--and not just 
since--I want to emphasize you have done an excellent report on 
Lehman, but we could go and look at many other financial 
institutions that failed with clean reports, you know, the ink 
still not dry. So what dynamic was there? And, in fact, I must 
say it is rather discouraging to hear you sort of say the only 
consistent response was, ``That is not my job, that is not my 
job, that is not my job.'' Maybe it is, you know, beginning my 
life in the army where everybody assumed it was their job 
regardless of who officially was responsible. But your comment, 
and then I will ask everyone, because I think this is a 
critical threshold question, because if we do not kind of 
understand--not every detail but what were the incentives, the 
disincentives, what can we do to fix it. So I will start with 
you, Mr. Valukas, please.
    Mr. Valukas. Your comment was spot on. If the auditors had 
walked into the board of Lehman Brothers and said, ``Lehman is 
engaging in $50 billion worth of off-balance-sheet 
transactions, the sole purpose of which is to improve their 
leverage numbers because they are concerned about public 
perception,'' those transactions are reversed 5 days after the 
close of the published opinion, I have no doubt that that--and 
we cannot abide that. I have no doubt that those transactions 
would have ended as of that moment and/or, alternatively, they 
would have written a disclosure statement which would have 
included it, which would have obviated the reason for the 
transactions in the first place. The whole idea was to conceal 
that that is the way they were reducing the leverage.
    So an auditor threatening a public company with something 
other than a clean report has enormous leverage. I represent a 
large number of corporations in the board room. Everybody looks 
to see what the auditor is going to say. So the auditor in one 
sense controls the entire process.
    In this situation, the auditor and their able 
representative took the position that the only thing they were 
required to review was the theory behind the practice, not the 
practice itself, that they had no responsibility for 
determining the volume of Repo 105s or the timing of Repo 105s 
or the purpose of Repo 105.
    Simple questions we--this was no great mystery. There were 
at least a dozen executives within Lehman who we interviewed 
who said the purpose of Repo 105 is the following, and this is 
what we are doing, and the e-mail traffic reflected it. So 
there was no shortage of information. The auditors, in fact, 
only interviewed one person who claimed they did not have 
information about it. The auditors at the time they did that 
interview knew that there had been $50 billion worth of 
transactions. But they pointed to various aspects within the 
accounting rules which relieved them of the responsibility of 
having to do anything further than to check the theory behind 
the practice and not how the practice was being used.
    It seems to me a simple question that someone ought to put 
on their auditors is on their checklist: Are there any 
transactions the purpose of which is to dress up the balance 
sheet? If so, what are they? What is the volume? And we need to 
disclose that to the audit committee. That would go a long way 
toward ending the practice, because the executives knew what 
they were doing and they did not really conceal it.
    Chairman Reed. Let me just ask a follow-up question. 
Senator Hagan made reference to regulatory arbitrage. I seem to 
recall--and please correct me if I am in error--that part of 
what they did was get opinions from British attorneys because 
there was a British subsidiary, and that under British 
accounting rules this theoretical approach was appropriate. Am 
I misconstruing that?
    Mr. Valukas. No. You are absolutely accurate. They could 
not get an opinion from U.S. counsel that a Repo 105 which 
qualify as a sale under U.S. law. They were able to get an 
opinion from reputable counsel in England that it would qualify 
under British law, so what they would do is transfer the 
assets, in essence a wash sale, to the British subsidiary and 
transact the repo transactions in that subsidiary. It was a 
consolidated balance sheet, so it was all done under GAAP, but 
that was the manner in which they were able to do it.
    Chairman Reed. I guess the final question on this topic, 
Mr. Valukas, is: Are you confident from what you have heard 
today that those simple sort of changes, like the checklist or 
the rules that basically require--and not just auditors but 
also lawyers. Apparently at least the United States lawyers 
were nervous enough about this that they were not going to sign 
anything--are going to be adopted by the FASB and enforced by 
the PCAOB?
    Mr. Valukas. I am not sufficiently qualified to answer 
that. I have not been following that. But I----
    Chairman Reed. That is a wise response.
    Mr. Valukas. But I would suggest one thing, and that is 
that the default should not be immateriality. It should be 
transparency. And that to me is a mind-set, that, you know, we 
seek to find something to be immaterial rather than going 
behind it and suggest that transparency is critical. That is an 
issue, it seems to me, that those boards need to wrestle with 
and come up with some clear answers.
    Chairman Reed. Thank you very much.
    Ms. Fornelli, please, your comments.
    Ms. Fornelli. Well, as we heard Ms. Seidman and Mr. Kroeker 
talk about, the FASB and the SEC have addressed these 
accounting and disclosure issues. They have got rules that are 
in the process of being implemented, and I think with the 
design toward making sure that--or helping to enhance the 
transparency to investors. And so transparency to investors is 
the primary goal, and I think that is well underway.
    Chairman Reed. Thank you.
    Mr. Quaadman, your comment, please.
    Mr. Quaadman. Sure, just a few thoughts on those very good 
questions that you raised. A couple things.
    One is, you know, there is, number one, the tryer of fact 
in the Lehman's case has not actually made a decision, so I 
think there is still some information that needs to come out 
there. And I think there is also a lag time between the last 
audited financial reports in that case and the final crack-up 
in Lehman. I just raise that because I think the situation 
between April 2008 and September 2008 was obviously different. 
From September 10th to September 15th could have been radically 
different as well.
    I do believe that regulatory arbitrage is a problem. I do 
believe that having international standards for both accounting 
and auditing does start to get at that. But I think it is also 
important to understand as well--and I was happy to hear that, 
you know, the PCAOB is doing some work on what the role of the 
auditor is, which I know that CAQ is doing as well. But there 
is also a difference between auditing financial information and 
actually strategic decisions. Because I think if you look at 
some people in the financial services community, they were 
looking at economic situations and making radically different 
strategic decisions. Some of them failed. Some of them 
survived.
    So I think it is important to understand that the auditor 
does not necessarily pass judgment on strategy and risk but is 
focused on the financial statements.
    Chairman Reed. Mr. Turner, your comments. You have, I 
think, alluded to some of these comments, but please go ahead.
    Mr. Turner. Thank you, Chairman Reed.
    When I step back, this is one where I think you have to get 
back out of the trees, and it is a very simple. If the auditor 
is right that the accounting is correct, then we have got a 
seriously flawed accounting standard. To turn around and say 
you can take stuff off your balance sheet at the very end of 
that period, dress up your balance sheet, make it look better 
than what you really are, and then 5 days after reverse it and 
say that is OK, I do not think it takes an accounting degree to 
figure out, and you do not need to be a business strategician. 
This is a business strategy. This was a scheme and device. I 
have been an executive in a couple businesses. This is not 
strategy. This is nothing to do with business strategy. This is 
how to mislead your investors, your owners of your company. It 
is that simple. And if the accounting was correct, then we have 
got an accounting standard setter that we got big problems 
with.
    I personally think Mr. Valukas is right with the use of the 
words ``colorful claims.'' Some may say that color is black and 
white, and, in fact, if someone knew that someone had gone 
hunting for an opinion in the U.S., could not get it, and then 
had to go and find one from the Brits, that in and of itself 
tells you from a common-sense perspective this was not a good 
thing that was going on. And to think that the very people that 
we have to rely on for confidence in the numbers was turning 
around and, without giving us any warnings, saying that was OK, 
regardless of how the tryer of fact turns out, that is very 
troubling to me as an individual, as an investor. So I think it 
is very problematic.
    Do we have it fixed? The FASB is working on some stuff. We 
will see if that standard works. But I think Mr. Valukas hit on 
what needs to be done and has not been done, and that is, you 
cannot hide behind materiality if something is not transparent. 
And the FASB has for years been urged to adopt a rule that says 
if additional disclosure is necessary to keep the financials 
from being misleading, you need to make it. And the FASB has 
constantly refused to put that standard in place, and until we 
put that standard in place, as Mr. Valukas just urged, we are 
going to have a problem.
    Chairman Reed. Thank you very much.
    Let me ask a question about some of the recommendations or 
suggestions or comments made by the previous panel. Mr. Doty 
testified, ``It is troubling to me that we do not see firms . . 
. going back and performing more work to address the 
significant audit deficiencies identified by inspectors.'' And, 
again, please feel free to correct me, but my recollection is 
that in every audit there are recommendations even if the audit 
is given unqualified, but there are specific concerns addressed 
typically. I think that is accurate. And what Mr. Doty seemed 
to be saying is a lot of these, you know, helpful hints, if you 
will, are not being followed through.
    Is that something you would agree with? And is your group 
trying to encourage more sort of proactive remediation?
    Ms. Fornelli. Well, Mr. Chairman, the Center for Audit 
Quality and the audit profession is very focused on audit 
quality and trying to continuously improve audit quality. And 
so the system of oversight that was put into place by Sarbanes-
Oxley is a very robust one and one that we very much respect 
and support. And part of that system, of course, is the 
inspection process, and the audit process, and I would say the 
inspection process as well, is one of continuous improvement.
    So we take very seriously the findings that the PCAOB has. 
The firms work very closely with the PCAOB to understand where 
the deficiencies may lie and then work to improve on those and 
to implement them. And so I know this is something that the 
firms take very seriously, and we will continue to work with 
the PCAOB and our member firms.
    Chairman Reed. Just let me follow up. With respect to the 
comment that Mr. Turner made that there should be a specific 
guidance to disclose information if, in fact, it is necessary 
or that it would give a more accurate picture of the status of 
the company, what is your view on that type of proposal?
    Ms. Fornelli. Well, as Ms. Seidman stated, they work very 
closely, and I think they have been doing a much better job 
lately of working with a whole constituency of stakeholders as 
they go about setting their accounting standards. And so I 
think that is very important to get that wide range of input, 
and we will continue to be part of that process.
    But, again, the process that was put into place by 
Sarbanes-Oxley where you have these counterbalances--I think 
that is how Chairman Doty referred to them--that you have got a 
strong audit committee, you have got a strong, independent 
auditor, you have management who is responsible for preparing 
those statements, and then also a rigorous inspection and, if 
needed, enforcement program is the counterbalance to some of 
these issues that we are talking about.
    Chairman Reed. Let me also bring up another suggestion Mr. 
Doty made, which is that under Sarbanes-Oxley the PCAOB is 
restricted from public disclosure of its deliberations, of its 
disciplinary proceedings, and this, as he points out, actually 
raises the question that there could be a company that has 
already been if not sanctioned, at least a finding has been 
made, but still operating in the public without the public 
having any knowledge of that. Is that something we should move 
for, a more open process? Mr. Quaadman, do you have----
    Mr. Quaadman. Sure. Thank you for asking that question. You 
know, Lynn and I do agree; the Chamber of Commerce does believe 
in strong enforcement.
    You know, just a couple thoughts in that regard. The 
current procedures put in place by Congress in Sarbanes-Oxley--
and actually it is very analogous to similar procedures with 
the Securities and Exchange Commission, other agencies, 
including the Federal Election Commission. So I think if there 
is going to be more openness, I think there should be a debate 
about that, because I think some of what we have to look at 
here is are we going from a system that allows for innocent 
before guilty to shifting to a system of guilty before being 
proven. And if we are going to go to a system like that, what 
are the impacts going to be on investors? Because if you are 
going to have ten proceedings and one of them leads to a 
finding that is going to lead to more enforcement, what do you 
do with the other nine? It is the old saying of, you know, 
where do I go to get my reputation back.
    So I think we have to have a debate about that and really 
understand what the potential downsides are for that with 
investors, and also, I think we also need to ask the question 
as well, is there a reason we want to single out the auditing 
community from other financial institutions and even elected 
officials with the disciplinary proceedings they would have to 
go through in similar circumstances.
    Chairman Reed. Mr. Turner or anyone else have a comment on 
the proposal that would be a much more open and transparent 
process in which a company was being evaluated by the PCAOB?
    Mr. Turner. There are two aspects to that. Currently, and 
since 1989, the SEC has made its enforcement actions against 
professionals open. The SEC adopted that rule about the time I 
went to it the first time, in 1989. That has served, I think, 
the public very well, and there is no reason, I think, to have 
a difference between what has worked well for the SEC and what 
is currently not working very well for the PCAOB.
    What I do know from talking to people not only within the 
PCAOB but outside amongst attorneys is the fact that these 
cases are kept under wraps and quiet is having a detrimental 
effect in that they are causing the auditing firms to drag out 
the proceedings as long as they possibly can. I think some of 
that would be mitigated--in fact, I think a lot of that would 
be mitigated with public hearings. And you do not make it 
public until you have gone through all your investigation and 
you have got a good reason for cause. So the rights of people 
need to be protected, as you would know, Chairman, and that 
process that the SEC has does protect those rights very 
carefully. So I think that has worked.
    The other piece of it, though, is the PCAOB--and there was 
a good case just this last week. The PCAOB has also kept from 
investors which companies were being audited where the audits 
did not get done right. And, of course, we quite often vote on 
auditors each year, whether or not to reappoint them.
    If the PCAOB knows that an audit has not been done right 
and there are problems and even cites it in a report but keeps 
it confidential from us, that is troubling as well, and that is 
occurring today. We recently have seen a situation where people 
were able to match it up, and the company acknowledged it, 
where the auditor, in fact, failed to get adequate audit 
evidence on a very significant item in the audit. I think we 
ought to be on top of that when we decide whether or not to 
reappoint a particular auditor. So I think that needs to be 
made public, and people need to quit withholding that 
information from us as well so we can make informed decisions 
rather than flying in the dark.
    Chairman Reed. Ms. Fornelli, do you want to comment?
    Ms. Fornelli. Certainly, I would be happy to. Mr. Chairman, 
there is a process now and a mechanism now for the disclosure 
of these proceedings, and that is through the SEC. So there is 
that valve there available.
    Also, I would point out in the Sarbanes-Oxley Act it was 
set up so that the inspection reports, a portion of those are 
made public, so the public does have some insight into some of 
the issues that would be flagged in the inspections. So there 
is some transparency, and we do not see that with respect to 
the inspections of mutual funds or broker-dealers or even 
banking financial institutions.
    Chairman Reed. Thank you. Well, I want to thank you all for 
very thoughtful, obviously well-prepared testimony that has, I 
think, provided us a great deal of insight. I think it is also 
good to emphasize that once again this is an issue not specific 
to one auditing firm or to one company, but this unfortunately 
was a systemic crisis of multiple computers and multiple firms. 
And what we are trying to do is avoid such a crisis by 
thoughtful rules.
    And the other aspect, too, I just have to say is that--you 
know, and again this is a reflection going back--you know, we 
felt a sense of accomplishment and I maybe dare say self-
satisfaction that after the Enron problem we did enact a 
provision we thought was just this soup-to-nuts direction to go 
ahead and take care of these off-balance-sheet transactions, 
and then to sort of begin to probe in 2008 and then at the end 
of 2008 to discover that this was one of the major problems 
with a major finance institution who essentially had to pull 
back billions of dollars worth of transactions on their books 
and then discover that it took so long for the rules to be 
written, the guidance to be given, I think another important 
lesson of this process. And, you know, Mr. Quaadman has made a 
very good point about the need to do these Dodd-Frank 
regulations. Part of this is getting good regulations done with 
the notion that they can and will be improved over time, but 
searching for the perfect regulation for 6 years usually ends 
up with another bigger problem occurring. So that is just a 
thought.
    Again, thank you very much. We will ask my colleagues to 
provide questions by Friday, and we would ask you for answers 
as quickly as possible.
    Thank you very much, and the hearing is adjourned.
    [Whereupon, at 11:32 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
                  PREPARED STATEMENT OF JAMES R. DOTY
          Chairman, Public Company Accounting Oversight Board
                             April 6, 2011
    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, thank you for the opportunity to appear before you today 
on behalf of the Public Company Accounting Oversight Board (PCAOB or 
Board) to testify on the role of the accounting profession in 
preventing another financial crisis.
    I look forward to discussing with the Subcommittee the role that 
the PCAOB plays in protecting investors and fostering confidence in our 
securities markets. I joined the Board on February 1, 2011. Many of the 
achievements and initiatives I will describe to you were the work of, 
or begun by, my predecessors on the Board as well as the PCAOB staff. 
The PCAOB remains actively engaged in these and many new initiatives to 
protect the investing public by enforcing high quality audits.
I. Introduction
    You have asked me to address three questions: Did the accounting 
profession perform as expected leading up to and during the financial 
crisis? What, if any, improvements have been made or should be made by 
the U.S. Securities and Exchange Commission (SEC or Commission), the 
Financial Accounting Standards Board (FASB), or the PCAOB as a result 
of the financial crisis? And what, if any, policy changes should 
Congress consider?
    In general terms, the PCAOB's inspections of audits conducted 
during the financial crisis indicated that accounting firms must do a 
better job of addressing in their audits the risks of misstatements in 
financial statements that emerge as economic conditions change. The 
PCAOB issued a report last fall describing the kinds of audit 
deficiencies the PCAOB identified on audits affected by the financial 
crisis. The PCAOB also issued several practice alerts on various 
auditing risks during the course of the crisis.
    The PCAOB is focused on taking appropriate steps in its inspection 
and enforcement programs in order to improve audit quality and enhance 
protection of the investing public. The PCAOB is also using information 
gained in inspections and investigations, along with information 
received from investors, audit committee members, auditors and others, 
to improve auditing and related professional practice standards to 
improve the quality of audits during periods of economic stress.
    I will discuss each of these points and explain how the PCAOB is 
using the lessons from the financial crisis to improve the quality of 
audits and auditor communications to investors. Finally, I will echo a 
suggestion made previously by the Board of a policy change for Congress 
to consider. It is a legislative change to enhance the PCAOB's 
effectiveness by permitting the Board to disclose its decisions to 
institute disciplinary proceedings to enforce applicable laws and 
standards against registered public accounting firms and their 
associated persons.
II. The Responsibilities of the PCAOB
    More than half of American households invest their savings in 
securities to provide for retirement, education, and other goals. The 
financial statement auditor's job is to protect these investors' 
interests by independently auditing and reporting on management's 
historical financial statements. Reliable financial reporting is one of 
the linchpins on which our capital markets depend. If investors lose 
confidence in financial reporting, they may demand prohibitively high 
returns as a condition of investing or they may withdraw from the 
capital markets altogether. The result would be to make it more 
difficult and expensive to finance the businesses on which our economy 
depends. Moreover, inaccurate financial reporting can mask poor 
business strategies or fraud that, if left uncorrected, may result in 
the misallocation of capital, business failures, and layoffs. Even 
accurate, well-supported financial information does not mean the 
business strategy is good.
    As the accounting scandals related to Enron, Adelphia and other 
public companies demonstrated, auditors can face strong pressures and 
incentives to acquiesce to questionable accounting. The Sarbanes-Oxley 
Act of 2002 (Sarbanes-Oxley or the Act) was passed in the wake of the 
collapse of confidence that resulted from these and other financial 
reporting breakdowns. Title I of the Act created the PCAOB to serve as 
a counterweight to those pressures and incentives. Congress rightly 
determined in 2002 that rigorous, independent oversight was essential 
to the credibility of the auditor's watchdog function.
    Prior to the creation of the PCAOB, public company auditors were 
subject to oversight by their professional association and to peer 
reviews conducted by other auditing firms. Title I of the Sarbanes-
Oxley Act profoundly changed the environment in which public company 
auditors operate by providing for ongoing accountability to the PCAOB. 
The Board exercises that oversight through four basic functions:

    Registration of accounting firms--No accounting firm may 
        prepare, or substantially contribute to, an audit report for a 
        public company that files financial statements with the SEC, or 
        for a broker-dealer, without first registering with the PCAOB. 
        There are currently 2,431 accounting firms registered with the 
        Board. This includes 906 non-U.S. firms and 522 firms that are 
        registered only because they have broker-dealer audit clients. 
        Registered firms must file annual and other reports that 
        provide the Board and the public with updated information about 
        the firm and its audit practice. Contrary to what some believe, 
        mere registration with the PCAOB does not reflect an 
        examination of the firm's audit quality, which does not happen 
        until we inspect.

    Inspection of firms and their public company audits--Since 
        2003, the PCAOB has conducted more than 1,600 inspections of 
        firms' quality controls and reviewed aspects of more than 7,000 
        public company audits. The audit engagements the PCAOB reviews 
        are not selected at random. To make the most effective use of 
        its resources, the PCAOB uses a variety of analytical 
        techniques to select high-risk engagements and audit areas that 
        are likely to raise challenging or difficult issues. \1\ 
        Throughout this rigorous process, PCAOB inspections have 
        identified numerous audit deficiencies, including failures by 
        the largest U.S. and non-U.S. firms. These findings have led to 
        changes in firm auditing processes, and, in some cases, more 
        audit work performed after the fact or to corrections of client 
        financial statements.
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     \1\ The PCAOB devotes considerable effort to collecting, quality 
checking, and analyzing data from public sources, vendors, registered 
firms and internal sources. The PCAOB uses this data to monitor 
financial reporting and auditing risks. The PCAOB's various screening 
techniques combine nonpublic data collected in the inspection process 
with publicly available data to identify those firms, offices, 
partners, engagements, and issues that present the greatest audit 
risks. PCAOB analysts then perform in-depth analysis to provide 
inspectors with actionable intelligence when they go into the field.

    Investigation and disciplinary proceedings--The Board has 
        broad authority to impose sanctions on registered firms and 
        associated persons that have violated applicable laws and 
        standards. The PCAOB has publicly announced the resolution of 
        37 enforcement proceedings. These proceedings include 29 
        sanctions on firms, including 19 revocations of firms' 
        registrations, preventing them from auditing public companies 
        in the future, and 40 sanctions on individuals. Sanctions have 
        also included significant monetary penalties. The announced 
        decisions do not, however, reflect the full extent of PCAOB 
        enforcement activity. Under the Sarbanes-Oxley Act, all PCAOB 
        investigations and all contested proceedings (i.e., cases in 
        which the Board files charges and the respondent elects to 
        litigate, rather than settle) are nonpublic. There are a 
        significant number of matters under active investigation and an 
        additional number in litigation, which may take years to be 
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        resolved.

    The Board closely coordinates its enforcement efforts with the SEC. 
        In certain instances, the PCAOB investigates the auditor's 
        conduct and the SEC focuses its investigation on the public 
        company, its management, and other parties. In other cases, the 
        SEC's Division of Enforcement takes responsibility for an 
        auditor investigation and requests that PCAOB defer to that 
        investigation.

     Establishing auditing, quality control, ethics, 
        independence, and other standards--The Board is responsible for 
        establishing the auditing and related professional practice 
        standards under which public company audits are performed. 
        Prior to the Sarbanes-Oxley Act, public company audits were 
        performed according to standards set by the profession itself. 
        The PCAOB has an active standard-setting agenda, as I will 
        describe later in my testimony.
    All of the Board's responsibilities are discharged under the 
oversight of the SEC. Chairman Schapiro, the Commissioners, and Chief 
Accountant Kroeker have taken a deep interest in the PCAOB's work, and 
I am grateful to them for their support and for the strong working 
relationship they have fostered between our organizations.
III. Auditor Performance Before and During the Financial Crisis
    Through its inspection and enforcement programs, the PCAOB actively 
assesses whether auditors are doing their job appropriately and takes 
action when they are not.
    Neither financial statement audits nor PCAOB oversight are intended 
to assess any company's liquidity structure, capital adequacy or risk 
management, including financial institutions. Nor does the PCAOB set 
accounting and disclosure requirements. That is the purview of the 
FASB, the International Accounting Standards Board, in the case of 
institutions permitted to use International Financial Reporting 
Standards, and the SEC.
    Rather, the PCAOB evaluates whether auditors have done their job, 
which is to make sure an institution's financial statements and related 
disclosures fairly present its results--good or bad--to investors in 
conformity with applicable accounting and disclosure standards. The 
Board is deeply focused on the lack of transparency in financial 
reporting during the crisis and the corresponding effect this had on 
the fairness of our securities markets. The Board is also focused on 
implementing lessons from the financial crisis in audits and our 
programs.
A. Inspections
    The PCAOB's inspection program is the core of its oversight of 
registered firms' public company audit work. The PCAOB's inspection 
staff represents more than half of its staff. In addition, the PCAOB's 
Office of Research and Analysis devotes the majority of its resources 
to support the inspection program. As required by the Act, the PCAOB 
conducts annual inspections of firms that regularly audit the financial 
statements of more than 100 public companies. In 2010, the PCAOB 
inspected nine such firms. Firms that regularly audit the financial 
statements of 100 or fewer public companies must be inspected at least 
once every three years. The PCAOB inspected 245 such firms in 2010, 
including 64 non-U.S. firms located in 20 jurisdictions. Many of these 
non-U.S. firms are affiliated with a global network of firms. They can 
be quite large, measured by number of professionals as well as by 
market capitalization of audit clients.
    Each firm in a global network of firms, including the Big Four, is 
independently owned by the partners in their country. Since each of 
those firms must register separately with the PCAOB, they are subject 
to the same frequency of inspections as any other firm. Substantial 
portions of the audits of many of the largest U.S. companies are 
performed by affiliated network firms, including firms we have not 
inspected.
    In the course of the PCAOB's 2010 inspections, PCAOB inspectors 
reviewed portions of more than 350 audits performed by the nine firms 
subject to annual inspection, and portions of more than 600 audits 
performed by the remaining 245 inspected firms. During 2010, the PCAOB 
inspected aspects of audits for some of the largest public companies in 
the world, including many of the largest financial services and other 
companies with complex financial instruments and transactions and risks 
driven by market volatility. \2\
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     \2\ The Dodd-Frank Wall Street Reform and Consumer Protection Act, 
P.L. No. 111-203 (Dodd-Frank), authorized the Board to establish, by 
rule, a program of inspection of auditors of brokers and dealers. On 
December 14, 2010, the Board proposed a temporary rule that, if 
adopted, would establish an interim inspection program while the Board 
considers the scope and other elements of a permanent inspection 
program. Under the temporary rule, the Board would begin to inspect 
auditors of brokers and dealers and identify and address with the 
registered firms any significant issues in those audits. The Board 
expects that insights gained through the interim program would inform 
the eventual determination of the scope and elements of a permanent 
program. During the interim program, the Board at least annually would 
provide public reports on the progress of the program and significant 
issues identified, but the Board would not expect to issue firm-
specific inspection reports before the scope of a permanent program is 
set. For more information about the proposed interim inspection 
program, see PCAOB Release No. 2010-008 (December 14, 2010).
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    After completion of the inspections field work, PCAOB inspectors 
engage in a dialogue with firms, through written comments, and in 
certain cases, in-person meetings, about audit deficiencies they have 
identified. The PCAOB then issues a report after each inspection. The 
inspection report is not a complete report card on the firm's entire 
audit practice, but rather focuses on areas where inspectors found 
deficiencies. The public portion of an inspection report describes 
matters that inspectors have identified as significant audit 
deficiencies. These findings, presented in Part I of the report, 
generally involve situations in which PCAOB inspectors believe that the 
auditor failed to obtain sufficient evidence to support the audit 
opinion or failed to identify a material departure from generally 
accepted accounting principles. Consistent with restrictions in the 
Sarbanes-Oxley Act, however, the PCAOB does not publicly disclose the 
identity of the companies that are the subject of audits discussed in 
an inspection report.
    Consistent with the Sarbanes-Oxley Act, the PCAOB discusses any 
criticism of or potential defects in a firm's system of quality control 
in Part II of its inspection reports. The Act affords inspected firms 
one year within which to remediate Board criticisms concerning firm 
quality controls. If the Board is not satisfied with a firm's 
remediation efforts, the portion of the report containing the 
discussion of the quality control deficiencies becomes public. The 
Board transmits full inspection reports, including the nonpublic 
portions of such reports, to the SEC and appropriate State boards of 
accountancy. The Board is also permitted to share full reports with 
certain other U.S. and non-U.S. authorities. In addition, the Board 
sends a special report to the SEC when, as a result of information 
developed in an inspection, it appears that financial statements filed 
with the Commission, and on which the public is relying, may be 
materially inaccurate.
            2007-2009 Inspection Cycles
    Last fall, the Board issued a report to inform the public about the 
audit risks and challenges that PCAOB inspectors had found in 
connection with the economic crisis. \3\ That report discussed audit 
deficiencies inspectors uncovered during the 2007 through 2009 
inspection cycles related to the impact of the crisis. Among other 
things, the report described deficiencies relating to auditing fair 
value measurements, especially related to financial instruments; 
impairment of goodwill, indefinite-lived intangible assets, and other 
long-lived assets; allowance for loan losses; off-balance-sheet 
structures; revenue recognition; inventory valuation; and income taxes.
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     \3\ PCAOB, Report on Observations of PCAOB Inspectors Related to 
Audit Risk Areas Affected by the Economic Crisis (Sept. 29, 2010), 
available at http://pcaobus.org/Inspections/Pages/PublicReports.aspx.
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    We have observed that firms have produced internal guidance and 
training to address the deficiencies. They have not, however, been 
consistently applied by individual engagement teams.
    The report does not evaluate the root causes of the crisis. Most 
postmortems to date have pointed to the failure of corporate risk 
management and financial institution liquidity structure or capital 
adequacy as root causes of the crisis. Other contributing factors have 
been cited as well, such as the behavior of the credit rating agencies, 
the role of the Government-sponsored housing finance entities, 
regulatory gaps and failures, and even unintended consequences of 
legislative and regulatory incentives related to home ownership, to 
name just a few.
    The PCAOB has neither the authority nor the resources to look back 
at the crisis with the broader view necessary to develop an informed 
opinion on all of the different factors that caused the crisis. The 
PCAOB has, however, inspected and considered the role of auditors of 
financial institutions and other public companies affected by the 
crisis. As described in our public report, inspectors identified 
multiple instances where auditors failed to perform the work mandated 
by PCAOB standards. Firms must do a better job in adjusting to emerging 
audit risks as economic conditions change so that investors will have 
reliable information about the performance and financial position of 
public companies during periods of economic volatility. The PCAOB 
intends to use these lessons in driving improvements through subsequent 
inspections and appropriate standards setting.
            2010 Inspection Cycle
    Most of the audits that the PCAOB inspected during 2010 were of 
financial statements for fiscal years ending in 2009. The PCAOB staff 
is currently considering firms' responses to the questions and comments 
our inspectors raised, and are preparing draft inspection reports based 
on and reflecting their evaluation.
    Although the PCAOB's 2010 inspection reporting cycle is not yet 
complete, so far PCAOB inspectors have continued to identify 
significant deficiencies related to the valuation of complex financial 
instruments, inappropriate use of substantive analytical procedures, 
reliance on entity level controls without adequate evaluation of 
whether those processes actually function as effective controls, and 
several other issues. PCAOB inspectors have also identified more issues 
than in prior years.
    In any event, the Board is troubled by the volume of significant 
deficiencies, especially in areas identified in prior inspections. The 
PCAOB is working on several initiatives to drive improvements in audit 
quality.
            2011 Inspection Plan
    In 2011, the PCAOB will continue to focus on high-risk audit areas 
posed by the ongoing effects of the crisis and any future similar 
events, including, for example, the financial statement effect of the 
obligation to repurchase mortgages previously sold and mandated 
modifications to certain mortgages at financial institutions.
    The PCAOB also intends to enhance its consideration of root causes 
when PCAOB inspectors find audit deficiencies. As in past years, the 
PCAOB will also continue to press firms to identify root causes of 
deficiencies and address them.
    PCAOB inspectors will also look closely at corrective actions taken 
by firms when inspectors identify problems. A firm's failure to obtain 
sufficient evidence to support its opinion does not mean that the 
financial statements themselves are necessarily misstated. But it does 
mean that corrective actions are required, both to shore up the 
deficient audit as well as to better plan and perform future audits. 
Inspections can only protect investors from audit failures if firms act 
on inspection results. It is troubling to me that we do not see firms 
consistently going back and performing more work to address the 
significant audit deficiencies identified by inspections. Now, I will 
say, we have begun to see some firms going back quite recently, but I 
do not consider this problem to be resolved yet.
    Moreover, my concern is compounded by the fact that we have 
received reports from members of audit committees that firms sometimes 
represent to audit committees that their PCAOB inspection reports raise 
merely minor concerns, typically attributable to documentation of 
procedures they claim--but just can't demonstrate--they performed. 
Therefore, we are exploring ways to encourage the firms to provide more 
faithful reporting to audit committees in the future.
    Inspectors will also continue to examine firms' quality control 
systems to evaluate how they manage audit quality, so as to enhance the 
PCAOB's basis for assessing, in this year and in future years, whether 
that system is appropriately designed and implemented to achieve the 
goal of conducting independent audits that are objective and in 
compliance with applicable standards. To this end, inspectors will 
continue to assess firms' processes and controls in certain functional 
areas related to audit performance, including, for example, a firm's 
monitoring of compliance with auditor independence requirements.
    In addition, the PCAOB plans to expand its examination of the 
quality control mechanisms of large firms that participate in global 
networks. As I will discuss later, the PCAOB's recent settlement with 
five Indian-based registered firms from PricewaterhouseCoopers' global 
network (PW India) highlights the risks inherent in these global 
networks. In particular, inspectors will examine firms' supervision of 
work performed by affiliated firms, including by assessing firms' 
controls over consultations on accounting and auditing standards, as 
well as engagement teams' use and evaluation of affiliates' work. We 
will also encourage firms to identify root causes and address them 
concomitantly throughout their global networks and not just within 
their U.S. member firms.
    PCAOB inspectors will also examine how audit fee pressures might 
affect the conduct of audits. It has been widely reported that audit 
committees are expecting auditors to agree to fee reductions. At the 
same time, economic conditions are adding to the complexity of audits. 
While audit firms cannot be immune to economic downturns, the PCAOB 
will evaluate whether such pressures result in fewer hours being 
devoted to audits, thereby impairing audit quality.
    Lastly, the PCAOB is developing a broker-dealer auditor inspection 
program to comply with Dodd-Frank. We expect to begin those inspections 
in 2011. The PCAOB's Office of Research and Analysis has worked closely 
with Financial Industry Regulatory Authority and the SEC over the last 
year to obtain critical data that will facilitate the broker-dealer 
auditor inspection program. \4\
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     \4\ On December 14, 2010, the PCAOB proposed a rule to establish 
an interim inspection program related to audits of broker-dealers. The 
comment deadline ended on February 15, 2011. The Board is considering 
those comments and expects to finalize the rule in the near future. See 
PCAOB, Proposed Temporary Rule for an Interim Program of Inspection 
Related to Audits of Brokers and Dealers (Dec. 14, 2010).
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B. PCAOB Access to Non-U.S. Registered Firms
    Approximately 260 non-U.S. firms are subject to regular PCAOB 
inspection. To date, the PCAOB has inspected 197 non-U.S. firms in 35 
jurisdictions, including countries where some of the largest foreign 
private issuers--whose securities also trade in U.S. markets--are 
located such as Brazil, India, Japan, Korea, Mexico, and the Russian 
Federation. As I mentioned earlier, in 2010 the PCAOB inspected 64 non-
U.S. firms in 20 jurisdictions. Nineteen of these 64 inspections were 
performed on a joint basis with the local auditor oversight authority 
pursuant to negotiated cooperative arrangements. In each of the joint 
inspections, as well as the other foreign inspections not conducted on 
a joint basis, the PCAOB and its foreign counterpart have been able to 
resolve conflicts of law, sovereignty, and other issues that may arise 
when we are operating in another country.
    It is no secret that we have not been able to inspect all of the 
non-U.S. firms we are required to, though. Approximately 70 firms in 24 
jurisdictions--including in the European Union (EU), Switzerland and 
China--had inspection deadlines in 2010 or earlier that have not been 
met.
    The PCAOB is working hard to reach accords that will allow PCAOB 
inspectors into those jurisdictions: it is one of our highest 
priorities. I am pleased to report that, in January, the PCAOB 
concluded an agreement with U.K. authorities. Based on this agreement, 
the PCAOB is planning joint inspections of two large U.K. firms 
beginning in May.
    In addition, earlier this week, the PCAOB reached an agreement to 
conduct joint inspections with the authorities in Switzerland. We will 
commence joint inspections in Switzerland in May, with the goal of 
inspecting three Big Four affiliate firms by the end of the year.
    The U.K. and Swiss agreements are a significant step forward for 
U.S. investors. They are not ``mutual recognition'' arrangements, but 
arrangements for joint inspections that will enable PCAOB inspectors to 
evaluate audit work in these countries that U.S. investors rely on.
    These arrangements are the first cooperative agreements that the 
PCAOB has concluded since the passage of Dodd-Frank, which amended the 
Sarbanes-Oxley Act to permit the PCAOB to share confidential 
information with its non-U.S. counterparts under certain conditions. 
That amendment removed one of the obstacles to PCAOB inspections 
asserted by the EU.
    We hope that these agreements will serve as a model for cross-
border cooperation with other regulators in the European Union. We 
continue to make progress on this front and are encouraged by our 
discussions with authorities in several jurisdictions. However, the 
negotiations with other EU regulators continue to progress quite 
slowly.
    The PCAOB continues to be unable to conduct inspections in China, 
based primarily on assertions by the Chinese of national sovereignty 
issues. Currently, three mainland Chinese firms are overdue for 
inspection, and inspections of eight Hong Kong firms have been 
commenced but not completed because we were denied access to documents 
relating to operations of their clients in mainland China.
    The PCAOB's inability to gain access to PCAOB-registered firms in 
China is especially troubling given the growth in the number of Chinese 
companies seeking access to capital in U.S. securities markets. Last 
month, the PCAOB issued a research note on trends and risks related to 
reverse merger transactions involving companies from the China region. 
\5\ This note followed a July 2010 staff audit practice alert on 
auditing public companies with operations in China and other 
jurisdictions that accessed the U.S. markets through reverse mergers. 
\6\
---------------------------------------------------------------------------
     \5\ PCAOB, Activity Summary and Audit Implications for Reverse 
Mergers Involving Companies from the China Region: January 1, 2007, 
through March 31, 2010 (March 4, 2011), available at http://
pcaobus.org/News/Releases/Pages/03152011--ResearchNote.aspx.
     \6\ PCAOB Staff Audit Practice Alert No. 6, Auditor Considerations 
Regarding Using the Work of Other Auditors and Engaging Assistants From 
Outside the Firm (July 12, 2010).
---------------------------------------------------------------------------
    There are also significant risks associated with audits of 
operations of U.S. companies in China. For example, we are finding 
through our oversight of U.S. firms that even simple audit maxims, such 
as maintaining the auditor's control over bank confirmations, may not 
hold given the business culture in China.
    If Chinese companies want to attract U.S. capital for the long 
term, and if Chinese auditors want to garner the respect of investors, 
they need the credibility that comes from being part of a joint 
inspection process that includes the U.S. and other similarly 
constituted regulatory regimes. In light of these risks, the PCAOB's 
inability to inspect the work of registered firms from China is a 
gaping hole in investor protection.
C. Enforcement
    The PCAOB has broad authority to impose sanctions on registered 
firms and their associated persons that have violated applicable laws, 
rules and standards. The PCAOB is engaged in several investigations 
relating to audits of financial institutions and other public companies 
affected by the crisis. These investigations, and any contested 
disciplinary proceedings that may result, are confidential under the 
Sarbanes-Oxley Act.
    As an example of the scope of the issues the PCAOB is addressing 
rigorously through enforcement, earlier this week the Board issued a 
settled order against five PW India firms in connection with the audit 
of the financial statements of Satyam Computer Services, an India-
based, multinational IT service provider with securities traded on the 
New York Stock Exchange. The Board's order included a $1.5 million 
penalty against two of those firms for violations of PCAOB rules and 
standards that contributed to the firms' failure to detect an 
accounting fraud by Satyam management. The Board also found that all 
five firms violated the Board's quality control standards. In addition 
to the penalty, the Board (i) imposed significant limitations on the PW 
India firms' ability to accept new clients or issue audit reports, (ii) 
required the appointment of an independent monitor to ensure audit 
quality improvements, and (iii) censured the firms.
    The Board-imposed sanctions are in addition to a $6 million penalty 
and other sanctions imposed on the firms by the Commission. The PCAOB 
closely coordinated its investigation of the PW India firms with the 
SEC. This coordination will continue, as the independent monitor will 
report its findings to both the SEC and the PCAOB.
IV. Auditing Standards
    The PCAOB's standard-setting program responded to the financial 
crisis at various stages by reminding auditors how existing standards 
apply in the context of specific challenges. The PCAOB issued Staff 
Audit Practice Alerts to explain to auditors how applicable 
requirements bear on various issues raised by the crisis. For example, 
in December 2007, the PCAOB staff issued Practice Alert No. 2, Matters 
Related to Auditing Fair Value Measurements of Financial Instruments 
and the Use of Specialists, and in December 2008, the PCAOB issued 
Staff Audit Practice Alert No. 3, Audit Considerations in the Current 
Economic Environment (December 5, 2008). These alerts helped auditors 
to focus on applicable audit requirements. They covered several audit 
topics relevant to the crisis, including auditing fair value 
measurements and accounting estimates; auditing the adequacy of 
disclosures; the auditor's consideration of a company's ability to 
continue as a going concern; and additional audit considerations for 
selected financial reporting areas.
    In light of the Lehman bankruptcy examiner's report, as well as 
deficiencies identified by PCAOB inspectors in connection with the 
auditing of significant unusual transactions, the PCAOB issued Staff 
Audit Practice Alert No. 5, Auditor Considerations Regarding 
Significant Unusual Transactions (April 7, 2010). This alert focused 
auditors on the evaluation of significant transactions that may be 
mechanisms to dress up a company's balance sheet, as opposed to serving 
a valid business purpose.
    In December 2010, the PCAOB issued Staff Audit Practice Alert No. 
7, Auditor Considerations of Litigation and Other Contingencies Arising 
from Mortgage and Other Loan Activities (December 20, 2010), to focus 
auditors on auditing liabilities and related disclosures resulting from 
issues arising from mortgage and foreclosure-related activities. As we 
continue to identify or anticipate new audit practice issues or 
challenges, the PCAOB will continue to issue timely guidance to 
auditors.
    Practice Alerts remind auditors of existing requirements. The Board 
also uses information that it learns in its inspections and from other 
sources to change the underlying auditing standards. In developing new 
standards, the PCAOB casts a wide net to seek input from various 
interested people and groups on ways to improve audits.
    The PCAOB has used insights gleaned from the crisis, including 
information from outside sources and from our oversight programs, to 
develop new standards to address risks that became apparent in the 
crisis, including standards for how auditors assess the risk of 
material misstatements in financial statements. The PCAOB meets 
quarterly with the representatives of the SEC and FASB to discuss and 
facilitate financial reporting and auditing initiatives. The PCAOB also 
is in the process of exploring potential improvements in standards that 
would address, among other things, the content of auditors' reports, 
how auditors evaluate management's estimates of fair values of assets 
and liabilities, and when an auditor should modify their report because 
of going concern uncertainties. These projects and others are described 
below.
A. Risk Assessment Standards
    In 2010, after two rounds of public comment and several public 
meetings with our Standing Advisory Group (composed of investors, 
auditors, financial statement preparers and others), the Board adopted, 
and the SEC approved, a series of eight new auditing standards, 
effective for 2011 audits. These standards address fundamental aspects 
of the audit, including audit planning and supervision, the auditor's 
assessment of and response to the risks of material misstatement in the 
financial statements, and the auditor's evaluation of audit results and 
audit evidence. The standards require the auditor to consider more 
thoughtfully, throughout the audit, the risk of misstatement due to 
fraud. They also require auditors to perform procedures to evaluate the 
completeness and fairness of financial statement disclosures, which are 
critical to providing investors a fair understanding of many matters 
that became particularly important during the financial crisis, such as 
valuation of complex financial instruments.
B. The Auditor's Report
    The auditor's report is the primary means by which the auditor 
communicates to investors and other users of the financial statements 
regarding its audits of financial statements. The form of the report 
has not evolved significantly from the pass-fail model of the early 
years; however, over the years, several committees and groups, such as 
the Cohen Commission, Treadway Commission, and the American Assembly, 
have suggested improvements or changes to the auditor's report. 
Similarly, in 2008, the Advisory Committee on the Auditing Profession 
convened by the U.S. Department of the Treasury (ACAP) recommended the 
PCAOB consider improvements to the auditor's reporting model and 
clarify in the auditor's report the auditor's role in detecting fraud. 
ACAP noted that the greater complexity in financial reporting supports 
improving the content of the auditor's report beyond the current pass-
fail model. \7\
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     \7\ An unqualified opinion indicating that the company's financial 
statements are presented fairly in accordance with the applicable 
financial reporting framework is considered the ``pass'' determination 
in the pass-fail model.
---------------------------------------------------------------------------
    On March 22, 2011, the Board held an open meeting to hear from the 
PCAOB's Office of the Chief Auditor on the results of the staff's 
outreach on a project to take a fresh look at the auditor's reporting 
model. The staff presented views and advice they received over several 
months from numerous in-depth meetings with dozens of people 
experienced in using or preparing audit reports, including investors, 
auditors, preparers, audit committee members, researchers, and others.
    Separately, the Board's Investor Advisory Group (IAG) discussed 
this issue at its March 16, 2011, meeting. At that meeting, the Board 
heard a presentation from a task force of the group's members about a 
survey they conducted to solicit views regarding changes to the 
auditor's report. The group surveyed institutional investors, including 
investment banks, mutual funds, pension funds, hedge funds, and others. 
Both the IAG survey and our staff's outreach underscore that investors 
believe they need more information from the auditor regarding the 
auditor's views on audit risk, management's judgments and estimates, 
and the quality of management's accounting policies.
    The Board's outreach effort, especially at such an early stage in 
the project, was unprecedented. In addition, the PCAOB's open meeting 
to discuss the input received was the first of its kind. The PCAOB 
staff is now preparing a written concept release to describe several 
potential changes for Board consideration and, if agreed, public 
comment.
C. Fair Value
    As noted in the Board's 2010 report on observations from audits 
during the crisis, PCAOB inspectors identified many audit deficiencies 
relating to auditing fair value estimates. In many cases, the 
deficiencies related to insufficient evidence gathered by the auditor 
when using third party pricing sources (e.g., pricing services or 
broker quotes) when valuing financial instruments such as investment 
securities. The largest accounting firms are devoting substantial 
effort to these issues, and we have seen some audit teams do what we 
expect. We are also hearing that the work that is required to validate 
pricing service reports is more than management is doing. To give 
deeper consideration to ways to prevent such deficiencies, the PCAOB 
has organized an ad hoc task force of our Standing Advisory Group to 
include investors, auditors, preparers, broker-dealers, and pricing 
services. Staff of the SEC and FASB will observe this task force. The 
task force's work is expected to inform the Board's development of new 
auditing requirements.
D. Going Concern
    Under the Board's standards, the auditor should modify the report 
if there is a significant doubt about a company's ability to continue 
as a going concern for a reasonable period of time.
    Investors and others have raised questions about why more audit 
opinions expressing substantial going-concern doubt were not issued 
before companies affected by the financial crisis failed (or would have 
failed except for Government intervention). The FASB has a project on 
its agenda that is intended to improve the ability of investors to 
understand the risks and uncertainties about an entity's ability to 
continue as a going concern and to meet its obligations when they 
become due. Such improvements in the accounting standards could assist 
in providing an early warning for investors. The PCAOB is working 
closely with the FASB and the SEC on this matter. If the PCAOB 
determines to issue further guidance in this area, it will be closely 
coordinated with the FASB's efforts. The Board recognizes the 
importance of this subject to investors.
E. Related Parties and Significant Unusual Transactions
    The Board is considering revising its standard on relationships and 
transactions with related parties, including financial relationships 
with executive officers and transactions that are outside the normal 
course of business. As part of that project, the Board is evaluating 
ways for the auditor to gain a deeper understanding of the risk of 
misleading financial statements or disclosures, by considering a 
company's financial relationships with its executive officers and 
evaluating how those relationships might affect management's financial 
reporting incentives. Transactions with related parties and significant 
unusual transactions can pose significant risks of material 
misstatement. Their substance might differ materially from their form. 
They might be structured to achieve desired accounting results 
inconsistent with the underlying economic substance. And they might 
include terms not available in third-party, arm's-length transactions.
V. Policy Changes for Congress To Consider
    Under the Sarbanes-Oxley Act as it exists today, the PCAOB's 
disciplinary hearings--our version of trials and appeals--are 
nonpublic, unless the Board finds there is good cause for a hearing to 
be public and each party consents to public hearings. \8\ The auditors 
and audit firms charged with violating applicable laws, rules or 
standards have little incentive to consent to opening the case against 
them to public view and in fact, none have ever done so. On the 
contrary, the fact that, absent consent, PCAOB disciplinary proceedings 
are required to be secret creates a considerable incentive to litigate. 
PCAOB disciplinary proceedings remain nonpublic even after a hearing 
has been completed and adverse findings made by a disinterested hearing 
officer, if the auditors and firms do not consent to make the 
proceedings public and opt to appeal. Litigation postpones--often for 
several years--the day on which the public learns that the PCAOB has 
charged the auditor or firm, the nature of those charges, and the 
content of adverse findings.
---------------------------------------------------------------------------
     \8\ Section 105(c)(2) of the Sarbanes-Oxley Act of 2002.
---------------------------------------------------------------------------
    This secrecy has a variety of unfortunate consequences. Interested 
parties, including investors, audit committees, issuers and other 
auditors, are kept in the dark about alleged misconduct, even after a 
hearing and adverse findings. Investors are unaware that companies in 
which they have invested are being audited by accountants who have been 
charged by the PCAOB. In addition, unlike the authority the Exchange 
Act provides the Commission in its administrative proceedings, the 
PCAOB has no authority, while litigation is pending, to issue temporary 
cease-and-desist orders in appropriate cases, to prevent threatened 
violations or harm to investors or the public interest.
    This state of affairs is not good for investors, for the auditing 
profession, or for the public at large. It is unlike the disciplinary 
proceedings of other, comparable regulators. Indeed, decades ago, the 
SEC found that nonpublic proceedings in cases against auditors of 
public companies were not in the best interest of investors and opened 
their administrative proceedings against auditors to the public. The 
reasons cited by the Commission for the change included:

    Virtually all other administrative proceedings brought by 
        the SEC (including those against brokers, dealers, investment 
        advisers, and public companies) and all SEC injunctive actions 
        are public,

    Private proceedings create incentives for delays,

    The public and audit professionals are interested in timely 
        disclosure of the standards used to commence disciplinary 
        proceedings (the public and other auditors have a legitimate 
        interest in learning, on a timely basis, the facts and 
        circumstances that have led to the institution of proceedings), 
        and

    Public proceedings are more favored in the law than closed-
        door proceedings.

    These same reasons support the need for public PCAOB disciplinary 
proceedings. The Board, however, unlike the SEC, lacks the authority to 
make its proceedings public through a change to its rules. Investors 
would be best served by similar transparency in PCAOB disciplinary 
proceedings.
    In conclusion, I appreciate the Subcommittee's interest in the work 
of the PCAOB and I look forward to working with you in the future. I 
would be happy to answer any questions.
                                 ______
                                 
                PREPARED STATEMENT OF LESLIE F. SEIDMAN
             Chairman, Financial Accounting Standards Board
                             April 6, 2011
Introduction
    Chairman Reed, Ranking Minority Member Crapo, and Members of the 
Subcommittee, my name is Leslie Seidman and I am the Chairman of the 
Financial Accounting Standards Board (FASB or Board). I would like to 
thank you for this opportunity to participate in today's important 
hearing.
    As the Subcommittee examines the role of accountants and auditors 
in helping to prevent another financial crisis, I thought it would be 
helpful to outline for you the manner in which accounting standards are 
developed. In doing so, I would like to begin by providing a brief 
overview of the FASB and its parent organization, the Financial 
Accounting Foundation (FAF). I also want to be sure the Committee 
understands both the FASB's robust due process and how we remain 
accountable to our stakeholders. Then I would like to discuss some of 
the changes to accounting standards the FASB has made in response to 
the financial crisis. Finally, I want to update you on several of our 
pending convergence projects with the International Accounting 
Standards Board (IASB), which address issues related to the financial 
crisis.
The FASB
    The FASB is an independent private-sector organization that 
operates under the oversight of the FAF. For nearly 40 years, the FASB 
has established standards of financial accounting and reporting for 
nongovernmental entities, including both businesses (public and 
private) and not-for-profit organizations. Those standards are 
recognized as authoritative, Generally Accepted Accounting Principles 
(GAAP) by the U.S. Securities and Exchange Commission (SEC or 
Commission) for public companies and by the American Institute of 
Certified Public Accountants (AICPA) for other nongovernmental 
entities.
    GAAP is essential to the efficient functioning of the U.S. economy 
because investors, creditors, donors, and other users of financial 
reports rely heavily on credible, transparent, comparable, and unbiased 
financial information. In today's dynamic financial markets, the need 
for integrity, transparency, and objectivity in financial reporting is 
increasingly critical to ensuring the strength of U.S. capital markets 
and providing investors with accurate and timely information.
    In 2002, Congress enacted the Sarbanes-Oxley Act, which included 
provisions protecting the integrity of the FASB's accounting standard-
setting process. The legislation provided the FASB with an independent, 
stable source of funding. The legislation mandated an ongoing source of 
funding for the FASB from annual accounting support fees collected from 
issuers of securities, as those issuers are defined in the Sarbanes-
Oxley Act.
    It is important to note that although the FASB has the 
responsibility to set accounting standards, it does not have authority 
to enforce them. Officers and directors of a company are responsible 
for preparing financial reports in accordance with accounting 
standards. Auditors provide an opinion as to whether those officers and 
directors appropriately applied accounting standards. The Public 
Company Accounting Oversight Board (PCAOB) is charged with ensuring 
that auditors of public companies have performed an audit in accordance 
with generally accepted auditing standards, which include an auditor's 
analysis of whether a public company has complied with appropriate 
accounting standards. The SEC has the ultimate authority to analyze 
whether public companies have complied with accounting standards.
The Mission of the FASB
    The FASB's mission is to establish and improve standards of 
financial accounting and reporting for the guidance and education of 
the public, including issuers, auditors, and users of financial 
information.
    We recognize the critical role that reliable financial reporting 
plays in supporting the efficient functioning of the capital markets: 
robust financial reporting increases investor confidence, which in turn 
leads to better capital allocation decisions and economic growth. 
Today, as the U.S. economy continues to recover from the financial 
crisis and recession, the FASB remains committed to ensuring that our 
Nation's financial accounting and reporting standards provide investors 
with the information they need to confidently invest in the U.S. 
markets.
    To accomplish its mission, the FASB acts to:

    Improve the usefulness of financial reporting by focusing 
        on the primary characteristics of relevance and reliability and 
        on the qualities of comparability and consistency;

    Keep standards current to reflect changes in methods of 
        doing business and changes in the economic environment;

    Consider promptly any significant areas of deficiency in 
        financial reporting that might be addressed through the 
        standard-setting process; and

    Improve the common understanding of the nature and purposes 
        of information contained in financial reports.

    As it works to develop accounting standards for financial 
reporting, the FASB is committed to following an open, orderly process 
that considers the interests of the many who rely on financial 
information. Because we understand that the actions of the FASB affect 
so many stakeholders, we are steadfastly committed to ensuring that the 
decision-making process is independent, fair, and objective.
The Standard-Setting Process
    An independent standard-setting process is paramount to producing 
high-quality accounting standards, since it relies on the collective 
judgment of experts, informed by the input of all interested parties 
through a thorough, open, and deliberative process. The FASB sets 
accounting standards through processes that are open, accord due 
process to all interested parties, and allow for extensive input from 
all stakeholders. Such extensive due process is required by our Rules 
of Procedure, set by the Board within the parameters of the FAF's 
bylaws. Our process is similar to the Administrative Procedure Act 
process used by Federal agencies for rulemakings but provides far more 
opportunities for interaction with all interested parties. In fact, in 
recent years, we have significantly expanded our ability to engage with 
stakeholders in a variety of ways.
    The FASB's extensive due process involves public meetings, public 
roundtables, field visits or field tests, liaison meetings and 
presentations to interested parties, and the exposure of our proposed 
standards for public comment. The FASB videocasts its Board meetings on 
its Web site; recently, we decided to also videocast our education 
sessions to make it easier for our stakeholders to observe the process 
that precedes our decisions. The FASB also creates podcasts and 
webcasts to provide short, targeted summaries of our proposals and new 
standards so that people can quickly assess whether they have an 
interest and want to weigh in. We have also been proactively reaching 
out to meet with stakeholders, including a wide range of investors and 
reporting entities, to discuss our proposals which helps us to assess 
whether the proposals will lead to better information and also to 
assess the related costs. These interactive meetings allow the FASB and 
its staff to ask questions to better understand why a person holds a 
particular view, which can accelerate the identification of issues and 
possible solutions.
    The FASB also meets regularly with the staff of the SEC and the 
PCAOB. Additionally, since banking regulators have a keen interest in 
GAAP financial statements as a starting point in assessing the safety 
and soundness of financial institutions, we meet with them on a 
quarterly basis and otherwise as appropriate. We also understand 
Congress's great interest and regularly brief Members and their staffs 
on developments.
    In short, the FASB actively seeks input from all of its 
stakeholders on proposals and processes and we are listening to them. 
The Board's wide consultation helps it to assess whether the benefits 
to users of improved information from proposed changes outweigh the 
costs of the changes to preparers and others. Wide consultation also 
provides the opportunity for all stakeholder voices to be heard and 
considered, the identification of unintended consequences, and, 
ultimately, broad acceptance of the standards that are adopted.
    Additional information about the FASB and the FAF can be found in 
the 2010 Annual Report of the FAF, which will be available on the FAF 
Web site later this month.
FASB Oversight
    The FASB's accountability derives from oversight at two levels. 
First, the Board is overseen by the independent Board of Trustees of 
the FAF. Organized in 1972, the FAF is an independent, private-sector, 
not-for-profit organization. The FAF exercises its authority by having 
responsibility for oversight, administration, and finances of the FASB 
and its sister organization the Governmental Accounting Standards Board 
(GASB). The FAF also has responsibility for:

    Selecting the members of the FASB, the GASB, and their 
        respective Advisory Councils;

    Overseeing the FASB's and the GASB's Advisory Councils 
        (including their administration and finances);

    Overseeing the effectiveness of the FASB's and the GASB's 
        standard-setting processes and holding the Boards accountable 
        for those processes;

    Protecting the independence and integrity of the standard-
        setting process; and

    Educating stakeholders about those standards.

    Second, the FASB is also subject to oversight by the SEC with 
respect to standard setting for public companies. The SEC has the 
statutory authority to establish financial accounting and reporting 
standards for publicly held enterprises. For nearly 40 years, the SEC 
has delegated this authority to the FASB. In 2003, the SEC issued a 
Policy Statement reaffirming this longstanding relationship.
FASB Activities
Response to the Financial Crisis
    The financial crisis led to a reprioritizing of the FASB's work. In 
particular, financial market participants and policy makers raised 
questions about:

  a.  Fair value measurement of assets and impairments, especially when 
        markets become illiquid;

  b.  Off-balance sheet risks, particularly those related to 
        securitizations (derecognition) and special purpose entities 
        (consolidation);

  c.  Disclosures about risk; and

  d.  Complexity in accounting for financial instruments.

    Accordingly, the FASB has undertaken projects to improve and 
simplify the accounting standards in each of these areas, which are 
described in further detail below.
            Fair Value Measurement and Impairments
    As the credit and financial crisis deepened and broadened in late 
2008 and early 2009, significant attention was placed on ``mark-to-
market,'' or fair value, accounting, including the effect of applying 
the fair value standard to report the value of impaired securities. The 
controversy reflected, in part, the difficulty of determining the fair 
value of assets or liabilities in illiquid markets. It also reflected 
the concern that the accounting for problem assets held by financial 
institutions, including loans, was ``procyclical'' and may have 
exacerbated the crisis (even though loan losses are generally not 
measured at fair value).
    While such determinations had been required in previous downturns, 
this was the first occasion in which a new standard for determining 
fair value, FAS 157, \1\ was in effect. It is important to note that 
FAS 157, issued in 2006, did not introduce mark-to-market or fair value 
accounting and did not expand the range of items that are required to 
be, or permitted to be, measured at fair value. Rather, FAS 157 
improves the consistency and comparability of fair value measurements 
within GAAP by more clearly defining fair value, establishing a 
framework for measuring fair value measurements, and expanding 
disclosures about a company's required fair value measurements.
---------------------------------------------------------------------------
     \1\ FASB Statement No. 157, Fair Value Measurements (September 
2006), as codified in Topic 820 of the FASB Accounting Standards 
Codification'.
---------------------------------------------------------------------------
    In 2008, the SEC conducted a comprehensive study on mark-to-market 
accounting and submitted a report to Congress detailing its findings on 
fair value accounting. The report concluded that fair value accounting 
was not a primary cause of the crisis. The study also included 
recommendations on how to improve fair value requirements, including 
the need for improved guidance on the determination of fair value in 
illiquid markets and the reporting of impairments. The FASB made these 
improvements in late 2008 and early 2009 by issuing three FASB Staff 
Positions. \2\
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     \2\ FASB Staff Position FAS 157-3, Determining the Fair Value of a 
Financial Asset When the Market for That Asset Is Not Active (October 
2008); FASB Staff Position FAS 157-4, Determining Fair Value When the 
Volume and Level of Activity for the Asset or Liability Have 
Significantly Decreased and Identifying Transactions That Are Not 
Orderly (April 2009); FASB Staff Position FAS 115-2 and FAS 124-2, 
Recognition and Presentation of Other-Than-Temporary Impairments (April 
2009). These staff positions have been codified in various topics of 
the FASB Accounting Standards Codification'.
---------------------------------------------------------------------------
    Since April 2009, the FASB has made additional targeted amendments 
to fair value guidance to address the following:

  a.  How to measure liabilities at fair value; \3\
---------------------------------------------------------------------------
     \3\ FASB Accounting Standards Update No. 2009-05, Fair Value 
Measurements and Disclosures (Topic 820)_Measuring Liabilities at Fair 
Value (August 2009).

  b.  How to measure investments in certain companies that calculate 
        Net Asset Value per Share; \4\ and
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     \4\ FASB Accounting Standards Update No. 2009-12, Fair Value 
Measurements and Disclosures (Topic 820): Investments in Certain 
Entities That Calculate Net Asset Value per Share (or Its Equivalent) 
(September 2009).

  c.  How to improve disclosures about fair value measurements. \5\
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     \5\ FASB Accounting Standards Update No. 2010-06, Fair Value 
Measurements and Disclosures (Topic 820): Improving Disclosures about 
Fair Value Measurements (January 2010).

    In addition, in conjunction with the FASB and the IASB convergence 
efforts (discussed below), the FASB and the IASB have developed a 
converged definition of fair value and common requirements for 
measuring fair value and for disclosing information about fair value 
measurements. To that end, the FASB plans to issue minor amendments to 
existing GAAP requirements in April 2011. The amendments in this 
convergence project will explain how to measure fair value but will not 
expand the range of items that are required or permitted to be measured 
at fair value.
            Off-Balance Sheet Financing
    In 2008 and 2009, the FASB completed projects to improve accounting 
and disclosure requirements for the areas that caused the greatest 
concern about off-balance sheet financings. In 2008, the FASB completed 
a project that requires a company to make additional disclosures about 
the extent of its continuing involvement with assets no longer reported 
on its balance sheet and its involvement with special-purpose entities 
(SPEs). \6\ Those disclosures became effective for calendar year end 
companies in 2008. The FASB then completed a project to amend the 
accounting guidance to provide greater transparency to investors about 
transfers (sales) of financial assets and a company's continuing 
involvement with such assets (FAS 166). \7\ The FASB also improved 
disclosures of a company's involvements with SPEs and tightened the 
requirements governing when such entities should be consolidated (FAS 
167). \8\ FAS 166 and 167 were issued in June 2009 and became effective 
in January 2010.
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     \6\ FASB Staff Position FAS 140-4 and FIN 46(R)-8, Disclosures by 
Public Entities (Enterprises) about Transfers of Financial Assets and 
Interests in Variable Interest Entities (December 2008).
     \7\ FASB Statement No. 166, Accounting for Transfers of Financial 
Assets--an amendment of FASB Statement No. 140 (June 2009), as codified 
in Topic 860 of the FASB Accounting Standards Codification'.
     \8\ FASB Statement No. 167, Amendments to FASB Interpretation No. 
46(R) (June 2009), as codified in Topic 810 of the FASB Accounting 
Standards Codification'.
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    In issuing Statements 166 and 167, the FASB provided necessary 
improvements to the accounting and reporting of securitizations and 
other involvements with SPEs. Before FAS 166 and 167, companies were 
required to consolidate an SPE only if they had the majority of risks 
and/or rewards of that entity. However, in making this determination, 
companies used complex mathematical calculations that often excluded 
key risks, such as liquidity risk. Consequently, some companies were 
able to structure transactions to avoid consolidating entities in which 
they retained significant continuing risks and obligations.
    FAS 166 and 167 significantly improve the disclosure standards for 
companies involved with SPEs. Under the new standards, companies that 
control the most significant activities of the entity and are exposed 
to the benefits or losses of the entity are required to report the 
assets and liabilities on their financial statements. The improved 
accounting standards will put investors in a better position to 
determine who will ultimately bear the losses and reap the rewards of 
SPEs.
    Since the issuance of FAS 166 and 167, the FASB has made one 
additional targeted amendment to consolidation guidance. As originally 
drafted, the new standards would have required investment managers and 
other similar entities to consolidate certain funds that they manage 
upon adoption of FAS 167. After considering all of the feedback 
received on this issue, the FASB decided to temporarily defer the 
effective date of FAS 167 for those entities in order to study the 
issue with the IASB. \9\
---------------------------------------------------------------------------
     \9\ FASB Accounting Standards Update No. 2010-10, Consolidation 
(Topic 810): Amendments for Certain Investment Funds (February 2010).
---------------------------------------------------------------------------
    The FASB plans to issue a proposal in May 2011 that would amend the 
consolidation guidance, further clarifying when a company with 
decision-making power over a SPE should be required to consolidate. The 
proposal also would eliminate the deferral of the guidance in FAS 167 
for investment managers and other similar entities.
    In addition to the projects outlined above, the FASB is revising 
the accounting standard for determining when a repurchase agreement 
should be accounted for as a sale or as a financing. The Board has 
determined that the existing criterion pertaining to an exchange of 
collateral should not be a determining factor when accounting for a 
repurchase agreement transaction. The FASB plans to issue this 
amendment in May 2011.
            Disclosures About Risk
    Disclosures are an integral part of a company's financial 
statements and provide information that is critical to an investor's 
ability to understand a company's risk exposures. The financial crisis 
revealed that disclosures about (a) fair value measurements, (b) credit 
risk, and (c) derivatives and other financial instruments needed to be 
enhanced to provide investors with a complete portrait of a company's 
risk exposure. To address this problem, the FASB issued several 
standards over the past few years.
    Disclosures About Fair Value Measurements. Timely and transparent 
information about fair value measurements and asset impairments is 
critically important, especially in illiquid markets. To improve 
disclosures in those areas, the FASB issued three standards in early 
2009. The first standard requires that the fair value disclosures 
previously made on an annual basis by public companies now be made on a 
quarterly basis. \10\ Similarly, the second standard requires companies 
to make qualitative disclosures that give investors insight into how a 
company performs its fair value measurements on a quarterly instead of 
an annual basis. \11\ Additionally, the third standard allows separate 
presentation of the credit-related and non- credit-related impairments 
of debt securities that were not intended to be sold and for which the 
entity could recover the decline in value by holding the securities. 
\12\ These amendments also enhance the nature and frequency of 
information disclosed about debt and equity securities in unrealized 
loss positions and about whether or not an other-than-temporary 
impairment had been recognized. Together, this guidance ensures more 
frequent and detailed information reporting about fair value changes in 
securities.
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     \10\ FASB Staff Position FAS 107-1 and APB 28-1, Interim 
Disclosures about Fair Value of Financial Instruments (April 2009), as 
codified in various Topics of the FASB Accounting Standards 
Codification'.
     \11\ FASB Staff Position FAS 157-4, Determining Fair Value When 
the Volume and Level of Activity for the Asset or Liability Have 
Significantly Decreased and Identifying Transactions That Are Not 
Orderly (April 2009), as codified in Topic 820 of the FASB Accounting 
Standards Codification'.
     \12\ FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and 
Presentation of Other-Than-Temporary Impairments (April 2009), as 
codified in various Topics of the FASB Accounting Standards 
Codification'.
---------------------------------------------------------------------------
    In 2008 and 2009, FASB received many comments from users of 
financial statements requesting enhanced disclosures about a company's 
fair value measurements. Accordingly, the FASB issued guidance in 
January 2010 to address user concerns. \13\ The guidance requires a 
company to disclose the following:
---------------------------------------------------------------------------
     \13\ FASB Accounting Standards Update No. 2010-06, Fair Value 
Measurements and Disclosures (Topic 820): Improving Disclosures about 
Fair Value Measurements (January 2010).

  a.  Significant transfers between Levels 1 and 2 (levels of fair 
---------------------------------------------------------------------------
        value measurement based on availability of inputs);

  b.  Activity within Level 3 fair value measurements during a period 
        (assets using significant unobservable inputs when measuring 
        fair value are Level 3 assets); and

  c.  Valuation techniques and inputs to fair value measurements.

    The guidance also requires a company to disaggregate its fair value 
measurement disclosures by class of asset or liability.
    Disclosures About Credit Risk. Many banks voluntarily provide some 
disclosures about the credit quality of their loan portfolios. However, 
in the past, investors have commented to the FASB that many banks 
provide these disclosures too late in the credit cycle--after 
significant problems have been identified. In addition, the extent of 
these disclosures and their information content varies significantly. 
To address these concerns, the FASB issued guidance in December 2005 to 
emphasize that nontraditional loans, such as interest-only loans, 
option adjustable-rate mortgages, and loans with high loan-to-value 
ratios, could significantly increase an institution's exposure to 
credit risk and consequently must be disclosed under existing 
standards. \14\ The FASB also issued a standard in July 2010 to enhance 
transparency about risks associated with traditional as well as 
nontraditional loans. \15\ That standard requires banks to disclose 
information that enables investors to understand the nature of credit 
risk inherent in a bank's loan portfolio; monitor changes in the credit 
quality of a bank's loan portfolios over time; and understand how those 
changes are reflected in the bank's allowance for loan losses. That 
standard also requires a bank to disaggregate its credit quality 
disclosures by class of asset.
---------------------------------------------------------------------------
     \14\ FASB Staff Position SOP 94-6-1, Terms of Loan Products That 
May Give Rise to a Concentration of Credit Risk (December 2005), as 
codified in Topics 825 and 310 of the FASB Accounting Standards 
Codification'.
     \15\ FASB Accounting Standards Update No. 2010-20, Receivables 
(Topic 310): Disclosures about the Credit Quality of Financing 
Receivables and the Allowance for Credit Losses (July 2010).
---------------------------------------------------------------------------
    Disclosures About Derivatives and Other Financial Instruments. Both 
the use and complexity of derivative instruments and hedging activities 
increased significantly in the years leading up to the financial 
crisis. FAS 133, \16\ which became effective in 2000, established 
accounting requirements for derivative instruments and hedging 
activities. While FAS 133 significantly improved the accounting for 
derivatives by requiring them to be measured at fair value, its 
disclosure requirements did not enable users to fully understand why a 
company uses derivatives and how those derivatives affect its financial 
statements. In March 2008, the FASB issued FAS 161 \17\ to address 
these concerns. Under FAS 161, a company must disclose qualitative and 
quantitative information about how and why the company uses derivative 
instruments, the volume of the company's derivative activity, and the 
impact of derivative instruments on the company's financial position, 
performance, and cash flows.
---------------------------------------------------------------------------
     \16\ FASB Statement No. 133, Accounting for Derivative Instruments 
and Hedging Activities (June 1998), as codified in Topic 815 of the 
FASB Accounting Standards Codification'.
     \17\ FASB Statement No. 161, Disclosures about Derivative 
Instruments and Hedging Activities--an amendment of FASB Statement No. 
133 (March 2008), as codified in Topic 815 of the FASB Accounting 
Standards Codification'.
---------------------------------------------------------------------------
    To further enhance the disclosure requirements in FAS 161, the FASB 
issued a FASB Staff Position in September 2008. \18\ This additional 
guidance requires sellers of credit derivatives to disclose the nature 
of the credit derivative (including its term, the reason for entering 
into the credit derivative, the events that would require the seller to 
perform under the credit derivative, and the current status of its 
payment/performance risk), the maximum amount of potential future 
payments the seller could be required to make under the credit 
derivative, the fair value of the derivative, and the nature of any 
recourse provisions that would enable the seller to recover from third 
parties any of the amounts paid under the credit derivative and any 
related collateral held.
---------------------------------------------------------------------------
     \18\ FASB Staff Position FAS 133-1 and FIN 45-4, Disclosures about 
Credit Derivatives and Certain Guarantees: An Amendment of FASB 
Statement No. 133 and FASB Interpretation No. 45; and Clarification of 
the Effective Date of FASB Statement No. 161 (September 2008), as 
codified in Topics 815 and 460 of the FASB Accounting Standards 
Codification'.
---------------------------------------------------------------------------
    In May 2008, the FASB issued FAS 163 \19\ to address 
inconsistencies in accounting for financial guarantee contracts by 
insurance companies (for example, monoline insurers). In addition to 
addressing those inconsistencies, FAS 163 requires insurance companies 
to provide expanded disclosures about financial guarantee insurance 
contracts. Those disclosures primarily focus on the information used by 
the insurance company to evaluate credit deterioration in its insured 
financial obligations (for example, how a company groups and monitors 
its insured financial obligations and financial information about each 
grouping).
---------------------------------------------------------------------------
     \19\ FASB Statement No. 163, Accounting for Financial Guarantee 
Insurance Contracts--an interpretation of FASB Statement No. 60 (May 
2008), as codified in Topic 944 of the FASB Accounting Standards 
Codification'.
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Convergence Efforts
    The FASB is working with the IASB to develop converged accounting 
standards in several key areas through a collaborative due process. We 
agree with the G20 and many others that in a global economy, investors 
should be able to rely on one set of high-quality accounting standards. 
The FASB's and the IASB's target date to complete deliberations on 
three priority projects--financial instruments, leasing, and revenue 
recognition--is June 30, 2011. Although it is an ambitious target, we 
have recently prioritized our agenda and are redeploying resources to 
these high-priority convergence projects. While the FASB is committed 
to working hard to develop improved, converged, and sustainable 
standards quickly, we are equally committed to making sure that, first 
and foremost, the standards result in improved financial information 
for investors and that companies and auditors understand the new 
requirements and can implement them in an orderly manner.
    With the comment period on those projects now closed, the FASB and 
the IASB are in the process of reviewing stakeholder input. The volume 
of feedback is impressive, and many issues have been identified. The 
FASB and the IASB plan to work through all of the issues methodically 
and thoughtfully. These standards go to the core of a company's key 
operating metrics, and we are committed to ensuring that stakeholders 
have ample opportunities to comment on proposed changes or possible 
implementation issues before the standards are finalized.
    A brief update on the key convergence projects follows.
            Accounting for Financial Instruments
    One of the FASB's and the IASB's top priorities is improving, 
simplifying, and converging the accounting for financial instruments. 
In May 2010, the FASB published a proposal that aims to provide a more 
timely and full description of a company's involvement in financial 
instruments. Since the release of the proposal, the FASB has continued 
its deliberations about how (a) to classify and measure financial 
instruments, (b) to account for impairments (loan loss provisioning), 
and (c) to improve reporting of hedging activities.
    The FASB and the IASB share a goal of issuing comprehensive 
improvements to the current standards that will foster international 
comparability of financial information about financial instruments. The 
Boards expect to achieve that goal by closely coordinating the 
deliberations of issues arising in their separate standard-setting 
projects.
    In addition to the broader effort to converge financial instrument 
accounting standards described above, the Boards decided to undertake a 
discrete joint project to improve and converge the differences between 
International Financial Reporting Standards (IFRS) and GAAP 
requirements relating to balance sheet netting of derivative contracts 
and other financial instruments. This joint project was added in 
response to stakeholders' concerns (including those of the Basel 
Committee on Banking Supervision and the Financial Stability Board) 
about a major difference between the balance sheets of U.S. financial 
institutions and their international counterparts.
    Classification and Measurement of Financial Instruments. The May 
2010 proposal to amend the guidance on the classification and 
measurement of financial instruments proposed a much greater use of 
fair value measurement for financial instruments than exists under 
current accounting guidance. As part of its deliberative due process, 
the FASB is in the process of considering the comments it has received 
from stakeholders and redeliberating most aspects of the May 2010 
Exposure Draft. The vast majority of investors, reporting entities, and 
other stakeholders did not believe that fair value was the most 
appropriate measurement attribute for some financial instruments in the 
balance sheet. They suggested various ways to enhance the information 
through a more robust impairment approach and expanded disclosures.
    Based on that feedback, in its deliberations to date, the FASB has 
tentatively decided that at least some assets should qualify for cost 
accounting based on the characteristics of the instrument and the 
entity's business strategy in holding them. The Board is also 
considering whether changes in the fair value of such assets should be 
recognized in other comprehensive income in certain circumstances. The 
FASB is continuing to discuss these issues and will continue to further 
refine the criteria for classifying financial instruments, as well as 
the application of those criteria to certain financial instruments 
(such as hybrid instruments). Once the FASB decides what changes, if 
any, it intends to make to its proposal, the FASB and the IASB will 
identify any differences that remain between IFRS and GAAP requirements 
and evaluate whether and how they might reduce the differences or 
otherwise enhance comparability. We believe that we will complete the 
deliberations on this phase of the project in the second quarter.
    Impairments of Financial Instruments. The May 2010 proposal would 
require a company to recognize the total credit losses expected to 
occur over the life of a financial asset ``immediately'' or at the 
first reporting date at or after the financial assets are originated or 
purchased. Under current U.S. accounting requirements, an impairment 
loss is not recognized until it is probable. In other words, under the 
FASB's proposal, a company would not wait until a loss is probable 
before recognizing an impairment loss. Further, the proposal would 
require companies to assess credit losses based on all available 
information about past events and existing conditions but would not 
require consideration of potential future economic events beyond the 
reporting date.
    The FASB received extensive input from stakeholders about the 
impairment proposal, most of which supported the development of a 
converged standard. Most commenters agreed with the proposal's 
elimination of the ``probable'' threshold. However, commenters 
expressed mixed views about the amount of the loss that should be 
recognized. Some comments supported recognizing total expected credit 
losses immediately, while others supported recognizing a portion of the 
credit losses expected to occur over the life of a financial asset. 
Additionally, a majority of commenters thought that the proposal should 
require all available information, including assumptions about future 
conditions and events, to be considered.
    In response to this feedback, the FASB and the IASB issued a joint 
supplementary proposal in January 2011 that proposes a revised approach 
for an impairment model for financial assets. Under the revised 
proposal, the amount and timing of recognition would vary based on the 
credit characteristics of the financial asset, specifically the degree 
of uncertainty about the collectability of cash flows. The Boards' aim 
is to consider the comments received on the revised approach and 
substantially complete deliberations related to this phase of the 
financial instruments project in the second quarter.
            Balance Sheet Netting
    Balance sheet netting of derivative contracts and other financial 
instruments is typically the most significant apparent difference 
between the balance sheets of financial institutions that apply GAAP 
and the balance sheets of those that apply IFRS. In January 2011, the 
Boards published a joint proposal to align this reporting. Under the 
proposal, companies that apply GAAP would no longer be able to ``net'' 
derivatives and repurchase and reverse repurchase transactions in the 
balance sheet. Consequently, companies may report significant increases 
in total assets and total liabilities as a result of the proposed 
changes. The Boards plan to engage in extensive consultations with 
interested parties to ensure all views are considered, including 
holding public roundtables, after the end of the comment period on 
April 28, 2011. The Boards aim to substantially complete 
redeliberations by June 2011.
Conclusion
    Thank you for the opportunity to provide a brief overview of the 
FASB and its many pending projects. I would be pleased to answer any 
questions.
                                 ______
                                 
                 PREPARED STATEMENT OF JAMES L. KROEKER
          Chief Accountant, Securities and Exchange Commission
                             April 6, 2011
    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, I am Jim Kroeker, Chief Accountant of the Securities and 
Exchange Commission. I serve as the principal advisor to the Commission 
on accounting and auditing matters. I appreciate the opportunity to 
testify today on behalf of the Commission regarding the role of the 
accounting profession in preventing another financial crisis.
Importance of Reliable Financial Reporting
    Financial reporting plays a critical role in establishing and 
maintaining the confidence of the investing public. The objective of 
financial reporting is to provide information useful to providers of 
capital in their decision-making processes. Information provided to 
participants in our capital markets must be neutral, reliable, and 
portray economic results in an accurate and faithful manner. Just as 
important, participants must have confidence that this is in fact the 
case.
    The U.S. system of financial reporting has long been considered a 
major asset of our capital markets. The prominence and reputation of 
the U.S. capital markets are directly linked to our system's ongoing 
commitment to high-quality, accurate financial reporting. This 
commitment provides investors with confidence, helping to minimize the 
cost of capital from uncertainty or suspicion as to an issuer's 
economic fundamentals and prospects. Reliable financial reporting 
becomes even more important in a financial crisis, when concerns about 
a company's fundamentals are most acute.
    The Federal securities laws mandate an independent audit according 
to specified standards by qualified professionals in order to provide 
assurance as to the faithfulness and integrity of the financial 
reporting presented. An audit by an independent public accountant is 
key to investor confidence and the functioning of our capital markets, 
and independent audits have long been recognized as important to 
credible and reliable financial reporting.
    The Sarbanes-Oxley Act of 2002 established the Public Company 
Accounting Oversight Board (PCAOB) under the Commission's oversight to 
supplement the Commission's role in overseeing the audits of public 
companies. The PCAOB registers, inspects, sets standards for, and, 
where appropriate, disciplines auditors in its focused mission to 
protect the interests of investors and further the public interest in 
the preparation of informative, accurate, and independent audit 
reports.
    This enhanced and independent oversight of the auditing profession 
is intended to provide tangible investor benefits through improvements 
to the quality of audits and thus financial reporting as a direct 
result. The Commission recently appointed three new board members: Lew 
Ferguson, Jay Hanson and its new Chairman, Jim Doty, who I am pleased 
to be joining on this panel today. They join Dan Goelzer, who recently 
served as Acting Chairman prior to Chairman Doty's appointment, and 
Steve Harris. We are appreciative of the work of the outgoing Board 
members who recently finished their terms, and we look forward to the 
newly constituted Board continuing the mission of protecting investors.
The Financial Crisis
    The recent financial crisis resulted in the deepest economic 
recession since perhaps the Great Depression. What started with 
defaults on subprime loans quickly spread to illiquid markets for many 
types of financial instruments and ultimately affected many companies 
around the world.
    As the financial crisis unfolded, regulators responded to financial 
reporting issues and auditing developments as they arose. For example, 
the SEC's Division of Corporation Finance published several ``Dear 
CFO'' letters from 2008 to 2010 to remind preparers of their 
responsibilities on a wide range of issues from fair value accounting 
to loss accruals and related disclosure. In 2008, the SEC staff and 
FASB staff jointly issued guidance on the application of fair value 
measurements. In addition, the PCAOB issued several staff audit 
practice alerts between 2007 and 2010 highlighting emerging economic 
circumstances of the financial crisis that affected how auditors 
conduct audits. Topics raised in the practice alerts included auditing 
fair value measurements, financial estimates, adequacy of disclosures, 
and ability to continue as a going concern. The PCAOB also issued a 
report that detailed observations of PCAOB inspectors across firms on 
audit risk areas affected by the financial crisis.
    As our Nation emerges from the financial crisis, we have both an 
opportunity and a responsibility to learn from it. This includes 
considering what lessons can be learned about the role of the 
independent auditor.
Role of the Auditor
    A financial statement audit is designed to provide the auditor with 
reasonable assurance (which is a high level of assurance) that a 
company's financial statements are presented fairly, in all material 
respects, in conformity with generally accepted accounting principles 
(GAAP). The work performed in an audit enables the audit firm to opine 
on the company's financial statements taken as a whole. In exercising 
this vital function, auditors play a key role with respect to one 
particular type of risk: the risk of material misstatement in financial 
statements reported to investors, or ``financial reporting risk.''
    When we look specifically at the role of the auditor, it is 
critical to distinguish between financial reporting risk and other 
risks, such as business and operational risks, which may affect a 
company and impact investment decisions. While auditors must understand 
these risks to the extent that they impact financial reporting risk, 
the auditor's procedures and communications are not designed to 
specifically address risks other than financial reporting risk or to 
make judgments about the merits of a company's business strategies. An 
audit is not designed, nor can it or should it be designed, to take all 
risk out of investing. Audits are instead designed to attest to the 
accuracy of financial statements in accordance with established 
accounting standards to provide investors with reliable financial 
information they can use in making investment decisions.
    Focusing, then, on financial reporting risk, there is reason to 
consider the extent to which improper, fraudulent, or inadequate 
financial reporting relating to GAAP reported results or to disclosures 
outside of the audited financial statements played a role in the 
financial crisis. SEC enforcement teams continue to pursue cases 
stemming from actions that contributed to the financial crisis, 
following settled enforcement actions involving Countrywide Financial, 
American Home Mortgage, New Century, IndyMac Bancorp, and Citigroup.
    When poorly performed audits contribute to or fail to detect 
financial reporting abuses, there are existing mechanisms for dealing 
with such misconduct, including SEC or PCAOB enforcement actions. For 
our part, we will continue to prosecute those who fail to comply with 
their obligations.
    We are considering whether audits performed during the financial 
crisis complied with the current standards and rules. Particularly, 
given the lack of confidence expressed by some investors during the 
financial crisis, we and the PCAOB are actively working to determine 
how standards can be improved. Moreover, we are looking further to 
determine how the role of the auditor can be improved.
Improvements in Audits
Root Causes of Auditing Deficiencies
    As I previously mentioned, the PCAOB issued a report detailing the 
observations of its inspectors on audit risk areas affected by the 
financial crisis. This report provided observations of financial 
reporting risk areas and related audit deficiencies across audit firms. 
While such reports represent a meaningful step to providing investors, 
auditors, audit committees, and others with information about audit 
quality, there is more work to be done to identify and address the 
underlying causes of the deficiencies.
    One such area relates to identifying the root causes of auditing 
deficiencies. The PCAOB's inspection program has played an important 
role in improving audit quality at inspected firms. At the end of each 
firm inspection, the PCAOB issues a report that details audit 
deficiencies noted during the inspection. We continue to work with the 
PCAOB to support their efforts to identify and consider the root causes 
of recurring audit deficiencies. Being able to identify these causes 
has the potential to improve implementation and maintenance of 
appropriate quality controls, as well as to identify areas where 
auditing standards need to be improved.
Auditing Standards
    The PCAOB has implemented processes, including the establishment of 
its Standing Advisory Group as contemplated by the Sarbanes-Oxley Act, 
where the Board performs regular outreach to investors, preparers, and 
auditors to seek input on a variety of topics, including its standard-
setting activities. That outreach has been considered by the Board in 
adopting its recently issued standards, including eight standards that 
deal with the auditor's assessment and response to risks of material 
misstatement. The new risk assessment standards also emphasize 
considerations of fraud throughout the audit and the importance of 
auditing disclosures.
Auditor's Reporting Model
    The project relating to the auditor's reporting model is a 
particularly important initiative of the PCAOB's standard-setting 
agenda. Some investors have raised questions about the sufficiency of 
information they receive from auditors, including whether investors 
could benefit from additional early warnings from auditors. The PCAOB's 
project, which also has been taken up by other standard setters around 
the world, is to look at the content of the auditor's report. The goal 
of this project is to understand whether there is information investors 
are not getting from auditors today that would be useful in making 
investment decisions. A related question is who should be the 
appropriate party to provide that information to investors. That is, is 
this information the auditor should be providing, or is this 
information from management or the audit committee that needs to be 
addressed? Other questions include the form and manner in which 
investors receive such information.
Auditing Considerations Around the Globe
International Inspections
    The ability of the PCAOB to inspect foreign registered firms that 
audit issuers in the U.S. capital markets is a significant aspect of an 
effective auditor oversight regime. Section 981 of the Dodd-Frank Act 
allows the PCAOB to share information with its foreign counterparts. As 
a result of that statutory change, coupled with the hard work by the 
PCAOB and its counterpart in the United Kingdom, the PCAOB has been 
able to reach an agreement to resume inspections there. In light of the 
importance of inspections, we have been working with the PCAOB in their 
ongoing efforts to reach similar agreements with additional regulatory 
bodies in those locations where inspections are not currently being 
performed.
Other Standard Setters and Regulators
    Interest in the role of auditors in the financial reporting system 
is not limited to U.S. regulators and standard setters. For example, 
the European Commission and the U.K.'s Financial Reporting Council also 
have projects underway to consider, for example, audit policy matters 
and the role of auditors and audit committees. Some of the ideas being 
explored are ideas that have been previously incorporated into the U.S. 
capital markets. For example, as a result of the Sarbanes-Oxley Act, 
the United States already has provisions for audit partner rotation and 
for listed companies to have an independent audit committee appoint the 
independent auditor. Nonetheless, these international undertakings have 
sparked interesting dialogue and debate, and it is important that we 
explore all reasonable ideas to improve audit quality for the sake of 
investor protection and the financial system as a whole.
Accounting
    Because the role of the auditor is so directly tied to the 
accounting standards themselves, the recent financial crisis also 
provides us with the opportunity to examine whether accounting 
standards could be improved. I am pleased also to be here today with 
the FASB Chairman, Leslie Seidman. The financial crisis highlighted the 
type of information that investors, regulators, and other users of 
financial reports need to see reported on a company's financial 
statements. My office requested in January 2008 that the FASB improve 
financial reporting for many financings, securitizations, and other 
transactions that previously had not been consolidated on the balance 
sheet. This request was consistent with the leadership shown by this 
Subcommittee and Chairman Reed in the 2008 hearing on Transparency in 
Accounting and Proposed Changes to Accounting for Off-Balance Sheet 
Entities. The existing standards were in need of improvement regarding 
what companies should be reporting as their own assets and liabilities, 
and we believed immediate action was needed. The President's Working 
Group on Financial Markets made similar recommendations in March 2008.
    In response, the FASB completed a major standard-setting initiative 
for the accounting of financial asset transfers and consolidation. 
These requirements became effective for reporting 2010 results. A 
critical component of these reforms was to eliminate the previous 
exemption for so-called ``qualifying special purpose entities.'' This 
structure was used for many securitizations. This so-called ``scope 
exception'' had grown beyond its original purpose, and the FASB 
determined to place all securitization structures and other structured 
entities under a single accounting model.
    The new model addresses concerns that accounting and consolidation 
determinations were too often based on complex mathematical 
calculations rather than a more qualitative, objectives-based analysis. 
This was consistent with a Commission staff study in response to the 
Sarbanes-Oxley Act on appropriate models for accounting. In addition, 
recognizing that it is not possible to predict each type of structure 
that could be created to circumvent or otherwise avoid the new 
consolidation guidance, the FASB included a general protective measure 
that nonsubstantive terms, transactions, and arrangements are to be 
disregarded when applying the consolidation criteria.
    The new standards also require a number of new disclosures that are 
designed to provide better information about a company's exposure to 
risks, regardless of whether that asset or liability is recorded on the 
balance sheet. Among other disclosure requirements, companies are 
required to disclose the significant judgments and assumptions made in 
forming their consolidation determinations.
    These new standards should enhance financial reporting 
transparency. However, Commission staff will continue to monitor their 
effectiveness. This includes not only guarding against attempts to 
circumvent the new model, but also relaying to the FASB, based on our 
experience with the resulting reporting, further refinements that may 
be needed.
Continuing Improvements to Accounting Standards
    The FASB and the International Accounting Standards Board (IASB) 
are working on joint projects to improve financial reporting and 
eliminate unnecessary differences between U.S. GAAP and International 
Financial Reporting Standards (IFRS) in a number of key areas. The FASB 
has made significant progress towards completion of a project to 
improve and simplify accounting for financial assets and related 
impairments. As the FASB and IASB move forward, there are two 
fundamental issues that have been raised as a result of the crisis: (1) 
was there in fact compliance with existing accounting and disclosure 
requirements; and (2) what improvements could be made to what is 
required to be reported in an issuer's financial statements to assure 
that they reflect an entity's financial condition. The result of the 
FASB's and IASB's work also is extremely important to the Commission's 
own consideration of whether to incorporate IFRS into the financial 
reporting system for U.S. issuers.
    The Commission staff will continue to review companies' accounting 
and reporting practices to determine if companies are complying with 
existing requirements and to determine whether changes to those 
requirements are warranted. As Chairman Schapiro testified last year 
before the full Committee, we will take appropriate action where we 
find that companies are improperly reporting their financial condition. 
We also will continue to consider whether existing disclosure 
requirements are adequate to provide full and transparent disclosure.
Conclusion
    One of the most significant lessons from the recent financial 
crises was the same one that led to the philosophy of this country's 
commitment to securities regulation over 75 years ago. That is, when 
pressures are highest, and investor confidence has the greatest 
potential to be shaken by uncertainty, the importance of transparent, 
objectively audited financial reporting to investors, and an 
independent and objective system to establish standards for such 
reporting, are necessary and critical components to both short term and 
long term success. Working with the FASB and the PCAOB, we will 
diligently continue to look for ways to improve the financial reporting 
system.
                                 ______
                                 
                 PREPARED STATEMENT OF ANTON R. VALUKAS
                      Chairman, Jenner & Block LLP
                             April 6, 2011
    Dear Chairman Reed, Ranking Member Crapo, and Members of the 
Committee, I appreciate the opportunity to appear before you to address 
what role the accounting profession can play in helping to prevent 
another financial crisis. I address this question primarily from the 
perspective of my role as the Examiner in the Lehman Brothers 
bankruptcy proceeding.
    I want to emphasize at the outset that I did not make any finding 
as to whether regulators or auditors necessarily could have prevented 
Lehman's collapse. Lehman failed in part because it was unable to 
retain the confidence of its lenders and counterparties and because it 
did not have sufficient liquidity. Lehman was unable to maintain 
confidence because it made a series of business decisions that left it 
with heavy concentrations of illiquid assets with deteriorating values, 
such as residential and commercial real estate. The extent to which 
Lehman's demise was, in part, the function of any act or failure to act 
by the auditors is a question we must leave for the courts.
    Lehman's executives--not regulators or auditors--made the decision 
to load up on illiquid assets. Lehman's executives--not regulators or 
auditors--were responsible in the first instance for preparing fair and 
accurate financial reports. I found that Lehman's decision not to 
disclose to the public a fair and accurate picture of its financial 
condition gave rise to colorable claims against senior officers who 
oversaw and certified misleading financial statements.
    Nevertheless, and wholly apart from the claims involving Lehman's 
auditors, we must recognize the general principle that auditors serve a 
critical role in the proper functioning of public companies and 
financial markets. Boards of Directors and audit committees are 
entitled to rely on external auditors to serve as watchdogs--to be 
important gatekeepers who provide an independent check on management. 
And the investing public is entitled to believe that a ``clean'' report 
from an independent auditor stands for something. The public has every 
right to conclude that auditors who hold themselves out as independent 
will stand up to management and not succumb to pressure to avoid 
rocking the boat.
    I found that colorable claims exist against Lehman's external 
auditor in connection with Lehman's issuance of materially misleading 
financial reports. As I explained in my Report:

        [I]n this Report a colorable claim is one for which the 
        Examiner has found that there is sufficient credible evidence 
        to support a finding by a trier of fact. The Examiner is not 
        the ultimate decision maker; whether claims are in fact valid 
        will be for the triers of fact to whom claims are presented. 
        The identification of a claim by the Examiner as colorable does 
        not preclude the existence of defenses and is not a prediction 
        as to how a court or a jury may resolve any untested legal, 
        factual, or credibility issues.

    If Lehman had earlier presented a fair and accurate picture of its 
financial condition, regulators and Lehman's Board may have had a 
fighting chance to make needed corrections or arrange for a smoother 
landing. As there is litigation pending against some of the individuals 
and entities covered by my findings, it would not be appropriate for me 
to comment directly on any issues that will have to be decided by the 
courts. There are, however, important lessons that can be gleaned as to 
how auditors can help prevent another financial crisis.
    In Lehman's final months, two issues were of critical importance: 
leverage and liquidity. In both instances the system broke down. 
Information given to the investing public was misleading or inaccurate, 
and opportunities to identify severe problems were missed.
Leverage: Lehman's Balance Sheet Manipulation
    Beginning in 2007, market observers began demanding that investment 
banks reduce their leverage. Lehman knew that if it did not reduce 
leverage it would suffer a ratings downgrade, which would have an 
immediate and tangible monetary impact. Paolo Tonucci, Lehman's Global 
Treasurer, recognized in 2007 that ratings agencies were ``most 
interested and focused on leverage.'' In early 2008, Erin Callan, 
Lehman's CFO, noted that reducing leverage was necessary to ``win back 
the confidence of the market, lenders, and investors.''
    Lehman's CEO Richard Fuld knew that Lehman had to improve its net 
leverage ratio by selling inventory, but by mid-2007, much of Lehman's 
inventory had become ``sticky''--difficult to sell without incurring 
substantial losses. As detailed in my Report, Lehman opted to create a 
perception of reducing its net leverage ratio through increased use of 
a device known as ``Repo 105.''
    Lehman repeatedly and heavily relied on Repo 105 transactions to 
temporarily remove--and I emphasize temporarily--some $50 billion off 
of Lehman's balance sheet right at quarter end. Lehman undertook $38.6 
billion, $49.1 billion, and $50.38 billion of Repo 105 transactions at 
quarter end fourth quarter 2007, first quarter 2008, and second quarter 
2008, respectively. Lehman executives described this accounting device 
as a ``gimmick,'' ``window dressing,'' and a ``drug we r on.'' Martin 
Kelly, Lehman's former Global Financial Controller, stated 
unequivocally that there was ``no substance to the transactions.'' $50 
billion of transactions with no business purpose. I uncovered ample 
contemporaneous evidence that the sole purpose of these transactions 
was to make the published balance sheets look better than they actually 
were. To make matters worse, these transactions not only lacked any 
affirmative business purpose but required Lehman to pay a premium for 
the privilege of masking its true financial condition.
    Without getting into specifics as to contested issues that might be 
involved in litigation, there is no serious dispute that Lehman's 
external auditor was aware of Lehman's Repo 105 accounting policy and 
was aware of an allegation that Lehman had used that policy to move $50 
billion temporarily off the books at quarter end.
    Lehman did not publicly disclose that it used $50 billion of these 
transactions at quarter end. Whether due to gaps in professional audit 
standards or a failure to follow those standards, the result is the 
same: the external auditor did not object when Lehman omitted any 
reference to these transactions in its public filings.
    I found colorable claims that Lehman did not merely mislead by 
omission. Lehman represented to the investing public that it had worked 
to lower its net leverage ratio: Lehman stated in its Management 
Discussion and Analysis (MD&A) that net leverage is ``more meaningful'' 
than a simple leverage ratio. Lehman's statement that the net leverage 
ratio was a ``more meaningful'' measurement of leverage was misleading 
because that ratio was not an accurate indicator of Lehman's actual 
leverage, and in fact, understated Lehman's leverage significantly. I 
found that sufficient evidence exists for a judge or jury to find that 
Lehman's reported net leverage ratio was materially misleading.
    In analyzing what steps could help avoid similar misstatements or 
omissions in the future, it should be noted that rules in place at the 
time required that an MD&A include an analysis of known material 
trends, events, demands, commitments, and uncertainties. Existing 
regulations required registrants to discuss known trends involving 
their liquidity and capital resources, specifically including off-
balance sheet financing arrangements. The same regulations specified 
that a registrant should discuss, among other things, the ``nature and 
business purpose to the registrant of such off-balance sheet 
arrangements.'' As we have seen, Lehman's off-balance sheet arrangement 
had no business purpose. Lehman did not so advise the public.
    SEC guidance also stated that an MD&A should describe ``unusual 
events and transactions'' to help identify apparent trends. Lehman did 
not disclose the unusual nature of the Repo 105 transactions or the 
trend that Lehman's net leverage ratio only temporarily fell just when 
it was time to issue public reports.
    Lehman's auditor maintained that Repo 105 transactions were but one 
of numerous end-of-quarter transactions that investment banks do to 
make their balance sheets look better. The auditor maintained that 
there is nothing remarkable about Repo 105 and that an auditor's only 
role with respect thereto is to make sure the accounting is correct. If 
the accounting is correct, the auditor maintained, it does not matter 
if the transactions are being done as a means to manipulate net 
leverage. The auditor further asserted that Lehman engaged in 
substantial volumes of other off-balance sheet transactions that a 
reader of Lehman's financial statements would not know about, and that 
those transactions dwarfed the Repo 105 transactions.
    Lehman's external auditor further stated that net leverage ratio is 
not a GAAP measure expected to be included in financial statements and 
that disclosures of Repo 105 activity were not required at the time of 
Lehman's financial reports. With respect to MD&A issues, the external 
auditor stated that it is not responsible unless (i) the numbers 
contained in the MD&A were inconsistent with the numbers in the 
financial statements; (ii) there is a material inconsistency between 
the MD&A and financial statements; or (iii) the auditor knew that 
information in the MD&A was materially misleading. The auditor asserted 
that none of those scenarios applied to the Lehman MD&A, and that the 
MD&A is the responsibility of management and disclosure counsel.
    Whether the auditor correctly understood its responsibilities is 
for a trier of fact to decide, but a few points are abundantly clear: 
Ratings agencies and senior Lehman executives well understood the 
critical importance of Lehman's leverage to the investing public; the 
auditor did not qualify its opinion in any way or advise the Board of 
the end-of-period Repo 105 transactions; and the public traded millions 
of Lehman's shares without knowledge of the extent or purpose of 
Lehman's end-of-period Repo 105 transactions.
Lehman's Liquidity Pool
    The inadequacy of Lehman's liquidity pool--the cash, Government 
securities and other high-quality assets that Lehman set aside for its 
known funding needs--played a key role in Lehman's bankruptcy filing. 
Lehman represented in its regulatory filings and public disclosures 
that its liquidity pool was intended to cover expected cash outflows 
for 12 months in a stressed liquidity environment. Lehman reported that 
its liquidity pool contained $34 billion at the end of the first 
quarter of 2008, $45 billion at the end of the second quarter of 2008, 
and $42 billion at the end of the third quarter of 2008. In all cases, 
Lehman represented that its liquidity pool was unencumbered, meaning 
that it was composed of assets that could be ``monetized at short 
notice in all market environments.''
    After Bear Stearns' near collapse in March 2008, regulators, 
lenders and the investing public all looked to Lehman's liquidity pool 
as a key indicator of Lehman's financial health. Though Lehman was well 
aware of this focus, it began to cut corners as clearing banks and 
overnight lenders sought increasing amounts of collateral. By the 
summer of 2008, Lehman began to count in its liquidity pool assets it 
had deposited or pledged to its clearing banks. In the days before 
Lehman's bankruptcy filing, encumbered assets that likely could not 
have been converted to cash quickly in a funding emergency comprised a 
significant portion of the pool.
    Lehman never affirmatively advised its Board, the ratings agencies 
or the investing public of the billions of dollars of deposits and 
pledges that affected its liquidity pool. At the same time, Lehman did 
not attempt to hide from the regulators what it was doing. The SEC and 
the Fed each knew that significant amounts counted as liquidity were in 
fact posted as comfort deposits in order for Lehman to do business; the 
Fed knew that significant amounts counted as liquidity were in fact 
actually pledges to lenders. The agencies internally disagreed with 
Lehman's inclusion of these amounts as liquidity, yet took no action to 
require Lehman to adjust its public reporting of the numbers.
    How could Lehman count deposits, pledged property and other 
encumbered assets in its liquidity pool? The fault lies, of course, 
with Lehman itself and to some extent with regulators for failing to 
regulate Lehman's practices, but it did not help that there was no 
consistent standard of what constitutes a liquid asset.
    In the absence of a clear definition, Lehman and its regulators 
created their own. For example, Mr. Tonucci stated that an asset 
monetizable in five days was suitable for Lehman's liquidity pool, 
although Lehman did not always comply with this definition. Other 
Lehman managers said they were unaware of a five-day rule. The SEC 
applied a 24-hour test, meaning that to be considered liquid an asset 
had to be convertible to cash in one day; however, the SEC rarely 
questioned whether certain types of assets were appropriate for a 
liquidity pool. The Federal Reserve Bank of New York (FRBNY) had no set 
rule for determining what assets were appropriate for a liquidity pool; 
it evaluated pool assets on a case-by-case basis, noting that certain 
assets could be considered liquid if the clearing banks released their 
liens. When the FRBNY calculated the amount of Lehman's liquidity pool 
for its own purposes, the FRBNY subtracted assets pledged to Lehman's 
clearing banks from the total amount of the liquidity pool, even though 
Lehman continued to count these assets.
    Lehman publicly discussed its liquidity pool because liquidity was 
essential to maintaining the confidence of Lehman's trading partners. 
On June 9, 2008--just three months before declaring bankruptcy--Lehman 
announced its liquidity pool was, at $45 billion, its ``largest ever.'' 
That same month one of Lehman's clearing banks, Citibank, required that 
Lehman post $2 billion as a ``comfort deposit,'' as a condition for 
Citi's continued willingness to clear Lehman's trades. Later in June, 
Lehman posted $5 billion of collateral to JPMorgan, Lehman's main 
clearing bank, in response to an earlier demand by JPMorgan. Lehman 
continued to count virtually all of these deposits in its reported 
liquidity pool.
    On September 10, 2008--five days before it filed for bankruptcy--
Lehman publicly announced that its liquidity pool was holding steady at 
approximately $41 billion. By Friday, September 12, however, Lehman 
actually had less than $2 billion of assets that could readily be 
turned into cash; it literally did not have sufficient cash to open for 
business on Monday, and it filed for bankruptcy protection on September 
15. We now know that Lehman's report of a $41 billion liquidity pool on 
September 10 was off by tens of billions of dollars.
    Lehman's auditor stated that it was highly involved in monitoring 
Lehman's liquidity pool. But when I asked if the auditor was aware of 
or had concerns with Lehman's inclusion of certain assets in the 
liquidity pool, the auditor stated that the composition of the 
liquidity pool was a matter for the regulators, not the auditor. 
Whether or not this description of responsibility is accurate, the 
bottom line is that the auditor apparently did not check whether 
Lehman's liquidity pool was in the least bit liquid. And anyone who 
tried would have been faced with widely disparate definitions of 
liquidity. Clear standards are needed to ensure that someone other than 
the party in interest provides a check on whether liquidity pools are 
liquid and can actually serve their intended purpose.
Lessons Learned
    Lehman's auditors maintained that Repo 105 transactions were 
permissible under existing accounting rules and that existing 
accounting rules did not require any analysis of the content of 
liquidity pools. Whether they are right about what the rules did and 
did not require is a matter for litigation and is not for me to comment 
on. But I can say that if the existing rules did not require better 
disclosure, this Committee ought to consider filling that vacuum.
    Lehman's collapse and misleading disclosures offer a tragic example 
of a silo mentality, with no one taking responsibility for the entire 
farm. The Fed and the Treasury were in a position to intervene but 
viewed the SEC as Lehman's primary regulator. Yet former SEC Chairman 
Cox told me that the SEC's jurisdiction was limited to Lehman's broker-
dealer subsidiary, not Lehman itself. To be fair, Chairman Cox's 
successor, Mary Schapiro, took a different view and acknowledged that 
mistakes were made. But the point is that the consistent story I heard 
was that ``it was not my job.'' It is important that someone be 
identified--with no ambiguity--and tasked with the job of taking 
responsibility for financial oversight.
    Lehman's former Global Financial Controller Martin Kelly stated 
that he expressed his concern over Lehman's undisclosed Repo 105 
activity to consecutive Lehman CFOs (Erin Callan and Ian Lowitt), and 
warned each of them of the ``reputational risk'' Lehman faced if its 
reliance on Repo 105 became known to the public. Yet Mr. Kelly 
contended that it was the job of more senior officers to limit or stop 
Lehman's Repo 105 activity. Lehman's outside disclosure counsel said he 
was never told of Lehman's Repo 105 activity, although some of the 
Lehman personnel he communicated with and relied upon knew about the 
Repo 105 transactions and their effect on net leverage.
    Ms. Callan stated that it was the job of controllers and auditors 
to determine what came off the balance sheet at quarter-end. When she 
had to certify Lehman's financial statements, Ms. Callan said she 
relied upon subcertification by Chris O'Meara, the previous CFO. When 
it came time for Mr. Lowitt to certify financial statements, he said he 
relied upon Ms. Callan's subcertification. Richard Fuld, Lehman's 
former CEO, said that he relied upon Lehman's Chief Legal Officer and 
CFOs to inform him whether any information that should be in the 
financial statements was missing before he would certify them.
    So to review the bidding, Lehman's senior executives weren't 
responsible because they relied on the auditors and other executives. 
The auditors weren't responsible because they relied on the executives 
and the lawyers. And the lawyers relied on the executives. But the 
public--who rely on the financial statements--who do they get to rely 
on?
    Lehman's external auditor erected several of its own silos. 
Representatives of the auditor, including the lead auditor, stated the 
following:

    The auditor reviewed Lehman's Repo 105 accounting policy, 
        but not Lehman's Repo 105 practice. The auditor reviewed 
        Lehman's Repo 105 policy ``on a theoretical level.''

    The auditor was not required to look at either the volume 
        or timing of Lehman's Repo 105 transactions at quarter end.

    The auditor does not have responsibility for the MD&A 
        unless the numbers are inconsistent with the financial 
        statements, there is a material inconsistency between the MD&A 
        and the financial statements, or if the auditor actually knew 
        that information in the MD&A was materially misleading. I 
        understand this position to mean that, regardless of how 
        apparent a materially misleading statement may be, an auditor 
        has no responsibility for the MD&A if it has not actually put 
        two and two together.

    If the accounting is technically correct, it does not 
        matter to the auditor if the Repo 105 transactions were being 
        done to manipulate net leverage. When I asked if technical 
        adherence to an accounting rule could nevertheless lead to a 
        material misstatement, the lead auditor stated, ``You've got to 
        ask an attorney.''

    The auditor intended to perform additional tests regarding 
        alleged balance sheet manipulation as part of the annual audit, 
        and was not required to do so for the quarterly reviews.

    I am not here to serve as judge and jury as to whether these 
interpretations of an auditor's duties are consistent with the 
professional standards. If they are, then this Committee should 
consider whether the standards need to be revised. But I can say that 
the end result was that Lehman's auditor did not question Lehman's 
nondisclosure of Repo 105 accounting transactions or consider whether 
these transactions were undertaken solely to dress up the balance 
sheet. Lehman's auditor never communicated anything about Repo 105 
transactions to Lehman's Audit Committee members even though the Audit 
Committee instructed the auditor to investigate allegations regarding 
the balance sheet made by a whistleblower.
    My Report cites rules that require financial statements to be fair, 
accurate, and not misleading, beyond including technically correct 
accounting. It is important to emphasize that in the world of financial 
reporting, the whole is supposed to be greater than the sum of the 
parts. If a mere recitation of numbers and technical accounting masks a 
trend (such as billions of dollars coming off and on the balance sheet 
at period end), the financial reports may not be fair and accurate. To 
the extent the existing rules are ambiguous, there should be rules that 
require the auditors, before they issue an unqualified report to 
accompany financial statements, to assure themselves that technical 
accounting procedures are not being used to manipulate material 
indicators like leverage. If the rules do not exist already, there 
should be rules that require the auditors, before they issue an 
unqualified report, to assure themselves that material issues like 
liquidity are accurately portrayed. If auditors are not already 
required to determine whether the specific assets held out to the 
public as liquid are in fact liquid, they should be. And to assist the 
auditors, a common, concrete definition of liquidity for accounting 
purposes is needed.
    This is a subject deserving of careful study. Common sense dictates 
that fundamental concepts like ``net leverage'' and ``liquidity'' 
should not be a function of manipulation and subterfuge. We need to 
have clear and understandable rules if we are going to avoid these 
mistakes in the future.
    Based on my experience from the Lehman investigation and several 
decades of civil and criminal litigation, and in addition to the points 
raised above, I offer the following suggestions for how auditors can 
help prevent the next financial crisis. I will defer to the accounting 
experts and this Committee whether existing rules need to be tightened 
in some of these areas or whether improvement lies in execution and 
enforcement.

  1.  Do not marginalize the ``whistleblower.'' Auditors must take 
        seriously and fully analyze allegations of financial 
        impropriety. Auditors face intense pressures to conclude their 
        analyses quickly in order to allow financial statements to be 
        released on time but have an important responsibility to follow 
        the facts wherever they may lead.

  2.  Abandon the Quest for Immateriality. When red flags arise, 
        auditors must avoid the mindset of first and foremost finding a 
        way to describe the issue as immaterial. Existing rules require 
        analyses of qualitative materiality--particularly when 
        management is trying to actively manage the financial 
        statements--and not just number-crunching, to determine if an 
        issue is material. These rules need to be tightened or enforced 
        more aggressively.

  3.  Management representations are one piece of evidence, not 
        insurance policies for auditors. External auditors cannot be 
        expected to uncover every instance of fraud or other 
        wrongdoing. But existing rules require auditors to assume 
        neither that management is honest nor dishonest. Existing rules 
        require auditors to approach their work with independence and 
        professional skepticism and to rely on ``competent'' evidence 
        rather than accepting whatever they may be told by a bad egg in 
        management. Auditors are certainly entitled to place some 
        reliance on management representations, but as the engagement 
        letter between Lehman and its auditor acknowledged, 
        representations must be viewed as only one piece of evidence 
        available to auditors. For example, Lehman's auditors could 
        have, but did not, ask the relevant Lehman personnel the 
        business purpose of the $50 billion of end-of-period Repo 105 
        transactions, and could have, but did not, examine any evidence 
        of the volume, timing, and purpose of those transactions.

  4.  The client is the Audit Committee. Related to my prior 
        observation, auditors must remember that their client is the 
        company's Board of Directors and Audit Committee, not 
        management. Auditors face immense pressure to be ``team 
        players'' with senior management and not to rock the boat, but 
        they must serve the Board as an independent check on 
        management.

  5.  The ``review'' process must have some teeth. Auditors often 
        emphasize the difference between a full audit of annual 
        financial statements and more limited reviews of quarterly 
        financial statements. Although it is not realistic or cost-
        effective to require full-blown audits every quarter, when red 
        flags appear existing rules need to be tightened or enforced to 
        ensure that an adequate analysis is performed even for 
        quarterly filings.

  6.  Existing rules must be tightened and enforced. In some areas, the 
        rules are not up to the task. For example, there are no clear 
        rules for the measurement and reporting of the critical metric 
        of liquidity; there should be. But one rule does exist that 
        needs to be better enforced. Under existing rules, auditors are 
        not permitted to stop at whether the individual pieces of a 
        financial statement are in technical compliance with accounting 
        principles--they must opine on whether the financial statements 
        taken as a whole accurately and fairly portray the entity. In 
        other words, the whole is greater than the sum of its parts, 
        and the public does rely on auditors to perform this critical 
        function. A clean audit report should mean that the financial 
        statements fairly portray the company. When auditors fail to 
        identify or find ways to excuse material misstatements--whether 
        by classifying errors and misstatements as immaterial, placing 
        undue reliance on management representations, or providing 
        other explanations to avoid rocking the boat--they fail in 
        their fundamental role. Unless we enforce these existing rules 
        and standards, it will be difficult to count on the auditors to 
        help prevent another financial crisis.
                                 ______
                                 
               PREPARED STATEMENT OF CYNTHIA M. FORNELLI
              Executive Director, Center for Audit Quality
                             April 6, 2011
I. Introduction
    Mr. Chairman and Members of the Subcommittee, my name is Cindy 
Fornelli and I am the Executive Director of the Center for Audit 
Quality (CAQ). I appreciate the opportunity to testify today on how the 
audit and independent auditors can aid in preventing a future financial 
crisis, an important topic for all of us who are committed to 
protecting investors and maintaining confidence in our capital markets.
    The CAQ was formed in 2007 to serve investors, public company 
auditors and the markets by enhancing the role and performance of 
public company auditors. We are a membership organization with nearly 
700 public company auditing firm members that are registered with the 
Public Company Accounting Oversight Board (PCAOB). Our member firms are 
committed to the public interest role that auditors play in our 
markets.
     As a public policy organization, we strive to assure that our 
efforts are infused with a public interest perspective. Our three 
independent public board members strengthen our focus on the public 
interest and also bring us expertise in financial reporting, securities 
law and corporate governance. The members of our Governing Board (which 
includes the CEOs of the eight largest accounting firms and the AICPA) 
have a keen understanding and appreciation of the important role the 
public company auditing profession has in serving the public interest 
and honoring the public trust.
    To realize our vision, the CAQ works with investors, academics, 
audit committee members, preparers, internal auditors, and policy 
makers to explore issues and collaborate on initiatives that can 
advance audit quality. The CAQ consistently has supported the 
implementation of the Sarbanes-Oxley Act of 2002 (SOX or Sarbanes-Oxley 
Act) and, working in collaboration with others with responsibility for 
financial reporting, has a number of initiatives underway to advance 
the deterrence and detection of financial statement fraud. We also 
support research on issues relating to investor confidence, public 
company auditing and the capital markets by issuing grants that fund 
independent academic research and other activities. In all that we do, 
we are particularly interested in investors' views, as they are the 
ultimate users of the audited financial statements.
    My testimony today is on behalf of the Center for Audit Quality and 
speaks to the policy issues before us. I cannot speak to the 
circumstances of any particular public auditing firm. In my role as the 
Executive Director of the CAQ, I focus on the public policy issues 
impacting the profession. I have a background in securities law and was 
previously a senior official of the Securities and Exchange Commission 
(SEC).
    Following the past several years of global economic turmoil, there 
have been extensive examinations by panels and commissions to identify 
the root causes of the financial crisis and determine what could be 
done to reduce the risk of a future similar crisis. While none of the 
panels or commissions found that auditing was a root cause of the 
financial crisis, auditors, like all participants in the capital 
markets, have a responsibility to examine their role in light of 
lessons learned from the crisis and consider what improvements can be 
made in audit standards and what more they can contribute to market 
integrity and investor protection.
    In my testimony today, I thought it would be helpful to provide my 
perspectives on the financial crisis, a brief description of our 
current regulatory environment and, more specifically, some thoughts on 
what an audit is and its role in our system of investor protection. I 
then will describe current activities being explored by various 
stakeholders (including the profession) pertinent to the central 
question posed in this hearing, which is whether the auditor can play a 
role in helping to prevent another financial crisis. The public company 
auditing profession welcomes discussions about enhancing their role.
    The PCAOB has been examining the need for changes to the current 
auditor reporting model, and CAQ member firms have participated fully 
in the PCAOB's outreach to stakeholders on this topic. We have 
suggested a number of areas to the PCAOB where the auditor's report 
could be clarified or expanded. These include providing assurance in 
connection with Management's Discussion and Analysis (MD&A) (including 
with respect to critical accounting estimates disclosed in MD&A); 
updating wording to include references to related disclosures in the 
notes to the financial statements and language related to the auditor's 
responsibility for information outside the financial statements; 
providing additional information relating to audit scope and 
procedures; and, providing for auditor's assurance or association with 
respect to an expanded report by the audit committee. As the PCAOB 
moves forward, we will continue to participate fully in the standard 
setting process. This effort may not fundamentally change the nature of 
the audit, but could offer additional information pertaining to the 
financial statements and the audit.
    We believe strongly that the broader question of whether the 
auditor's role should be expanded beyond the boundaries of the 
financial statement audit should be explored fully by the full range of 
stakeholders, including investors, regulators, policy makers, 
preparers, boards and audit committee members, academics and the 
profession, as well as other interested parties. The public company 
auditing profession can play, and is committed to playing, a 
constructive role in how their role should evolve.
    In this regard, in January of this year, the CAQ initiated a 
program to convene stakeholders in a number of cities around the 
country to consider a range of issues relating to the role of the 
auditor. Some of the issues to be considered include the auditor's 
current roles and responsibilities and whether they should evolve; the 
relationship and communication between the auditor and the audit 
committee, management and investors; and the role of standard setters, 
oversight bodies and regulators. A key focus of our effort will be 
identifying the information most needed by investors (including early 
warnings about business risks) and who can best provide that 
information.
II. Recent Financial Crisis
    Much has been written about the causes of the recent financial 
crisis. Easy access to seemingly inexpensive credit to fund an 
increasing supply of residential housing, coupled with the 
proliferation of innovative financial instruments, as well as lax loan 
underwriting standards and documentation, led to an asset bubble that 
eventually burst the way asset bubbles tend to do. This was an economic 
reversal caused by a breakdown in risk management at many levels.
    Consumers took on too much debt; lenders issued high-risk mortgages 
that were packaged and resold and those lenders held large amounts of 
risky, leveraged instruments; and investors purchased complex 
securities that they did not understand. The impact of the reversal was 
exacerbated by the interconnectedness of our financial system.
    In response to the crisis, Congress adopted the Dodd-Frank Wall 
Street Reform and Consumer Protection Act (Dodd-Frank Act)--a far 
reaching and comprehensive piece of legislation designed to respond to 
the root causes of the financial crisis and prevent a similar crisis in 
the future. The Dodd-Frank Act focused on risk management, leverage and 
capital at financial institutions, complex and unregulated financial 
instruments and industries, consumer protection, and substantially 
greater oversight and regulation of large, interconnected, and 
systemically important financial institutions.
    Company management and the board of directors are responsible for 
setting the company's business strategies, including its risk tolerance 
and system of controls. Management also must prepare the company's 
financial statements that reflect transactions completed by the company 
and present the company's financial position as of a specific date. The 
role of the external independent auditor, under the oversight of the 
independent audit committee, is to determine whether the financial 
statements prepared by company management, taken as a whole, are fairly 
stated in all material respects in accordance with generally accepted 
accounting principles (GAAP). The auditor's report is based on facts 
and circumstances known at the time it is issued.
    In October 2007, as the crisis began to unfold and liquidity in the 
subprime markets began to decline, the profession's response was to 
focus even more closely on appropriate fair value measures. With 
illiquid markets, financial institutions found it difficult to 
determine the fair value of highly leveraged and other assets because 
the relatively new and complex fair value accounting standards required 
the use of sophisticated modeling techniques to value their assets.
    To help allay the considerable confusion on this issue, the CAQ 
Professional Practice Executive Committee prepared three white papers 
to assist auditors of public companies where the following topics might 
come into play: measurements of fair value in illiquid markets, 
consolidation of commercial paper conduits, and accounting for 
underwriting and loan commitments. While the white papers did not break 
new ground or establish new accounting or auditing standards, they had 
the effect of highlighting the valuation issues (i.e., the need for 
asset impairments) and consolidation issues (i.e., the need to 
consolidate structures because of changing risk characteristics) that 
needed to be addressed. These papers also reinforced consistency, 
skepticism and professional judgment by auditors working in this area 
and clarified the accounting for these instruments by financial 
institutions and other holders of these illiquid instruments and 
commercial paper conduits. But again, these efforts were focused on 
determining point in time valuations, not predicting market changes. 
And, many of the instruments that ultimately lost all of their value 
were actively traded right up to the collapse of the subprime mortgage 
market.
    Annual reports (which include financial statements) of many 
financial institutions leading up to the financial crisis contained 
numerous warning signals about the leverage, falling asset values, and 
other information that served to alert users to the rising risk 
profiles of many of those institutions. A number of analysts and hedge 
fund managers reacted to the risks on a timely basis. But there were 
market participants and others who should have been among the first to 
recognize credit and liquidity risk within highly regulated financial 
institutions but did not.
III. Our System of Investor Protection
    By law, a publicly traded company must provide information about 
its liquidity, operations and past financial results to the public, and 
must comply with Federal and State laws and requirements designed to 
protect investors and promote confidence in the U.S. capital markets. 
Ours is a system made up of a number of parties, laws, and requirements 
designed to assure that public companies meet their obligations. A 
company's CEO and CFO, the board of directors and the audit committee, 
internal auditors, external auditors, regulators, and standard setters 
all have responsibilities for assuring that financial reports are 
accurate and fairly present the company's financial position and 
operating results in accordance with GAAP. The SEC has authority to 
bring actions for fraud by any person in connection with the public 
securities markets, and specifically oversees publicly traded companies 
and sets their reporting requirements. A company must have an annual 
independent audit of its financial statements and the auditor's opinion 
must be in its annual report. The auditors who perform these audits are 
a key contributor to our system of investor protection. Since 2003, the 
PCAOB has regulated auditors of public companies.
Sarbanes-Oxley Act
    The Sarbanes-Oxley Act was passed largely in reaction to serious 
financial reporting frauds at several large publicly traded companies. 
SOX placed significant responsibilities on company CEOs and CFOs, audit 
committees, auditors and regulators that were designed to strengthen 
corporate governance and assure the integrity of financial reporting by 
publicly traded companies. It also created a new independent regulator 
for public company auditors.
    Oversight of Public Company Auditing Firms. SOX overhauled 
regulation of the audit profession, ending self-regulation relative to 
public company audits. Only accounting firms that are registered with 
and regulated by the PCAOB may perform audits of public companies. The 
PCAOB sets the standards for the audit process, audit firm quality 
controls and other professional standards. It also regularly inspects 
the firms (annually for any firm that audits more than 100 public 
companies) and the quality of their audits, and, in appropriate 
circumstances, may initiate disciplinary proceedings against a firm or 
professional.
    SOX strengthened the independence standards for auditors to 
increase capital market confidence in the objectivity of auditors. In 
fact, SOX prohibits the auditor from offering nine specific categories 
of nonaudit services to a company that it audits and the PCAOB has 
imposed additional restrictions. As noted, an important aspect of 
assuring auditor independence is oversight of auditors by the audit 
committee, not company management. SOX also mandates audit partner 
rotation for lead and engagement quality review partners every 5 years 
to strengthen the auditor's independence from management. Every year, 
audit committees operating on behalf of investors make recommendations 
to shareholders on the appointment of a new auditor or the 
reappointment of the existing auditor.
    Changes to the Role of Audit Committees. SOX mandated significant 
governance changes for all public companies, many of which had a direct 
impact on public company auditors. For example, prior to the enactment 
of SOX, company management often controlled the process for the 
selection of the auditor and management had the authority to hire or 
dismiss the auditor. This responsibility now lies with the audit 
committee. SOX placed on audit committees--a committee of the board of 
directors--particular responsibilities to investors. It placed 
responsibility for financial reporting and auditor oversight directly 
with the audit committee, rather than on the company's management. The 
audit committee must be completely comprised of individuals who are 
independent from the company and its management.
    SOX changed the role of audit committees with respect to:

    Auditor selection and approval of fees;

    Audit and nonaudit services pre-approval;

    Review of critical accounting treatments; and

    Internal complaint procedures including ``whistleblower'' 
        protections.

    To fulfill its responsibilities, the audit committee meets 
regularly with financial management of the company and its external 
auditors to discuss issues related to accounting policies and judgments 
embedded in the company's financial reports and determine whether they 
are appropriate.
IV. The Value of the Audit
    It is important to have an appreciation for what a financial 
statement audit represents today before one can reasonably consider 
whether the audit should be changed. The audit opinion, the form of 
which is prescribed by the PCAOB's auditing standards, is issued at the 
completion of the audit. The audit itself is a robust process, in which 
the audit team tests transactions and management's assertions and 
challenges the quality of the accounting, selection of accounting 
policies and, ultimately, the company's financial reporting.
The Financial Statement Audit Today
    The financial statement audit examines a company's annual financial 
statements, which provide a point in time snapshot of the company's 
financial position at the end of its fiscal year and its results of 
operations and cash flows for that fiscal year. In essence, the auditor 
performs a series of tests to collect evidence that provide reasonable 
assurance whether the public company's financial statements, taken as a 
whole, are fairly presented in accordance with GAAP.

    The external audit firm is hired by and reports to the 
        company's audit committee of the board of directors, which 
        monitors the scope and performance of the audit, as well as the 
        firm's continuing independence from the company;

    The audit team is made up of professionals led by a 
        certified public accountant who is a partner of the firm. 
        Members of the audit team are assigned based on their 
        individual skills relative to the specific requirements of the 
        particular audit, including knowledge of the company's business 
        and industry, and experience with the types of transactions and 
        business operations covered in the financial statements;

    The auditor is required to conduct a risk assessment of the 
        potential for the financial statements to contain a material 
        misstatement due to error or fraud on the part of the company's 
        management, personnel or reporting systems. As part of the risk 
        assessment, auditors specifically consider the risk of fraud. 
        The fraud risk assessment includes brainstorming by the audit 
        team about how and where they believe the company's financial 
        statements might be susceptible to misstatement due to fraud, 
        with appropriate adjustments to the audit plan;

    The auditor must exercise professional skepticism in 
        planning and conducting the audit. Professional skepticism 
        requires objectivity and a questioning mindset in assessing the 
        audit evidence. The auditor must be attentive to 
        inconsistencies or other indications that something may not be 
        right and challenge management when necessary. The audit team 
        uses its experience and judgment in selecting the areas to be 
        tested in light of the risks identified. The audit team's focus 
        can include complex transactions, weak controls over the 
        financial reporting process, and issues affecting the industry 
        as a whole;

    Auditors are responsible for obtaining audit evidence 
        through the testing of the assertions made by management and 
        the amounts and disclosures included in management's financial 
        statements. Based on its risk assessment, the audit team must 
        gather sufficient and appropriate evidence to support its 
        opinion as to whether the company's financial statements fairly 
        present the company's financial position, and results of 
        operations and cash flows in accordance with GAAP. The process 
        includes reaching out to the audit committee to discuss 
        accounting issues during and at the end of the process;

    The audit team documents its risk assessment, the work 
        performed to address the identified risks and its conclusions. 
        Prior to issuing an opinion, the audit team must consider 
        whether there is substantial doubt about the company's ability 
        to continue as a ``going concern'' for a reasonable period, 
        generally interpreted as the next 12 months. The evaluation is 
        based upon facts and circumstances in existence and known at 
        the time the opinion is issued;

    Before the audit opinion is issued, an experienced auditor 
        outside of the audit team reviews the scope of work and the 
        judgments and conclusions made by the audit team to evaluate 
        the quality of the audit. The engagement quality review is just 
        one of the many processes firms implement to assure high 
        quality audit work;

    If the financial statements comply with GAAP and fairly 
        present the company's financial position, the auditor issues an 
        unqualified or ``clean'' opinion; if the auditor concludes that 
        the financial statements do not comply with GAAP in some 
        respects or do not provide a fair presentation of the company's 
        financial position, the auditor must issue a qualified or 
        adverse opinion.

    For companies with market capitalization greater than $75 million, 
the audit report also contains an opinion on the effectiveness of the 
company's internal control over financial reporting. We believe that 
the auditor's involvement in providing an opinion on the effectiveness 
of internal control over financial reporting has enhanced the 
reliability of financial statements.
V. Should the Auditor's Report Be Expanded?
    The PCAOB has been examining the need for changes to the current 
auditor reporting model, which has not changed much over the years, 
while the size and complexity of companies and their annual reports and 
financial statements have grown exponentially. In recent months, the 
PCAOB staff and its Investors Advisory Group (IAG) each have canvassed 
a number of investors and other stakeholders to determine whether the 
audit opinion is still useful to users of financial statements. The IAG 
presented its findings to the PCAOB Board on March 16, 2011; PCAOB 
staff shared its findings with the Board at a public meeting on March 
22, 2011, described below. Both found that investors value the 
independent audit and the current audit report.
    According to this outreach, investors understand that the true 
value of the audit is not the opinion itself, but rather the very 
extensive amount of work that was performed in order for the auditor to 
provide reasonable assurance that the financial statements are free of 
material misstatement. They understand that in large global companies, 
audits can require teams made up of hundreds of individuals and 
partners, can take many thousands of hours, and can include audits of 
foreign subsidiaries.
    Both PCAOB staff and the IAG did find, though, that investors want 
more information in addition to the auditor's opinion to help them 
assess the quality of financial reporting at the company and the scope 
and quality of the audit. We have heard this from investors as well.
    It is clear to me that auditors can continue to enhance the role 
that they play and the value they provide to investors and the capital 
markets. Moreover, others with responsibility--particularly the audit 
committee, which has responsibility for overseeing the quality of the 
company's financial reporting and the external audit firm--also are in 
a position to improve the quality and relevance of information that 
they provide to investors. These changes should be made thoughtfully 
and should not merely result in a ``piling on'' of more disclosures 
that do not provide meaningful improvements to investors' ability to 
understand a company's financial results and other disclosures. 
Moreover, good public policy requires that a cost-benefit analysis of 
changes to the audit report or auditor's role be examined before 
additional requirements are put in place.
The Profession's Suggestions for Improving the Auditor's Report
    The profession is actively engaged with the PCAOB and has suggested 
a number of areas where the auditor's report could be clarified or 
their role could be expanded to provide more information about the 
audit process and key areas of focus, some of which may require SEC 
action before being implemented. These areas include:

    Auditor association with critical accounting estimates 
        disclosed in Management's Discussion and Analysis (or, 
        alternatively, a separate supplemental auditor communication on 
        critical accounting estimates);

    Auditor association with the entire Management's Discussion 
        and Analysis;

    Additional wording in the standard audit report to include:

      Reference to ``related disclosures in the notes to 
        financial statements'' in both the scope and opinion 
        paragraphs; and

      New language related to the auditor's responsibility for 
        information outside the financial statements;

    Additional information/communication relating to audit 
        scope and procedures, including:

      Providing a ``link'' within the auditor's report to a 
        separate document that describes the audit process, including a 
        discussion of the responsibilities of auditors, management and 
        audit committees; and,

      A discussion of specific audit procedures performed.

    The PCAOB has stated that it plans to issue a Concept Release this 
June, followed by a roundtable discussion, with a proposed rulemaking 
in early 2012. Based on PCAOB staff comments during the recent PCAOB 
public meeting and a subsequent meeting of the PCAOB's Standing 
Advisory Group, the PCAOB may propose ways to provide more detail to 
supplement the current form of the opinion. Some options discussed 
include adding wording to the opinion indicating that the auditor must 
plan and perform the audit to obtain reasonable assurance about whether 
the financial statements are free of material misstatement ``whether 
caused by error or fraud''; explaining that reasonable assurance is a 
high level of assurance but is not absolute assurance; adding wording 
that the auditor is independent as required by applicable rules and 
regulations; and adding a requirement that the auditor's report be 
addressed to both the board of directors and shareholders. The 
profession supports these clarifying changes in addition to those I 
noted above.
    We hope the PCAOB will consider the suggestions of the profession. 
We also hope that the PCAOB will work with the SEC to explore the 
benefits of an expanded audit committee report to investors and 
consider whether auditor association would be appropriate, which also 
was discussed with the PCAOB Board at its March 22 open meeting.
VI. Should the Role of the Auditor Be Expanded?
    Even as the PCAOB's consideration of the auditor's reporting model 
continues throughout this year, the CAQ has for some time believed that 
the broader question--whether the auditor's role should be expanded 
beyond the boundaries of the financial statement audit--should be fully 
and openly discussed by the full range of stakeholders, including the 
profession, preparers, audit committees, investors, regulators, 
standard setters, policy makers, advisors, analysts, legal counsel, 
academics, and other interested parties.
    The CAQ has informed the SEC and the PCAOB of its plan to convene 
stakeholders across the country to:

    Consider the public company audit profession's current 
        roles and responsibilities, including obligations of 
        professional objectivity and skepticism; and consider the roles 
        of management and audit committees in the financial reporting 
        process;

    Discuss whether there is a need for the role of the auditor 
        to further evolve in order to improve the quality and delivery 
        of information provided to stakeholders, and consider how such 
        changes fit with the current reporting model and whether such 
        changes would further improve audit quality and investor 
        protection;

    Discuss how the role of the auditor intersects and relates 
        with audit committees, management, advisors, analysts and 
        others and examine the potential need for those roles to evolve 
        as well given interdependencies in serving the interests of 
        investors;

    Consider the role of policy makers (including standard 
        setters and oversight authorities) in effecting improvements in 
        the quality and delivery of information provided to 
        stakeholders and consequential impacts on audit quality and 
        investor protection; and

    Identify areas of consensus and open issues, and recommend 
        short and longer term actions that would have a positive impact 
        on the capital markets and the value of the audit to investors 
        and other stakeholders.

    Some of the issues we hope to discuss include identifying what 
information investors rely on most in making investment decisions and 
where they find that information; the extent to which annual reports 
and financial statements are useful; whether auditors should provide 
some level of assurance on nonfinancial information disclosed in the 
annual report, as well as whether auditors should provide some level of 
assurance on information disclosed outside of the annual report (such 
as press releases). We also want to explore whether auditors could--and 
should--provide some level of assurance around forward looking 
information provided by a company, and how auditors and other experts 
could manage the risks of being associated with such information. An 
important element of these discussions will be to consider what 
information will be truly useful to investors. Certainly the issues 
raised today will help to inform our discussions.
    We will need to guard against changes to the role of the auditor 
that would undermine the legal and ethical responsibilities of CEOs and 
CFOs to assure the integrity of their companies' financial reporting 
processes, and of audit committees to oversee the company's financial 
reporting process and the performance of the auditors. Any exploration 
of the change in the auditor's role should strengthen and not undermine 
the responsibilities of these parties.
    Finally, we will want to explore, as a practical matter, the extent 
to which auditors may be able to provide early warnings if they 
identify business risks as distinct from risks of material misstatement 
of the financial statement due to error or fraud.
    Our hope is that these discussions will expose stakeholders to 
these potentially paradigm-changing issues in a way that encourages 
hard thinking around the cost-benefits of various proposals, and 
identifies areas of consensus. In this way, our work on the role of the 
auditor will inform policy decisions here, including the PCAOB's 
upcoming standard-setting on the auditor's reporting framework, and 
abroad, where the role of the auditor also is being examined.
VII. Recommendations
    A number of major efforts are underway to implement the numerous 
requirements of the Dodd-Frank Act, which represent Congress's set of 
priority responses to the recent financial crisis. Assuring that the 
SEC is adequately resourced to meet its statutory objectives is 
critical to assuring investor confidence and participation in our 
capital markets. While Congress did not choose to streamline regulatory 
regimes over financial firms and markets, simplification of these 
regimes is of great importance to maintaining efficient markets that 
attract issuers and investors. We would like to see the SEC and the 
Financial Accounting Standards Board continue efforts to remove 
unnecessary complexity from accounting standards in the United States 
and move toward a single set of high-quality global accounting 
standards.
    One final recommendation: given the global nature of our companies 
and markets, I strongly urge policy makers and regulators in all 
jurisdictions to work together to achieve consistency in approaches to 
allow the profession to meet the needs of investors.
VIII. Conclusion
    I appreciate the opportunity to speak with the Committee today. I 
applaud you for recognizing that the role of the audit and the auditor 
is important. Our discussions today reflect a deep interest in finding 
the best way to serve investors and users of financial information. The 
CAQ will continue to participate in these discussions and work with all 
stakeholders to determine the best ways forward.
    Thank you. I look forward to answering any questions you might 
have.
                                 ______
                                 
                 PREPARED STATEMENT OF THOMAS QUAADMAN
   Vice President, Center for Capital Markets Competitiveness, U.S. 
                          Chamber of Commerce
                             April 6, 2011
    Chairman Reed, Ranking Member Crapo, and Members of the Securities, 
Insurance, and Investment Subcommittee, my name is Tom Quaadman, Vice 
President for the Center for Capital Markets Competitiveness at the 
U.S. Chamber of Commerce. The Chamber is the world's largest business 
federation, representing more than three million businesses and 
organizations of every size, sector, and region. We appreciate the 
opportunity to testify before the Subcommittee today on behalf of the 
businesses that the Chamber represents, investors, and our economy.
    We are here to discuss the role of the accounting and auditing 
profession in preventing another financial crisis. This is a very 
timely and relevant topic and one that could be the subject of multiple 
hearings. For decades, standard setters have been operating under 
inadequate rules and guidance, resulting in the impairment of financial 
reporting and as a contributing factor that escalated the financial 
crisis. In order to prevent the next crisis we must address the 
fundamental flaws with the system.
    Businesses need and want strong financial reporting policies. 
Companies require investors and capital to grow and create jobs. 
Capital will only go where it is welcome and can act with legal 
certainty, coupled with a disclosure of the knowable risks involved. 
All parties must enter into transactions with a full understanding of 
the facts, and financial reporting is a key disseminator of that 
information. Credible financial reporting is one of the indispensable 
active ingredients for capital formation, which fuels economic growth 
and job creation.
    Therefore, the development of standards for credible financial 
reporting policies through the work of the Financial Accounting 
Standards Board (FASB), Public Company Accounting Oversight Board 
(PCAOB), and the Securities and Exchange Commission (SEC), are critical 
for accounting and auditing to effectively function in a free 
enterprise economy.
    In short, if the United States is to create the 20 million jobs 
that it needs to revive the economy over the next decade, financial 
reporting must play its crucial part.
    Before I get too far, let me state that Jack Brennan, Chairman of 
the Financial Accounting Foundation (FAF) and Leslie Seidman, Chairman 
of FASB, have been making great strides to make FASB more inclusive and 
transparent. James Doty, the Chairman of the PCAOB has only recently 
come into office, and we have pledged to work with him, as we have with 
FAF and FASB. Nevertheless, we are concerned that standard setters have 
been operating with inadequate rules and guidance, which we shall go 
into greater detail later in this testimony. We believe that these 
inadequacies have prevented the standard setters from fulfilling their 
mission and undermine the ability of financial reporting to achieving 
its intended purpose.
    The purpose of accounting and auditing is to reflect economic 
activity. Yet, over the past twenty years, we have seen some standards 
promulgated that reflect conceptual agendas rather than providing 
investors and businesses with useful information. As a result, 
financial reporting was under great stress before, during, and after 
the financial crisis. The performance of financial reporting during the 
crisis was symptomatic of systemic issues that remain unresolved.
    CIFiR Report: The turn of the century saw an explosion in financial 
restatements. At the height of these events, the restatement rate was 
10 percent a failure rate that clearly indicates a broken system. 
Though the rate has been decreasing over the past several years, the 
number of restatements indicates issues remain. In 2008, The SEC 
Advisory Committee on Improvements to Financial Reporting (CIFiR 
Report) made recommendations, including the concept of investor 
materiality to reduce restatements. The Chamber has supported those 
recommendations and encourages their implementation. While the 
regulators have not been willing or unable to fix the problem, Congress 
has looked to impose additional penalties for company restatements.
    Fair Value Accounting: Fair value accounting was, in our opinion, 
an exacerbating factor to the financial crisis. The failure to 
recognize and correct the inability of standards to provide clarity for 
the valuation of assets in inactive markets, which were auditable, was 
a symptom of the failure of FASB, PCAOB, and to an extent the SEC, to 
recognize a problem and quickly correct it. This failure caused further 
damage to the economy. The Chamber proposed a compromise in October 
2008 to fix the standard that was acted upon 6 months later following a 
Congressional hearing. Part of the problem was simply that some members 
of FASB believed in fair value as it existed and didn't want to make 
any changes. FAF Chairman Jack Brennan and FASB Chairman Leslie Seidman 
have, to their credit, made significant efforts to solicit as broad a 
range of opinions and positions as possible. That outreach and input 
has significantly assisted in the efforts to smooth over difficult 
issues in the convergence projects.
    Understanding of Investors: The standard setters purport to 
represent investors, yet they often fail to identify the investor 
interests they seek to represent and cannot describe the breadth of the 
investor community that has been consulted. The investors that may be 
consulted appear to be narrow. Sometimes, the investor interest is even 
described as a potential investor, though nobody has been able to 
explain who or what that means. Indeed the standard setters do not seem 
to understand the role of businesses--who make investments in financial 
instruments everyday to facilitate operations and mitigate risk--as 
investors. The lack of understanding and consideration of all investors 
broadly harms stakeholders.
    Financial Reporting Forum: CIFiR recommended the creation of a 
Financial Reporting Forum (FRF) made up of standard setters, 
regulators, and stakeholders to identify short-term and long-term 
financial reporting issues and propose solutions. The Chamber supported 
this concept as well as the Miller Amendment to the House financial 
regulatory reform bill creating such a forum. While the Financial 
Reporting Forum was in the original House passed bill, it was 
eventually deleted from the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (Dodd-Frank Act). Today, we still do not have a safety 
valve to spot and prevent potential problems in financial reporting 
policy before a crisis unfolds.
    Private vs. Public Companies: For decades, private companies have 
expressed frustration with public company accounting rules. These rules 
are sometimes incompatible with their investor needs. This year, a blue 
ribbon panel overwhelmingly recommended a separate standard setter to 
modify FASB standards for the 29 million private businesses in the 
United States, including many small business. It appears that this 
recommendation, which will help facilitate financial reports for 
America's entrepreneurs, faces an uphill battle at best.
    Auditing Liability: From an audit standpoint, members of the 
Treasury Advisory Committee on the Auditing Profession (ACAP) agreed 
that liability threats to the audit firms can be destabilizing to 
financial reporting and the economy as a whole. Solutions, however, 
cannot be agreed upon. Indeed the Dodd-Frank Act mandates studies that 
are geared to lay the groundwork to overturn the Stoneridge and 
Morrison Supreme Court decisions potentially increasing liability for 
the audit firms.
    We have also seen an uptick in prescriptive rule standard setting 
by the PCAOB that deprives the auditor of the judgment to call balls 
and strikes. This change endangers the role of the auditor and making 
it a rote exercise. Auditing is a profession with a long line of 
integrity and judgment, yet when we need that function the most, we are 
depriving them of the tools needed to do their job. Recognizing the 
importance of judgment, CIFiR also recommended that the PCAOB develop 
an audit judgment framework on how it evaluates the reasonableness of 
audit judgments in its inspection and enforcement activities.
    New Proposals: With regard to accounting standards, at times, it 
seems that standards are developed, not to provide investors with 
relevant information but to satisfy the demands of a small group of 
activist investors. For example, imposition of recent proposals to 
revise FAS 5 related to loss contingencies, would not only endanger the 
ability of companies to defend themselves in court, the increase in 
litigation would actually harm investors in direct contradiction to the 
mission of FASB. New proposals, such as with leases, would drive up 
compliance costs, skew financial activity, and prevent companies from 
engaging in proven business practices, again to the harm of investors.
    Convergence: Today, FASB and its international counterpart are 
working at a breakneck pace to converge accounting standards according 
to an arbitrary deadline set by the G20. The Chamber has called for an 
extension of time to get the projects completed without haste so that 
the end results stand the test of time. To facilitate this result and 
minimize unintended consequences, the Chamber has also proposed a 
formal review system to minimize unintended consequences. Furthermore, 
as the regulators are furiously working themselves to implement the 
provisions of Dodd-Frank, it seems as if the regulators and standard 
setters do not understand how the accounting rules and financial 
regulations interconnect and how accounting could in certain instances 
thwart the provisions of Dodd-Frank. In addition, discussions to 
determine the audibility of these new accounting standards, has not 
occurred.
    APA: Another important issue is that FASB and PCAOB, whose job it 
is to promote transparency in financial reporting, are not transparent 
in their governance nor do they follow the open, orderly procedures 
that regulators must follow. FASB and PCAOB are not required to follow 
the Administrative Procedures Act (APA), nor are their advisory bodies 
required to follow the Federal Advisory Committee Act (FACA). 
Therefore, economically significant actions by FASB and PCAOB that can 
destroy billions in wealth for investors and kill thousands of jobs, do 
not have to follow minimal transparency requirements that Federal 
regulators must follow.
    To summarize, for the past 20 years we have seen the financial 
reporting move from one crisis to the next. Numerous studies have been 
conducted with solutions seldom implemented. Standards have been 
written, not to reflect economic activity, but in search of a holy 
grail of purity that is simply unobtainable. During this time we have 
seen:

  1.  A steady decline in the listing of public companies in the United 
        States; and

  2.  American companies eschew the traditional form of public company 
        financing and consciously avoiding the American capital markets 
        to raise capital through private markets.

    Despite these issues, financial reporting policies in the United 
States are still the best in the world, but we need to correct those 
problems in order to make our capital markets attractive for years to 
come. And we need to act before it is too late. The following are among 
the steps that need to be taken:

    Financial Reporting Forum: A FRF should be formed and made 
        up of the SEC, FASB, PCAOB, financial regulators, investors 
        (broadly defined), and businesses and its mission should be to 
        identify and propose solutions to problems before they reach 
        the crisis stage. This will also provide a mechanism to allow 
        for appropriate coordination amongst regulators and input from 
        investors and businesses.

    Materiality for Investors: The SEC, FASB, and PCAOB should 
        develop standards of materiality for investors, as well as the 
        scope of outreach to the investor community. This will provide 
        perspective on various accounting and auditing issues such as 
        the need for restatements on the one end, while framing the 
        picture for input on the front end of standard setting.

    PCAOB, FASB, and Regulator Coordination: A formal, ongoing, 
        and transparent dialogue should be created to consider the 
        auditability of accounting standards. This would allow for the 
        auditing of accounting standards to work in conjunction with 
        standard development. It would also provide for the 
        identification and resolution of issues that arise in practice. 
        A similar process should be created to ensure that regulators 
        have an understanding of standards and that different entities 
        are not working at cross purposes. The era of ``not my 
        problem'' needs to end.

    APA and FACA: Recognition should be made that both FASB and 
        PCAOB can have an enormous impact on the economy. Accordingly, 
        FASB and PCAOB should abide by the same rules of procedure as 
        required by the APA and any advisory groups should be balanced 
        in representation and open in process.

    Formal Pre- and Post-Implementation Review by FASB: 
        Standards should be field tested and put through a rigorous 
        process to identify unintended consequences before 
        implementation and after. This process should include the 
        following:

    1.  Establish a 9-month period, following the finalization of the 
        convergence projects, for FASB and IASB to work with all 
        financial reporting stakeholders to identify transition issues 
        and issue an implementation plan;

    2.  Establish an Implementation Issuer Advisory Group, made up of 
        large cap, mid cap, and small cap public companies and 
        appropriate private company representation to advise FASB and 
        IASB on the transition issues and implementation plan;

    3.  Hold a series of roundtables, in conjunction with the 
        appropriate regulators, for all stakeholders to have a voice in 
        identifying issues and developing an implementation plan;

    4.  Commit to procedural transparency through adherence to the 
        Administrative Procedures Act and disclosure policies 
        established by U.S. financial regulators in the wake of the 
        Dodd-Frank Act rulemaking;

    5.  Consult with appropriate financial regulators; and

    6.  Develop a formal implementation and post-implementation process 
        as proposed by CIFiR.

    PCAOB Business Roundtables and Formation of Business 
        Advisory Group: In the coming weeks the Chamber and other trade 
        associations will call upon the PCAOB to hold a roundtable and 
        for a business advisory group to understand the role of 
        companies as investors and their use of investments. Such a 
        group should be transparent and formed under FACA.

    PCAOB Audit Advisory Group: To provide for current, 
        relevant expertise in the standard setting process and 
        facilitate the identification and resolution of issues that 
        arise in practice, the PCAOB should form an audit advisory 
        group.

    Cost Benefit Analysis: In developing accounting and 
        auditing standards, FASB and PCAOB must conduct a cost benefit 
        analysis for investors and businesses before moving forward 
        with a proposal. Standards should also show a justification for 
        market efficiency and capital formation.

    Less Reliance on Prescriptive Rulemaking: Hand-in-hand with 
        the appropriate use of judgment is avoiding a system that is 
        overly prescriptive in the formulation and application of 
        standards and rules. The danger of an ever increasing number of 
        rules and regulations by which audit firms are required to 
        operate and auditors are required to apply has a danger of 
        limiting the perspective of audit firms and auditors by 
        displacing the application of principles and the exercise of 
        judgment.

    Global Standards: The SEC, FASB, and PCAOB should work 
        towards the convergence of accounting and auditing standards to 
        create a global system that will benefit investors from around 
        the world. This convergence must create quality standards and 
        should not adhere to a strict timeline to achieve that goal. 
        Additionally, the SEC, and Administration should continue 
        efforts to achieve the international recognition of 
        inspections.

    Liability: It should be recognized that large, medium, and 
        small audit firms are needed, just as our economy needs large, 
        medium, and small financial institutions. However, the unique 
        aspects of the industry and the potential for catastrophic 
        failure because of liability require a serious effort at 
        liability reform, as has been accomplished in other 
        jurisdictions or for other industries here in the United 
        States.

    The Chamber believes that these reforms would have dramatic 
benefits and provide a resiliency that was lacking during the financial 
crisis. All stakeholders would have the ability to provide input to 
FASB and PCAOB in an open and transparent manner. Standards would be 
improved and accounting and auditing would be on the same page. The 
same would be true of the regulators who, with the standard setters, 
would have a better feel for the overlap and interplay of seemingly 
disparate yet interconnected disciplines.
    Auditors would be empowered to use their best judgment to impose 
integrity and accountability into the system. Global standards and 
cross-border cooperation will increase the ability of investors to 
understand a global marketplace, and for regulators to better provide 
for safety and soundness.
    If we want to have transparent financial disclosures, the 
regulators and standard setters need to be transparent themselves and 
disclosures must be relevant and rational. The Chamber believes that 
significant reforms to the transparency of the standard setting 
process, a better understanding of the roles and empowerment of 
stakeholders, while addressing liability issues are important 
developments to make financial reporting policy an integral part of the 
21st century economy.
    We cannot and should not eliminate risk from the system. Risk 
provides for the growth opportunities our economy needs to thrive. 
While we can try to strengthen the system, we must also recognize that 
fraud can never be fully eliminated. Rational and enforceable financial 
reporting policies will help spur long-term economic growth and job 
creation, and the Chamber is willing to work with any and all parties 
to make that a reality. I will be happy to take any questions that you 
may have.
                                 ______
                                 
                  PREPARED STATEMENT OF LYNN E. TURNER
      Former Chief Accountant, Securities and Exchange Commission
                             April 6, 2011
    Thank you Chairman Reed and Ranking Member Crapo, for holding this 
hearing on an important issue to investors in America's capital 
markets. Investors receiving credible financial information is the 
``lifeblood'' to the capital markets. It is paramount to confidence and 
ability of those markets to attract capital. In fact, the turmoil in 
the markets in recent years has no doubt had a very real negative 
effect on capital formation in this country and the ability of 
companies to obtain that capital.
    Before I start, it might be worthwhile to provide some background 
on my experience. I have held various positions in the accounting 
profession for some 35 years. I started my career with one of the 
world's largest international accounting and auditing firms where I 
rose to become an audit and SEC consulting partner. I served as a CFO 
and vice president of an international semiconductor company that had 
audited financial statements. I have had the good fortune to be the 
Chief Accountant of the Securities and Exchange Commission (SEC). In 
addition, I have been a member of chaired audit committees of corporate 
boards of both large and small public companies, a trustee of a mutual 
fund and a public pension fund, and a professor of accounting. I have 
also used and relied on audits as director of research of a financial 
and proxy research firm. In 2007, Treasury Secretary Paulson appointed 
me to the U.S. Treasury Advisory Committee on the Auditing Profession 
(ACAP). I have also served on various advisory committees and task 
forces of the Financial Accounting Standards Board (FASB), and the 
Standing Advisory Group (SAG) and Investor Advisory Group (IAG) of the 
Public Company Accounting Oversight Board (PCAOB).
Lessons Learned From the Crisis
    Let me start by stating that if the financial system was working as 
intended, it is indeed scarier than the idea that the system failed. 
However, we hear some constantly repeating the theme of ``Do No Harm'' 
which is the equivalent of saying do nothing. And doing nothing would 
be the same as saying the system worked as intended.
    The Subcommittee presented three very worthwhile questions to those 
testifying today. They in essence ask the question of what lessons have 
we learned from the crisis and what changes should be made to prevent a 
repeat of this horrific event resulting in the Great Recession. This is 
a question not only of interest here in the United States, but also 
abroad where the European Commission and the British Parliament have 
undertaken to study the issue.
    It also brings to mind the first hearing of the full Senate Banking 
Committee on the Dodd/Frank legislation on February 4, of 2009. At that 
hearing, Senator Shelby stated:

        As I have said many times and will continue to say, I believe 
        that before we discuss how to modernize our regulatory 
        structure, or even before we consider how to address the 
        current financial crisis, we need to first understand its 
        underlying causes. If we don't have a comprehensive 
        understanding of what went wrong, we will not be able to 
        determine with any degree of certainty whether our regulatory 
        structure was sufficient and failed, or was insufficient and 
        must change . . . .this Committee should and must conduct a 
        full and thorough investigation of the market practices, 
        regulatory actions, and economic conditions that led to this 
        crisis. The Committee should hear testimony from all relevant 
        parties and produce a written report of its findings.

    I believe Senator Shelby was right about the need for a 
comprehensive study and his comments are just as relevant today. I 
believe the PCAOB should undertake such a study of the role of the 
auditors and accounting profession in the financial crisis and issue a 
public report on its findings. Earlier this month, the Investor 
Advisory Group to the PCAOB urged such a study be undertaken citing a 
number of issues with respect to audits as set forth in the attached 
Exhibit A.
    It is worth noting that in the past week, the House of the Lords in 
Britain issued such a report that was critical of the auditing 
profession and the ability to audit international accounting standards. 
In a good example of study in retrospective review of the crisis, the 
International Monetary Fund has also issued a self examining public 
report on the crisis which I believe is very valuable to addressing 
necessary changes. I believe such as retrospective review, in-depth 
study and report by not only the PCAOB, but also both the SEC and FASB 
should be undertaken and published.
    At the same time, I have heard the calls from some in Congress to 
reopen the debate on the Dodd/Frank legislation. While there is debate 
between investors on one side, and the financial and business community 
on the other side about the need for, and impact of that legislation, I 
would urge Congress not to reopen the debate, until as Senator Shelby 
has suggested, an in-depth investigation by the Senate Banking 
Committee occurs to provide a basis for changes to be made.
Did the Profession Perform As Expected--Did It Protect Investors?
    The first question asked by the Subcommittee is:

  1.  Did the accounting profession perform as expected leading up to 
        and during the financial crisis? Specifically:

    a.  Did auditors perform as expected during the financial crisis?

    b.  Did the public company audit provide informative, accurate, and 
        independent reports to investors?

    c.  Should the auditors have provided advance warning to investors 
        or others?

    d.  Did the accounting standards and financial statements provide 
        investors, creditors, and others with adequate protections and 
        accurate and reliable disclosures?

    e.  If not, what changes, if any, would you recommend.
The Role of the Auditor
    The ultimate responsibility for the financial statements of a 
company rests with its management. In turn, audit committees of boards 
of directors are responsible for the oversight of the internal 
controls, financial reporting and audit process of a public company. It 
is important to state that auditors DID NOT create the financial 
crisis. They did not run the companies involved, did not make the 
uncollectible loans or enter into the toxic derivatives, and certainly 
did not prepare the financial statements issued to investors.
    However, auditors did have an extremely important role as a 
gatekeeper to the capital markets both in the United States as well as 
abroad. Independent audits provide investors with reasonable 
assurance--that is high but not absolute assurance--the financial 
statements are correct and complete within the boundaries of 
materiality. It is the objectivity--the independence--of the auditor 
that creates the value of an audit. Without that independence and 
objectivity, an audit has no value. As the increasing complexity of 
business transactions, products and structures result in more 
subjective accounting standards, they also continue to create the need 
for judgment on the part of auditors. Subjective, very judgmental 
decisions by the auditor also greatly enhance the need for objectivity 
and professional skepticism on the part of auditors.
    Unfortunately, as described later on, gatekeepers including the 
auditors did play a role in the financial crisis. They failed to act on 
and provide information available to them to investors. This left 
investors much like the ship Titanic as it approached an unforeseen 
iceberg, without any red flags or warnings of the imminent dangers. In 
doing so, the auditors helped contribute to a crisis in confidence.
Lax and Untimely Accounting Standards
    The auditor does audit to accounting standards established by the 
accounting standard setters. The quality, or lack thereof in those 
standards can significantly impact the quality of financial information 
investors receive.
    The failure of the FASB to issued timely standards that protect 
investors is not a new situation and exposes long standing fundamental 
flaws in its structure and mission. In early 2008, Chairman Reed very 
appropriately wrote the accounting standard setters citing concerns 
about the accounting standards for off balance sheet debt that yet 
again allowed companies to hide obligations from the view of investors, 
similar to what happened at Enron. One of those letters also noted that 
it is likely, despite lax standards the FASB issued in response to 
Enron, that some of the companies had likely not complied with the 
accounting standards raising questions as the quality of the audits 
that had been performed. \1\ However, it is important to note the FASB 
originally issued its first standard creating the ability for companies 
to hide off balance sheet debt, FASB Standard No. 77, in December 1983, 
some 28 years ago. Prior to that, the applicable accounting standard 
required that financing transactions be reported as debt on balance 
sheets. And beginning soon after the issuance of the FASB's original 
standard, chief accountants of the SEC consistently warned the FASB 
that its standards needed significant change and improvement. Indeed, 
up to the very beginning of the financial crisis the FASB had been 
warned, and knew, its standard was deficient but failed to act 
promptly. Instead it chose to wait until after significant losses had 
been incurred by investors to take corrective action. And I for one am 
not yet convinced the most recent ``fix'' the FASB has put in place 
will be successfully in providing a remedy to the full extent of the 
problem.
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     \1\ In a letter from then FASB chairman Herz, to Chairman Reed, it 
states: ``The FASB is not responsible for auditing, regulating, or 
enforcing the application of accounting standards and disclosure 
requirements. Thus, the observations discussed herein regarding the 
application of existing requirements is solely based on our discussions 
with various constituents and our reading of published financial 
reports and press articles and may carry with them the benefit of 
hindsight. Based on these discussions and readings, we have questions 
about compliance with the existing standards and requirements in the 
following areas: (a) The use of QSPEs to securitize assets for which 
decisions were required that may have extended beyond those specified 
in legal documents; (b) The completeness and reasonableness of 
probability assessments used in estimating expected losses for 
determining the primary beneficiary of a securitization entity; (c) 
Whether all involvements with a securitization entity were considered 
in determining the primary beneficiary (including, for example, implied 
guarantees and support arrangements); (d) The adequacy of disclosures 
made pursuant to the requirements.
---------------------------------------------------------------------------
    In the past, the FASB also failed to issue other important 
standards on a timely basis. Some examples of this are:

  1.  In the 1990s, despite increasing volumes of derivatives, the FASB 
        failed to update their standards in a timely manner for these 
        transactions leading to large losses for such investors in such 
        companies as Proctor & Gamble. After those losses had been 
        incurred, the FASB did issue its standard No. 119 within a 
        year, showing it can, act quickly. However, in this instance it 
        was once again after the damage to investors had occurred.

  2.  In the 1990s, companies began to engage in inappropriate 
        ``earnings management'' when the management of the business had 
        failed, contributing to a number of corporate scandals at such 
        companies as Waste Management, Xerox, and Rite Aid. Yet the 
        FASB was slow to respond to the various schemes and .devices 
        management was using to manage earnings resulting in tens of 
        billions of losses for investors.

  3.  The FASB, when its independence was impacted by actions of some 
        in congress, was slow to respond to abuses in accounting for 
        stock options.

  4.  Despite serious, if not fatal flaws, in AICPA Statement of 
        Position 94-6, Disclosure of Certain Significant Risks and 
        Uncertainties, evidenced by lack of such disclosures during the 
        financial crisis, the FASB has failed to update this standard. 
        This failure directly contributed to the lack of timely 
        disclosures in financial statements of many financial 
        institutions.

  5.  In August, 2000, the Panel on Audit Effectiveness established at 
        the request of the SEC, recommended the FASB develop a new 
        standard highlighting management's responsibility to assess and 
        disclose if a company is able to continue as a viable ``going 
        concern.'' Yet a decade later, investors are still waiting for 
        such disclosures from management, especially in light of the 
        number of financial institutions that required huge Government 
        bailouts to remain afloat.

  6.  In their August 2009 report, as well as on other occasions, 
        members of the TARP Congressional Oversight Panel have noted it 
        was virtually impossible to decipher from existing disclosures, 
        the amount and magnitude--and value--of troubled assets in the 
        financial statements of financial institutions. In a discussion 
        held just this month at the PCAOB SAG meeting, a member of the 
        FASB was unable to describe which of their standards required 
        disclosure of such information in a concise, transparent 
        fashion.

  7.  The FASB's own Investor Technical Advisory Committee (ITAC) a 
        couple of years ago requested the FASB to adopt a disclosure 
        framework to help fill in the ``holes'' in the FASB's own 
        disclosure requirements. For example, while the SEC has rules 
        requiring that disclosure be made when information is material 
        and is necessary to prevent disclosures from being misleading, 
        the FASB has no such requirement for financial statements. 
        However, at a meeting this month of the PCAOB SAG, a member of 
        the FASB indicated such a project would not be forthcoming any 
        time soon.

  8.  There are differing views as to whether the Lehman ``Repo 105'' 
        transactions complied with the FASB's standards or not. I 
        believe the courts will be the judge of this. But one thing is 
        certain, and that is; if the standard was complied with, it was 
        an unacceptable standard. If it was not complied with, then one 
        must ask where is the SEC enforcement action?

  9.  Investors have asked the FASB for many years to provide a 
        standard that would provide greater and enhanced information 
        with respect to the cash flows and liquidity of companies. No 
        such standard has been forthcoming.

  10.  In the mid 1970s, the FASB issued a standard on how financings 
        of assets using lease agreements should be accounted for. This 
        has been considered a ``flawed'' standard almost from the date 
        it was issued as it has allowed many financings to be hidden 
        off balance sheet. The numbers of ``fixes'' the FASB has made, 
        or attempted to make over the years, to this standard are too 
        numerous to count. Decades late, the FASB is expected to issue 
        within the next year a revised standard, but even that standard 
        is currently going through revisions that some question.

    The failure on numerous occasions of the FASB to issue timely 
standards that would provide the capital market participants with the 
information necessary to make informed decisions when allocating 
capital, has proven costly. Failed standards such as those related to 
off balance sheet debt and disclosures of risks and uncertainties have 
resulted in the capital markets being inefficient due to a lack of 
important information. It also has resulted in markets being unable to 
effectively discipline themselves. Any notion that ``free markets'' can 
and will regulate themselves has gone out the window.
    At the same time, the FASB is about to issue several very 
significant new standards that are going to fundamentally change how 
companies do their accounting. Without appropriate consideration being 
given to the implementation dates, and whether the numbers resulting 
from those standards can be verified by the auditors, the quality of 
transparency and financial reporting in the U.S. capital markets and 
investors could suffer greatly. It is very important the FASB closely 
coordinate their work with that of the PCAOB in this regards.
Auditor Performance and Communication
    On Monday of this week, the current chairman of the PCAOB stated in 
an address to investors:

        A deeper analysis of what motivates auditors' behavior is 
        underway. Indeed, the PCAOB inspected the audits of many of the 
        issuers that later failed or received Federal bail-out funds. 
        In several cases--including audits involving substantial 
        financial institutions--PCAOB inspection teams found audit 
        failures that were of such significance that our inspectors 
        concluded the firm had failed to support its opinion.

        Several of these audits are now also the subject of pending 
        PCAOB investigations and may lead to disciplinary actions 
        against firms or individuals. Under the Sarbanes-Oxley Act, our 
        disciplinary actions must remain nonpublic (unless the 
        respondent consents), until both our proceeding and any SEC 
        appeal are finished.

    It should be no surprise that investors both in the U.S. and 
abroad, are asking ``where were the auditors?'' The findings of the 
PCAOB and others have raised a question as to whether auditors were in 
fact acting as objective examiners of the financial reports. Some have 
also questioned whether the auditors maintained the requisite level of 
professional skepticism as they performed their audits. Others are 
questioning the fundamental value of an audit in today's digital world 
and whether audits are relevant.
    As noted in Exhibit A, several financial institutions failed or 
required Government bailouts yet the companies received ``clean'' 
opinions from their auditors. ``Going Concern'' opinions in which 
auditors discuss the uncertainty of a company's ability to continue 
under the circumstances were in short supply, if not outright rare. The 
auditors also failed to give warnings with respect to off balance sheet 
debt that should have been on the financial statements. And they failed 
to warn of significant risks and uncertainties, albeit the disclosure 
standard in this regards is substandard at best.
    Exhibit B sets forth the auditor reports on financial institutions 
that received significant amounts in the Government bailout. Yet as a 
reader can see, the auditor reports issued on these institutions in 
early 2009 at the height of the financial crisis, when we were warned 
the financial system was on the verge of a total meltdown, contained no 
additional information or ``red flags'' when compared to the very same 
audit reports for the fiscal year ending in 2006, just at the peak of 
the economy and as the financial crisis began to unfold.
    But this is not the first time shortcomings in auditor's 
communication with investors have been noted. Surveys conducted by 
Chartered Financial Analysts (CFA) have shown on more than one occasion 
that investors believe auditors need to communicate more than what is 
currently communicated in the standard auditors boilerplate report. The 
PCAOB's own IAG conducted a survey that found: \2\
---------------------------------------------------------------------------
     \2\ See, PCAOB Web site: http://pcaobus.org/News/Events/Pages/
03232011_SAGMeeting.aspx for copies of the IAG presentations to the 
PCAOB.

    45 percent of respondents believe the current audit report 
        does not provide valuable information that is integral to 
        understanding financial statements (23 percent of respondents 
---------------------------------------------------------------------------
        believe the current audit report provides valuable information)

    73 percent of respondents skim the report quickly for 
        departures from the standard unqualified report while 18 
        percent believe it is of no use to them at all (7 percent read 
        the full report)

    In 2007, then Treasury Secretary Henry Paulson established a 
bipartisan committee that included corporate board members, investors, 
auditors, lawyers, former regulators and academics to study the 
auditing profession. This U.S. Treasury Advisory Committee on the 
Auditing Profession is often referred to as the ``ACAP'' committee. 
Former SEC Chairman Arthur Levitt, Former Federal Reserve Chairman Paul 
Volcker, Rodgin Cohen the chairman of Sullivan & Cromwell LLP, the 
Chairman and CEO of Xerox Ann Mulcahy and the Chairman of KPMG LLP 
Timothy Flynn were all members of this committee. It spent over a year 
studying the auditing profession and firms, held numerous public 
meetings and hearings, requested significant and important information 
from the profession, some of which was provided and some withheld, 
received public testimony from dozens including the profession, 
investors, lawyers and representatives from the business community. The 
report of this committee highlighted shortcomings in the report used by 
auditors to communicate with investors; the standards auditors use to 
detect fraud; and the governance and transparency of the auditing 
firms. In fact, shortcomings cited by this report have become even more 
self evident as a result of the financial crisis.
What Changes Are Needed?
    The Subcommittee has also asked the questions:

  2.  What, if any, improvements have been made or should be made by 
        the U.S. Securities and Exchange Commission, the Financial 
        Accounting Standards Board, or the Public Company Accounting 
        Oversight Board as a result of the financial crisis?

  3.  What, if any, policy changes should Congress consider?
Improving Accounting Standard Setting and the FASB
    The ongoing and continued inability of the FASB to issue timely 
standards that protect investors calls into question the fundamental 
structure and composition of the FASB. Its standards have become 
increasingly complex, in part due to the increasing complexity of 
structured and engineered financial transactions, and in part due to 
requests of the business community for ``compromises.'' What is 
uncertain is whether or not in each instance, the increasing complexity 
is serving investors well. I believe this is in part because the end 
user of financial reports are under represented among the actual voting 
members of the FASB, as well as its Emerging Issues Task Force which 
also issues a significant amount of guidance.
    In addition, in the past the FASB has failed to study on a timely 
basis, whether its new standards are achieving their stated objectives, 
have been implemented as intended, or require changes. As noted 
earlier, this has resulted in flawed standards existing that have led 
to investor losses. More recently the trustees of the FASB have 
instituted a process to review standards on a more timely and 
systematic basis. That process will be led by a former auditor. What is 
not readily transparent is what input investors will have into that 
process. In addition, it is vitally important that the SEC who has to 
oversee implementation of new standards, and the PCAOB who has to 
oversee the auditing of those new standards have a strong voice in that 
review process.
    However, I believe it may be time to reconsider the recommendations 
of some who testified before the Senate Banking Committee that a better 
model would be to include both the accounting and auditing standard 
setting under the same oversight board, the PCAOB. This view was 
previously expressed by the former Comptroller of the U.S. and head of 
the General Accountability Office (GAO) and others. I believe it 
warrants serious study, if not adoption at this time.
    In the meantime, the independence of the FASB needs to be fostered. 
Unfortunately, in recent years, some members of Congress have eroded 
that independence. This has resulted in numbers being reported by 
financial institutions being called into question, at a time when 
confidence in those numbers is vitally important. It seems as if 
Congress agrees the FASB's independence is important--but only so long 
as some constituency isn't being pushed towards greater transparency by 
the FASB. I would hope that someday Congress can find a better balance 
between its oversight responsibilities with respect to accounting 
standard setting, the need for millions of American investors to 
receive transparent information, and the demands of special interest 
groups.
Improving the Value of Audits
    The PCAOB has several new board members and a new chairman. I 
believe this provides a new opportunity for the board to demonstrate 
its value to investors, the auditing profession, and the capital 
markets. I applaud their beginning efforts to act to improve the 
quality of audits and investor protection. However, much work remains.
    The PCAOB should undertake the study of the auditing profession as 
urged to do so by its own IAG. This is consistent with past calls for a 
thorough investigation of the financial crisis by Senator Shelby.
    In the meantime, a number of improvements can be made that will 
enhance the quality of audits. For starters, Congress can respond to 
requests of the current and past chairs of the PCAOB to allow the 
agency to make their investigations public in the same manner the SEC 
makes its proceedings against auditors' public. Transparency is 
important to the credibility of the PCAOB. Its dearth of announced 
enforcement actions against the large audit firms has challenged that 
credibility as has the PCAOB's reluctance to provide investors with 
information that would identify which audits have been substandard.
    The recommendations of the U.S. Treasury ACAP Committee, included 
as Exhibit C, should be acted upon by the PCAOB and SEC in a timely 
manner. These recommendations to both the PCAOB and SEC have already 
been outstanding for over 2-1/2 years without results.
    The PCAOB should also act on the recommendations of its own IAG 
which are included as Exhibit D. Many of these recommendations are also 
consistent with or similar to those in the ACAP report. This includes 
improving the standard auditor report so that it provides information 
of value to investors.
    The auditing standard with respect to detection of fraud needs to 
be revisited. It also includes enhancing the transparency and 
governance of the auditing firms so that the PCAOB is not left in the 
dark, as they are now, with respect to the financial viability and 
stability of these large firms. That is not to say they firms should be 
treated as ``too big too fail'' which they should not, but that the 
PCAOB as their regulator should be in an informed position to 
proactively act if necessary when a firm has created systemic risk.
    Finally, the PCOAB has described instances that call into question 
the objectivity of auditors, the very foundation upon which each and 
every audit rests. As the PCAOB studies the profession, is should 
consider whether as it own IAG has recommended, there are steps it 
should take to ensure that auditors continue to remain independent of 
those they are examining, with the requisite degree of professional 
skepticism. Recent findings by investors, the SEC and PCAOB with 
respect to audits of Chinese companies listed in the United States 
would strongly indicate auditors and audits are falling short of their 
target.
Improving the Transparency of Audit Committees
    Some have expressed a view that the audit committees should play a 
key role in enhancing and improving the transparency of the audit 
process. I agree.
    I was chief accountant at the SEC at the time the Blue Ribbon Panel 
on Improving the Effectiveness of Audit Committees issued its report 
well over a decade ago. At that time, this stellar and widely respected 
panel set forth recommendations which have improved audit committees. 
However, further enhancements are necessary especially with respect to 
what audit committees communicate to investors. For example audit 
committees should inform investors as to how the audit committee has 
overseen the audit and financial reporting processes. Others such as 
Warren Buffet have also recommended there be greater transparency with 
respect to the discussions between audit committees, auditors, and 
financial management, including with respect to internal controls, 
completeness of disclosures and whether adjustments are needed to 
reported numbers or not. As an audit committee chair, I have 
implemented these recommendations by Mr. Buffet and found them to be 
beneficial to the members of the committee as well as investors. As a 
result, I believe the SEC should undertake to update the rules with 
respect to reports by audit committees.
    The SEC has also recently taken an enforcement action against 
members of an audit committee found to be derelict in a financial 
fraud. The SEC deserves credit for establishing accountability of these 
audit committees. However, given revelations of the Financial Crisis 
Inquiry Commission and the examiner's report on Lehman, one must ask 
why there haven't been more similar actions. Ultimately, it is 
important that audit committee members be held accountable for their 
actions, or lack of actions. Enhanced transparency will no doubt aid in 
establishing greater accountability.
Improvements at the SEC
    With respect to the SEC, it needs to exercise greater oversight of 
the FASB standard setting process. This includes overseeing those 
appointed to both the FASB itself as well as its trustees. This 
requires balancing the need to observe the independence of the FASB 
with the fact it has consistently failed to put out a product that 
provides investor protection. Clearly the FASB has failed to develop 
quality and timely standards and this begins and ends with the members 
of its board, and those who oversee its efforts. One likely cause of 
this is the FASB has a very diluted mission and objective of trying to 
serve all--auditors, financial management who prepares financial 
statements as well as investors. When one is tasked to serve all, it 
often results in none being served. Changing the mission of the FASB to 
specifically state it serves investors would certainly clarify and help 
strengthen the Board.
    The SEC also needs to ensure it enforces the standards that do 
exist. There appears to be a lack of enforcement cases related to 
financial reports these days, as evidenced by the lack of action 
discussed in the report of the examiner of Lehman. Without strong 
enforcement of standards, there are in fact, no standards.
    While the SEC enforcement division has set up several task forces, 
it has failed to establish any task force to examine financial 
reporting fraud. I believe this indicates a lack of focus on an area of 
fraud that has cost investors large losses, and is necessary if 
investors are to believe that the agency is clearly the ``investors 
advocate.''
    At the same time, the SEC needs the necessary resources and tools 
to do its job. I have met with staff at the SEC and found that they do 
in fact lack the tools for the job. They don't have the necessary 
information technology necessary for monitoring the markets and market 
participants. They lack many of the technologies and tools those they 
regulate have and use. And as the recent Boston Consulting Report 
confirmed, they do not have enough or the right people to do the job 
they have now been tasked to do.
    This is not an issue of ``balancing the budget'' as the funding for 
the SEC does not involve any taxpayer dollars. Rather its funding comes 
from fees that ultimately investors bear the cost of. And time and time 
again, investors have stated they are willing to bear those costs. 
Accordingly, failure to fund the SEC can only be viewed as an 
intentional and deliberate effort to handcuff this law enforcement 
agency, thereby exposing investors to substantial harm, as in the past.
    I have been at the SEC at times when it was ``starved'' by 
Congress, effectively ensuring a lack of regulation and exposure of 
millions of Americans to great risk of loss. Indeed, Congresses own GAO 
has stated in the past the SEC has been woefully underfunded. I believe 
the lack of such underfunding has directly led to a lack of confidence 
in the U.S. capital markets while tens of millions of investors watched 
trillions in value in their pensions and 401Ks disappear.
    If Congress believes the SEC needs to become more efficient and 
effective, then Congress is obligated to hold oversight hearings to 
ensure the agency spends the resources it receives wisely and 
effectively. But this should not be an excuse to defund the agency, at 
a time when tens of millions of American investors need it more than 
ever before. I will also add the same is true for the CFTC.
What Is Not Needed
    One of the key issues the ACAP committee deliberated and debated at 
length was the issue of further liability reforms requested by the 
audit firms. However, as the ACAP report aptly describes in detail, 
there was strong disagreement among the members of the committee as to 
whether such reforms were in fact necessary or not.
    The audit firms cited the need for further reforms as they are 
required to exercise judgment. Yet auditors have been required to 
exercise significant judgments when performing audits for many decades. 
Unfortunately, some of those judgments on audits such as Waste 
Management, Enron, Lehman, and Xerox have been correctly called into 
question, not only by investors and their lawyers, but also by 
regulators and others.
    What the evidence provided in reports by Cornerstone Research and 
the Stanford Law School Securities Class Action Clearinghouse 
demonstrate as set forth in Exhibit E, is that lawsuits naming the 
auditor as a defendant have dramatically declined since the passage of 
the Private Securities Law Reform Act (PSLRA) in 1995. Subsequent court 
cases have also further narrowed the ability of investors to recover 
from auditors through establishment of higher hurdles for proving loss 
causation and elimination of cases involving aiding and abetting of 
securities fraud. In fact, despite over 14,000 audit opinions issued on 
an annual basis by auditors of public entities, almost 4,900 
restatements of financial statements being reported during the years 
2005 through 2010, and a significant increase in the number of 
violations of the Foreign Corrupt Practices Act (FCPA), there has been 
on average less than one class action lawsuit brought each year against 
each of the ten largest auditing firms during that same period. As a 
result it is not surprising the ACAP was unable to reach a consensus 
that any further litigation reform is necessary for auditors.
Closing Comments
    Audits, when properly performed by truly objective and independent 
auditors, provide the capital markets with confidence the financial 
statements can be trusted. However, investors are questioning the value 
proposition of audits today, including the information they are 
provided and how auditors communicate that information to them. As a 
result, it is important auditors provide a product to their real 
client--investors--that the customer believes is worth the price being 
paid. If on the other hand, investors continue to question the 
relevance of the audit, the audit report and the information being 
reported, it will only be a matter of time in this digital age before 
audits do indeed lose their value and relevance.
    I would be happy to respond to any questions members of the 
Subcommittee might have.
EXHIBIT A
Presentation of the PCAOB Investor Advisory Group Subcommittee on 
        Lessons Learned From the Financial Crisis
            March 16, 2011
            
            
            
EXHIBIT B
Sample Audit Reports on Financial Institutions Receiving Federal 
        Bailout Funds for Fiscal Years 2006 and 2008
Report of Independent Registered Public Accounting Firm
    To the Board of Directors and Shareholders of Bank of America 
Corporation:

    We have completed integrated audits of Bank of America 
Corporation's Consolidated Financial Statements and of its internal 
control over financial reporting as of December 31, 2006, in accordance 
with the standards of the Public Company Accounting Oversight Board 
(United States). Our opinions, based on our audits, are presented 
below.
            Consolidated Financial Statements
    In our opinion, the accompanying Consolidated Balance Sheet and the 
related Consolidated Statement of Income, Consolidated Statement of 
Changes in Shareholders' Equity and Consolidated Statement of Cash 
Flows present fairly, in all material respects, the financial position 
of Bank of America Corporation and its subsidiaries at December 31, 
2006 and 2005, and the results of their operations and their cash flows 
for each of the three years in the period ended December 31, 2006, in 
conformity with accounting principles generally accepted in the United 
States of America. These Consolidated Financial Statements are the 
responsibility of the Corporation's management. Our responsibility is 
to express an opinion on these Consolidated Financial Statements based 
on our audits. We conducted our audits of these Consolidated Financial 
Statements in accordance with the standards of the Public Company 
Accounting Oversight Board (United States). Those standards require 
that we plan and perform the audit to obtain reasonable assurance about 
whether the financial statements are free of material misstatement. An 
audit of financial statements includes examining, on a test basis, 
evidence supporting the amounts and disclosures in the financial 
statements, assessing the accounting principles used and significant 
estimates made by management, and evaluating the overall financial 
statement presentation. We believe that our audits provide a reasonable 
basis for our opinion.
            Internal Control Over Financial Reporting
    Also, in our opinion, management's assessment, included in the 
Report of Management on Internal Control Over Financial Reporting, that 
the Corporation maintained effective internal control over financial 
reporting as of December 31, 2006, based on criteria established in 
Internal Control-Integrated Framework issued by the Committee of 
Sponsoring Organizations of the Treadway Commission (COSO), is fairly 
stated, in all material respects, based on those criteria. Furthermore, 
in our opinion, the Corporation maintained, in all material respects, 
effective internal control over financial reporting as of December 31, 
2006, based on criteria established in Internal Control-Integrated 
Framework issued by the COSO. The Corporation's management is 
responsible for maintaining effective internal control over financial 
reporting and for its assessment of the effectiveness of internal 
control over financial reporting. Our responsibility is to express 
opinions on management's assessment and on the effectiveness of the 
Corporation's internal control over financial reporting based on our 
audit. We conducted our audit of internal control over financial 
reporting in accordance with the standards of the Public Company 
Accounting Oversight Board (United States). Those standards require 
that we plan and perform the audit to obtain reasonable assurance about 
whether effective internal control over financial reporting was 
maintained in all material respects. An audit of internal control over 
financial reporting includes obtaining an understanding of internal 
control over financial reporting, evaluating management's assessment, 
testing and evaluating the design and operating effectiveness of 
internal control, and performing such other procedures as we consider 
necessary in the circumstances. We believe that our audit provides a 
reasonable basis for our opinions.
    A company's internal control over financial reporting is a process 
designed to provide reasonable assurance regarding the reliability of 
financial reporting and the preparation of financial statements for 
external purposes in accordance with generally accepted accounting 
principles. A company's internal control over financial reporting 
includes those policies and procedures that (i) pertain to the 
maintenance of records that, in reasonable detail, accurately and 
fairly reflect the transactions and dispositions of the assets of the 
company; (ii) provide reasonable assurance that transactions are 
recorded as necessary to permit preparation of financial statements in 
accordance with generally accepted accounting principles, and that 
receipts and expenditures of the company are being made only in 
accordance with authorizations of management and directors of the 
company; and (iii) provide reasonable assurance regarding prevention or 
timely detection of unauthorized acquisition, use, or disposition of 
the company's assets that could have a material effect on the financial 
statements.
    Because of its inherent limitations, internal control over 
financial reporting may not prevent or detect misstatements. Also, 
projections of any evaluation of effectiveness to future periods are 
subject to the risk that controls may become inadequate because of 
changes in conditions, or that the degree of compliance with the 
policies or procedures may deteriorate.

Pricewaterhouse Cooper, LLP,
Charlotte, North Carolina
February 22, 2007


Report of Independent Registered Public Accounting Firm

    To the Board of Directors and Shareholders of Bank of America 
Corporation:

    In our opinion, the accompanying Consolidated Balance Sheet and the 
related Consolidated Statement of Income, Consolidated Statement of 
Changes in Shareholders' Equity and Consolidated Statement of Cash 
Flows present fairly, in all material respects, the financial position 
of Bank of America Corporation and its subsidiaries at December 31, 
2008 and 2007, and the results of their operations and their cash flows 
for each of the three years in the period ended December 31, 2008, in 
conformity with accounting principles generally accepted in the United 
States of America. Also in our opinion, the Corporation maintained, in 
all material respects, effective internal control over financial 
reporting as of December 31, 2008, based on criteria established in 
Internal Control-Integrated Framework issued by the Committee of 
Sponsoring Organizations of the Treadway Commission (COSO). The 
Corporation's management is responsible for these financial statements, 
for maintaining effective internal control over financial reporting and 
for its assessment of the effectiveness of internal control over 
financial reporting, included in the Report of Management on Internal 
Control Over Financial Reporting appearing on page 108 of the 2008 
Annual Report to Shareholders. Our responsibility is to express 
opinions on these financial statements and on the Corporation's 
internal control over financial reporting based on our integrated 
audits. We conducted our audits in accordance with the standards of the 
Public Company Accounting Oversight Board (United States). Those 
standards require that we plan and perform the audits to obtain 
reasonable assurance about whether the financial statements are free of 
material misstatement and whether effective internal control over 
financial reporting was maintained in all material respects. Our audits 
of the financial statements included examining, on a test basis, 
evidence supporting the amounts and disclosures in the financial 
statements, assessing the accounting principles used and significant 
estimates made by management, and evaluating the overall financial 
statement presentation. Our audit of internal control over financial 
reporting included obtaining an understanding of internal control over 
financial reporting, assessing the risk that a material weakness 
exists, and testing and evaluating the design and operating 
effectiveness of internal control based on the assessed risk. Our 
audits also included performing such other procedures as we considered 
necessary in the circumstances. We believe that our audits provide a 
reasonable basis for our opinions.
    As discussed in Note 19--Fair Value Disclosures to the Consolidated 
Financial Statements, as of the beginning of 2007 the Corporation has 
adopted SFAS No. 157, ``Fair Value Measurements'' and SFAS No. 159, 
``The Fair Value Option for Financial Assets and Financial 
Liabilities.''
    A company's internal control over financial reporting is a process 
designed to provide reasonable assurance regarding the reliability of 
financial reporting and the preparation of financial statements for 
external purposes in accordance with generally accepted accounting 
principles. A company's internal control over financial reporting 
includes those policies and procedures that (i) pertain to the 
maintenance of records that, in reasonable detail, accurately and 
fairly reflect the transactions and dispositions of the assets of the 
company; (ii) provide reasonable assurance that transactions are 
recorded as necessary to permit preparation of financial statements in 
accordance with generally accepted accounting principles, and that 
receipts and expenditures of the company are being made only in 
accordance with authorizations of management and directors of the 
company; and (iii) provide reasonable assurance regarding prevention or 
timely detection of unauthorized acquisition, use, or disposition of 
the company's assets that could have a material effect on the financial 
statements.
    Because of its inherent limitations, internal control over 
financial reporting may not prevent or detect misstatements. Also, 
projections of any evaluation of effectiveness to future periods are 
subject to the risk that controls may become inadequate because of 
changes in conditions, or that the degree of compliance with the 
policies or procedures may deteriorate.

Charlotte, North Carolina
February 25, 2009


Report of Independent Registered Public Accounting Firm--Consolidated 
        Financial Statements
    The Board of Directors and Stockholders of Citigroup Inc.:

    We have audited the accompanying consolidated balance sheets of 
Citigroup Inc. and subsidiaries (the ``Company'' or ``Citigroup'') as 
of December 31, 2006 and 2005, the related consolidated statements of 
income, changes in stockholders' equity and cash flows for each of the 
years in the 3-year period ended December 31, 2006, and the related 
consolidated balance sheets of Citibank, N.A., and subsidiaries as of 
December 31, 2006 and 2005. These consolidated financial statements are 
the responsibility of the Company's management. Our responsibility is 
to express an opinion on these consolidated financial statements based 
on our audits.
    We conducted our audits in accordance with the standards of the 
Public Company Accounting Oversight Board (United States). Those 
standards require that we plan and perform the audit to obtain 
reasonable assurance about whether the financial statements are free of 
material misstatement. An audit includes examining, on a test basis, 
evidence supporting the amounts and disclosures in the financial 
statements. An audit also includes assessing the accounting principles 
used and significant estimates made by management, as well as 
evaluating the overall financial statement presentation. We believe 
that our audits provide a reasonable basis for our opinion.
    In our opinion, the consolidated financial statements referred to 
above present fairly, in all material respects, the financial position 
of Citigroup as of December 31, 2006 and 2005, the results of its 
operations and its cash flows for each of the years in the three-year 
period ended December 31, 2006, and the financial position of Citibank, 
N.A., and subsidiaries as of December 31, 2006 and 2005, in conformity 
with U.S. generally accepted accounting principles.
    As discussed in Note 1 to the consolidated financial statements, in 
2006 the Company changed its methods of accounting for defined benefit 
pensions and other postretirement benefits, stock-based compensation, 
certain hybrid financial instruments and servicing of financial assets, 
and in 2005 the Company changed its method of accounting for 
conditional asset retirement obligations associated with operating 
leases.
    We also have audited, in accordance with the standards of the 
Public Company Accounting Oversight Board (United States), the 
effectiveness of Citigroup's internal control over financial reporting 
as of December 31, 2006, based on criteria established in Internal 
Control-Integrated Framework issued by the Committee of Sponsoring 
Organizations of the Treadway Commission (COSO), and our report dated 
February 23, 2007, expressed an unqualified opinion on management's 
assessment of, and the effective operation of, internal control over 
financial reporting.

KPMG LLP,
New York, New York
February 23, 2007


Report of Independent Registered Public Accounting Firm--Consolidated 
        Financial Statements

    The Board of Directors and Stockholders of Citigroup Inc.:
    We have audited the accompanying consolidated balance sheets of 
Citigroup Inc. and subsidiaries (the ``Company'' or ``Citigroup'') as 
of December 31, 2008 and 2007, and the related consolidated statements 
of income, changes in stockholders' equity and cash flows for each of 
the years in the 3-year period ended December 31, 2008, and the related 
consolidated balance sheets of Citibank, N.A., and subsidiaries as of 
December 31, 2008 and 2007. These consolidated financial statements are 
the responsibility of the Company's management. Our responsibility is 
to express an opinion on these consolidated financial statements based 
on our audits.
    We conducted our audits in accordance with the standards of the 
Public Company Accounting Oversight Board (United States). Those 
standards require that we plan and perform the audit to obtain 
reasonable assurance about whether the financial statements are free of 
material misstatement. An audit includes examining, on a test basis, 
evidence supporting the amounts and disclosures in the financial 
statements. An audit also includes assessing the accounting principles 
used and significant estimates made by management, as well as 
evaluating the overall financial statement presentation. We believe 
that our audits provide a reasonable basis for our opinion.
    In our opinion, the consolidated financial statements referred to 
above present fairly, in all material respects, the financial position 
of Citigroup as of December 31, 2008 and 2007, the results of its 
operations and its cash flows for each of the years in the three-year 
period ended December 31, 2008, and the financial position of Citibank, 
N.A., and subsidiaries as of December 31, 2008 and 2007, in conformity 
with U.S. generally accepted accounting principles.
    As discussed in Note 1 to the consolidated financial statements, in 
2007 the Company changed its methods of accounting for fair value 
measurements, the fair value option for financial assets and financial 
liabilities, uncertainty in income taxes and cash flows relating to 
income taxes generated by a leverage lease transaction.
    We also have audited, in accordance with the standards of the 
Public Company Accounting Oversight Board (United States), Citigroup's 
internal control over financial reporting as of December 31, 2008, 
based on criteria established in Internal Control-Integrated Framework 
issued by the Committee of Sponsoring Organizations of the Treadway 
Commission (COSO), and our report dated February 27, 2009, expressed an 
unqualified opinion on the effectiveness of the Company's internal 
control over financial reporting.

KPMG LLP,
New York, New York
February 27, 2009


EXHIBIT C
Recommendations of the U.S. Treasury Advisory Committee on the Auditing 
        Profession
Final ACAP Recommendations
            Human Capital Recommendations
    Recommendation 1.  Implement market-driven, dynamic curricula and 
content for accounting students that continuously evolve to meet the 
needs of the auditing profession and help prepare new entrants to the 
profession to perform high quality audits.

  a.  Regularly update the accounting certification examinations to 
        reflect changes in the accounting profession, its relevant 
        professional and ethical standards, and the skills and 
        knowledge required to serve increasingly global capital 
        markets.

  b.  Reflect real world changes in the business environment more 
        rapidly in teaching materials.

  c.  Require that schools build into accounting curricula current 
        market developments.

    Recommendation 2.  Improve the representation and retention of 
minorities in the auditing profession so as to enrich the pool of human 
capital in the profession.

  a.  Recruit minorities into the auditing profession from other 
        disciplines and careers.

  b.  Institute initiatives to increase the retention of minorities in 
        the profession.

  c.  Emphasize the role of community colleges in the recruitment of 
        minorities into the auditing profession.

  d.  Emphasize the utility and effectiveness of cross-sabbaticals and 
        internships with faculty and students at Historically Black 
        Colleges and Universities.

  e.  Increase the numbers of minority accounting doctorates through 
        focused efforts.

    Recommendation 3.  Ensure a sufficiently robust supply of qualified 
accounting faculty to meet demand for the future and help prepare new 
entrants to the profession to perform high quality audits.

  a.  Increase the supply of accounting faculty through public and 
        private funding and raise the number of professionally 
        qualified faculty that teach on campuses.

  b.  Emphasize the utility and effectiveness of cross-sabbaticals.

  c.  Create a variety of tangible and sufficiently attractive 
        incentives that will motivate private sector institutions to 
        fund both accounting faculty and faculty research, to provide 
        practice materials for academic research and for participation 
        of professionals in behavioral and field study projects, and to 
        encourage practicing accountants to pursue careers as 
        academically and professionally qualified faculty.

    Recommendation 4.  Develop and maintain consistent demographic and 
higher education program profile data.

    Recommendation 5.  Encourage the AICPA and the AAA jointly to form 
a commission to provide a timely study of the possible future structure 
of higher education for the accounting profession.
            Firm Structure and Finances Recommendations
    Recommendation 1.  Urge the SEC, and Congress as appropriate, to 
provide for the creation by the PCAOB of a national center to 
facilitate auditing firms' and other market participants' sharing of 
fraud prevention and detection experiences, practices, and data and 
innovation in fraud prevention and detection methodologies and 
technologies, and commission research and other fact-finding regarding 
fraud prevention and detection, and further, the development of best 
practices regarding fraud prevention and detection.

    Recommendation 2.  Encourage greater regulatory cooperation and 
oversight of the public company auditing profession to improve the 
quality of the audit process and enhance confidence in the auditing 
profession and financial reporting.

  a.  Institute the following mechanism to encourage the states to 
        substantially adopt the mobility provisions of the Uniform 
        Accountancy Act, Fifth Edition (UAA). If states have failed to 
        adopt the mobility provisions of the UAA by December 31, 2010, 
        Congress should pass a Federal provision requiring those states 
        to adopt these provisions.

  b.  Require regular and formal roundtable meetings of regulators and 
        other governmental enforcement bodies in a cooperative effort 
        to improve regulatory effectiveness and reduce the incidence of 
        duplicative and potentially inconsistent enforcement regimes.

  c.  Urge the States to create greater financial and operational 
        independence of their State boards of accountancy.

    Recommendation 3.  Urge the PCAOB and the SEC, in consultation with 
other Federal and State regulators, auditing firms, investors, other 
financial statement users, and public companies, to analyze, explore, 
and enable, as appropriate, the possibility and feasibility of firms 
appointing independent members with full voting power to firm boards 
and/or advisory boards with meaningful governance responsibilities to 
improve governance and transparency at auditing firms.

    Recommendation 4.  Urge the SEC to amend Form 8-K disclosure 
requirements to characterize appropriately and report every public 
company auditor change and to require auditing firms to notify the 
PCAOB of any premature engagement partner changes on public company 
audit clients.

    Recommendation 5.  Urge the PCAOB to undertake a standard-setting 
initiative to consider improvements to the auditor's standard reporting 
model. Further, urge that the PCAOB and the SEC clarify in the 
auditor's report the auditor's role in detecting fraud under current 
auditing standards and further that the PCAOB periodically review and 
update these standards.

    Recommendation 6.  Urge the PCAOB to undertake a standard-setting 
initiative to consider mandating the engagement partner's signature on 
the auditor's report.

    Recommendation 7.  Urge the PCAOB to require that, beginning in 
2010, larger auditing firms produce a public annual report 
incorporating (a) information required by the EU's Eighth Directive, 
Article 40 Transparency Report deemed appropriate by the PCAOB, and (b) 
such key indicators of audit quality and effectiveness as determined by 
the PCAOB in accordance with Recommendation 3 in Chapter VI of this 
Report. Further, urge the PCAOB to require that, beginning in 2011, the 
larger auditing firms file with the PCAOB on a confidential basis 
audited financial statements.
            Concentration and Competition Recommendations
    Recommendation 1.  Reduce barriers to the growth of smaller 
auditing firms consistent with an overall policy goal of promoting 
audit quality. Because smaller auditing firms are likely to become 
significant competitors in the market for larger company audits only in 
the long term, the Committee recognizes that Recommendation 2 will be a 
higher priority in the near term.

  a.  Require disclosure by public companies in their registration 
        statements, annual reports, and proxy statements of any 
        provisions in agreements with third parties that limit auditor 
        choice.

  b.  Include representatives of smaller auditing firms in committees, 
        public forums, fellowships, and other engagements.

    Recommendation 2.  Monitor potential sources of catastrophic risk 
faced by public company auditing firms and create a mechanism for the 
preservation and rehabilitation of troubled larger public company 
auditing firms.

  a.  As part of its current oversight over registered auditing firms, 
        the PCAOB should monitor potential sources of catastrophic risk 
        which would threaten audit quality.

  b.  Establish a mechanism to assist in the preservation and 
        rehabilitation of a troubled larger auditing firm. A first step 
        would encourage larger auditing firms to adopt voluntarily a 
        contingent streamlined internal governance mechanism that could 
        be triggered in the event of threatening circumstances. If the 
        governance mechanism failed to stabilize the firm, a second 
        step would permit the SEC to appoint a court-approved trustee 
        to seek to preserve and rehabilitate the firm by addressing the 
        threatening situation, including through a reorganization, or 
        if such a step were unsuccessful, to pursue an orderly 
        transition.

    Recommendation 3.  Recommend the PCAOB, in consultation with 
auditors, investors, public companies, audit committees, boards of 
directors, academics, and others, determine the feasibility of 
developing key indicators of audit quality and effectiveness and 
requiring auditing firms to publicly disclose these indicators. 
Assuming development and disclosure of indicators of audit quality are 
feasible; require the PCAOB to monitor these indicators.

    Recommendation 4.  Promote the understanding of and compliance with 
auditor independence requirements among auditors, investors, public 
companies, audit committees, and boards of directors, in order to 
enhance investor confidence in the quality of audit processes and 
audits.

  a.  Compile the SEC and PCAOB independence requirements into a single 
        document and make this document Web site accessible. The AICPA 
        and State boards of accountancy should clarify and prominently 
        note that differences that exist between the SEC and PCAOB 
        standards (applicable to public companies) and the AICPA and 
        State standards (applicable in all circumstances, but subject 
        to SEC and PCAOB standards, in the case of public companies) 
        and indicate, at each place in their standards where 
        differences exist, that stricter SEC and PCAOB independence 
        requirements applicable to public company auditors may 
        supersede or supplement the stated requirements. This 
        compilation should not require rulemaking by either the SEC or 
        the PCAOB because it only calls for assembly and compilation of 
        existing rules.

  b.  Develop training materials to help foster and maintain the 
        application of healthy professional skepticism with respect to 
        issues of independence and other conflicts among public company 
        auditors, and inspect auditing firms, through the PCAOB 
        inspection process, for independence training of partners and 
        mid-career professionals.

    Recommendation 5.  Adopt annual shareholder ratification of public 
company auditors by all public companies.

    Recommendation 6.  Enhance regulatory collaboration and 
coordination between the PCAOB and its foreign counterparts, consistent 
with the PCAOB mission of promoting quality audits of public companies 
in the United States.


EXHIBIT D
Recommendations of the PCAOB Investor Advisory Group
  1.  Standard auditor's report should be revised to include more 
        useful information to investors.

  2.  The PCAOB should launch an in-depth study into the role auditors 
        played in the financial crisis. The goal of that study should 
        be to identity both the causes of and remedies for those 
        pervasive audit failures. The PCAOB should make such analysis 
        of audit failures an ongoing function of the Board, in order to 
        ensure that changes in policy and oversight practices are 
        adopted in a timely fashion to address correctable weaknesses 
        in the audit process.

  3.  The firms should produce an annual report, including financial 
        statements, which is filed with the PCAOB and made public and 
        certified to by the executives of the firm. The annual report 
        of the audit firm should include its key quality control 
        factors, global quality control processes, and how it is 
        structured and operates.

  4.  The PCAOB should require the governing boards of the firms, 
        either on the board itself or on an advisory board, appoint no 
        less than 3 independent members. These independent members 
        should include in the annual report of the firm, a report on 
        their activities for the year.

  5.  The PCAOB should continue to ask congress to pass legislation 
        that will allow it to make its disciplinary proceedings public.

  6.  The PCAOB should undertake a project to establish mandatory 
        rotation of the auditor, for example every ten years. During 
        that time period, to strengthen auditor independence and avoid 
        any ``opinion shopping,'' any rules adopted should permit the 
        auditor to be removed only for cause, as defined by the PCAOB.

  7.  The PCAOB as it updates its standards should undertake to study 
        and strengthen the supervision by the lead audit partner, of 
        the foreign audit work performed. Mere acceptance of foreign 
        auditors ``credentials'' is insufficient to ensure high quality 
        audits.

  8.  The auditor's report should be modified to state the amount or 
        percentages of assets and revenues that have been audited by 
        any auditors, who has refused to be inspected by the PCAOB. We 
        support the PCAOB's efforts to negotiate joint inspection 
        agreements with foreign regulators. However, we do not believe 
        mere reliance on those regulators inspections, without first 
        determining and monitoring their quality, is an acceptable 
        protection for investors.

  9.  Consistent with the recommendations of the Panel on Audit 
        Effectiveness, we recommend the PCAOB revise its standards to 
        require forensic auditing procedures and include greater 
        guidance on the forensic audit procedures that should be 
        performed. This should include requiring auditors to understand 
        the whistleblower programs and their independence and 
        effectiveness.



        
        
        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                       FROM JAMES R. DOTY

Q.1. In your remarks, you discussed the auditor's 
responsibility with respect to an entity's ability to continue 
as a going concern. Should this assessment be conducted during 
interim reviews? How could this be an early warning indicator? 
What work is the PCAOB doing with respect to this issue? What 
is the estimated timeline for completion or resolution of this 
issue or any related project on the PCAOB's agenda?

A.1. The financial crisis has highlighted the importance of an 
auditor's timely assessment of an entity's ability to continue 
as a going concern. The Board is sensitive to this issue and, 
as discussed below, its staff has been working with others on a 
project to consider improvements to Auditing Section 341, The 
Auditor's Consideration of an Entity's Ability to Continue as a 
Going Concern (AU 341). \1\ AU 341 currently requires that 
certain audit procedures be performed on annual audits, not 
interim reviews, of issuers' financial statements. \2\ The 
project underway is considering quarterly (interim) procedures 
as well as annual procedures.
---------------------------------------------------------------------------
     \1\ AU 341 was adopted by the Auditing Standards Board of the 
American Institute of Certified Public Accountants (AICPA) in the 1980s 
and was established by the PCAOB under section 103(a)(3) of the 
Sarbanes-Oxley Act of 2002, 15 U.S.C. 7213(a)(3), as an initial 
auditing standard. See, PCAOB Rule 3200T. Under U.S. generally accepted 
accounting principles (GAAP), financial statements are prepared based 
on the assumption by management that the company is a going concern; 
that is, absent information to the contrary, there is an assumption 
that the company will continue in business. Accounting Research 
Bulleting No. 43, Restatement and Revision of Accounting Research 
Bulletins.
     \2\ AU 341.01 and 341.02. Section 10A(a) of the Securities 
Exchange Act of 1934 (Exchange Act), 15 U.S.C. 78j-1(a), requires that 
each audit under the Exchange Act include an evaluation of whether 
there is substantial doubt about the entity's ability to continue as a 
going concern. The procedures for that evaluation, during the audit of 
annual financial statements, are found in AU 341.
---------------------------------------------------------------------------
    The PCAOB has been working with the Financial Accounting 
Standards Board (FASB) and the Commission to coordinate changes 
to both accounting and auditing standards relating to a 
company's assessment and disclosure of its ability to continue 
as a going concern and an auditor's evaluation of that 
assessment. Possible changes under consideration include 
whether and how the current going concern model could be 
expanded to further discuss risks and uncertainties about an 
entity's ability to continue as a going concern, and thus serve 
as more of an early warning indicator.
    It's important that the Board's actions are appropriately 
coordinated and sequenced with any actions the FASB and the 
Commission would need to take. The Board, however, recognizes 
the importance of the going concern project, and it remains a 
priority of the Board.

Q.2. Nearly all of the panelists addressed the issue of the 
necessary evolution of the auditor's report. What is the 
estimated timeline for consideration of this project? When do 
you anticipate Board action on any related standards?

A.2. The auditor's reporting model is a top standard-setting 
priority of the Board. On March 22, 2011, the Board discussed 
with its staff the results of the PCAOB's outreach to investors 
and others about potential changes to the auditor's reporting 
model, and directed the staff to prepare a concept release for 
publication this summer. A recording of that meeting is 
available at http://pcaobus.org/News/Webcasts/Pages/
03222011_OpenBoardMeeting.aspx.
    The scheduled milestones for this project include issuing 
the above-mentioned concept release for public comments this 
summer, holding a roundtable discussion in the fall of 2011 and 
issuing a proposed standard for public comments in early 2012.

Q.3. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four areas of potential 
improvement in auditor communications:

  a.  an assessment of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement and other significant 
        changes; and

  d.  an assessment of the quality of the issuer's accounting 
        policies and practices.

    What work is the PCAOB doing concerning each of the four 
areas?

A.3. As your question indicates, on March 16, 2011, the Board 
heard a presentation from members of a subcommittee of the 
Board's Investor Advisory Group (IAG) about the results of a 
survey conducted by the subcommittee to solicit views regarding 
auditors' communications to investors and possible changes to 
the auditor's report. The presentation of the results of the 
survey was followed by a discussion of related issues by all 
IAG members and the Board.
    The results of the survey and the IAG discussion provided 
valuable investor feedback that, along with information 
provided by auditors and others, has informed the Board's 
project on the auditor's reporting model, which is noted above 
in response to Question 2. The views expressed by IAG members, 
including the results of the survey, were consistent with views 
by some investors expressed in response to broader PCAOB staff 
outreach about potential changes to the auditor's report. 
However, other constituents, including some audit committee 
members, expressed reservations about the extent of any 
possible additional reporting by auditors. The Board will 
carefully consider all of the views received as it moves 
forward on this project.
    As noted above, the Board plans to issue a concept release 
on the auditor reporting model this summer. The concept release 
will seek public comment on not only the areas highlighted in 
the IAG survey, but also other potential ways to enhance the 
auditor's report and improve auditor communications to 
investors and other users of financial statements.

Q.4. What is your assessment of the report and each of the 
recommendations detailed in the Department of the Treasury's 
Advisory Committee on the Auditing Profession (ACAP) issued on 
October 6, 2008? What are the strengths and weaknesses of each 
recommendation? What further work is the PCAOB doing with 
respect to the issues discussed in the report and the related 
recommendations?

A.4. The Board considers the ACAP report as part of the total 
mix of information from serious and thoughtful sources that 
contain recommendations for possible policy, standards setting, 
and rulemaking initiatives.
    Generally speaking, the strengths of each recommendation 
stem from their being developed by thoughtful and committed 
experts with a common interest in improving audit quality. Any 
particular weaknesses could be viewed, in part, to arise from 
the limited access the ACAP had to the type of information 
which PCAOB inspectors have access to, and to the fact that the 
ACAP recommendations were made prior to the financial crisis.
    During the past few years, the Board has focused its 
resources on significant issues that arose subsequent to the 
ACAP, such as audit issues highlighted during the financial 
crisis and the Board's ability to gain access to foreign 
countries to conduct inspections of audits of companies, or 
subsidiaries or affiliates of companies, with securities traded 
in the United States.
    The Board has developed an active standard setting and 
regulatory agenda. Several of these initiatives are consistent 
with ACAP recommendations. \3\ For example:
---------------------------------------------------------------------------
     \3\ Further information about the ACAP recommendations is 
available on the Board's Web site in the briefing paper under ``Update 
on PCAOB Developments'', at http://pcaobus.org/News/Events/Pages/
10132010_SAGMeeting.aspx.

    The Board has created an Academic Fellow Program 
        and the first academic fellow soon will complete his 1-
        year fellowship in the Board's Office of Research and 
---------------------------------------------------------------------------
        Analysis.

    The Board also has created an outline for a 
        possible national center on financial reporting fraud 
        and solicited applications for the position of director 
        of the center.

    The Board issued a concept release to explore 
        issues related to engagement partners signing audit 
        reports in their own names.

    The Board also has increased its efforts to act 
        cooperatively with other regulators, such as the SEC, 
        FASB, the Financial Industry Regulatory Authority, the 
        Department of Labor, and the Federal Deposit Insurance 
        Corporation.

    The Board's regulatory collaboration and 
        coordination with its foreign counterparts has been 
        enhanced by entering into agreements with foreign 
        authorities that facilitate cooperation in the 
        oversight of auditors.

    And, the Board has encouraged smaller accounting 
        firms' participation by hosting numerous ``Forums for 
        Auditing in the Small Business Environment'' in cities 
        across the country and including small firm 
        representatives in its advisory groups.

    Most significantly, as noted above and consistent with an 
ACAP recommendation, the Board is considering revising the 
auditor's standard reporting model. The basic auditor report on 
a public company's financial statements has not changed 
significantly in over 60 years. During that period, investors 
and others have indicated that auditors have valuable insights 
into companies' financial statements and auditors, therefore, 
should communicate to investors more than a final conclusion on 
whether those financial statements comply with generally 
accepted accounting principles (GAAP). ACAP, for example, 
referred to the growing complexity of global business 
operations and a growing use of judgments and estimates in 
accounting as reasons for the Board to consult with investors, 
other financial statement users, auditors, public companies, 
academics, and others about the need for and possible 
improvements in the auditor reporting model. As discussed 
above, on March 22, 2011, the Board discussed with its staff 
the results of the PCAOB's outreach to investors and others 
about potential changes to the auditor's reporting model, and 
directed the staff to prepare a concept release for publication 
this summer. The Board also is considering holding a roundtable 
on the auditor reporting model in the fall of 2011, and issuing 
a proposed standard for public comments in early 2012.

Q.5. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Should audit firms publish 
annual audited financial statements? What do you believe are 
the strengths and weaknesses of such a proposal? What 
additional information should be disclosed? What work has the 
PCAOB done concerning the issue of increasing the transparency 
into large accounting firms? What additional work is being 
done?

A.5. The Board requires each registered firm to file an annual 
report that includes, among other things, information about 
audit reports issued, disciplinary histories of new personnel, 
and certain information about fees billed to issuer audit 
clients for various categories of services. Registered firms 
also are required to file special reports within 30 days after 
certain reportable events, which range from administrative 
matters such as changes in a firm's contact information to more 
substantive matters, including, for example, the institution of 
certain types of legal proceedings against a firm or its 
personnel. Each of these reports is posted to the Board's Web 
site and is available to the public at http://pcaobus.org/
Registration/rasr/Pages/RASR_Search.aspx. These reports provide 
the public with information relevant to a registered public 
accounting firm's audit practice and performance. The Board, 
however, is continuing to evaluate the appropriate content of 
these reports in view of the authority recently granted to the 
Board to oversee the audits of brokers and dealers, and other 
current events.
    Some auditing firms in the United States also have 
published reports that provide a high-level discussion of the 
firm's legal structure, global and U.S. governance structures, 
quality control framework, personnel headcounts, and the 
division of revenues among accounting and audit, tax, and 
consulting service lines. Little, if any, information that 
would appear in an entity's financial statements, however, 
generally is made part of such a report.
    A PCAOB inspection team, in certain cases, requests that a 
registered public accounting firm provide the Board with 
financial information concerning the firm's practice. In 
appropriate circumstances, inspectors also request information 
related to potentially catastrophic risks facing the firm, such 
as the likelihood of significant losses or costs associated 
with pending litigation or the possible failure of quality 
controls in high risk areas. The Board, therefore, currently 
has sufficient access to a firm's financial information to 
conduct its inspections and other regulatory programs.

Q.6. Mr. Valukas urged reconsideration of the paradigm 
concerning an auditor's assessment of materiality. Mr. Valukas 
noted that transparency should be placed above conclusions of 
immateriality. What has the PCAOB done, or is currently doing, 
concerning this issue? What is the estimated timeline for 
completion?

A.6. Mr. Valukas raised an important, and profound, concern, 
which I share. That is, when an auditor or the company itself 
identifies an error or other unfavorable information, too often 
their reaction is to engage in an exercise to find a rationale 
for determining that the error or information is immaterial and 
need not be disclosed to the audit committee or investors.
    The PCAOB's Auditing Standard No. 11, ``Consideration of 
Materiality in Planning and Performing an Audit'', discusses 
the concept of materiality for application in audits performed 
in accordance with PCAOB standards. The standard is based on 
the long-standing principle that materiality must be judged 
from the perspective of the reasonable investor. \4\ It 
requires auditors to establish materiality levels for the 
financial statements taken as a whole. It also requires 
auditors to determine whether separate materiality levels 
should be established for certain accounts or disclosures.
---------------------------------------------------------------------------
     \4\ Specifically, Auditing Standard No. 11 states that, in 
interpreting the Federal securities laws, the Supreme Court of the 
United States has held that a fact is material if there is ``a 
substantial likelihood that the . . . fact would have been viewed by 
the reasonable investor as having significantly altered the `total mix' 
of information made available.'' TSC Industries v. Northway, Inc., 426 
U.S. 438, 449 (1976). See, also Basic, Inc. v. Levinson, 485 U.S. 224 
(1988).
---------------------------------------------------------------------------
    To my mind, the problem Mr. Valukas cites would not be 
solved by requiring auditors to use lower materiality 
thresholds. Auditors find significant errors under existing 
standards. Rather, the problem is what auditors do about the 
error once they have found it.
    In the face of strong incentives to conform to management's 
views, auditors must exercise their professional skepticism in 
the collection of real, objective, and credible evidence to 
support their opinions. Courage to stand up to management when 
this evidence shows it is the right thing to do is one of the 
most difficult challenges an auditor faces, but it is the 
fundamental purpose of the audit.
    As I noted in response to your questions at the April 6 
hearing, the PCAOB has emphasized this issue in its inspections 
program, and there are indications that auditors themselves are 
recognizing that real change is needed. The Board intends to 
continue in its inspections and through other means to 
encourage registered public accounting firms to avoid 
temptations to minimize problems based simply on management's 
representations and, when appropriate, to present those 
problems to audit committees and others.

Q.7. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

    On March 29, 2010, the Board proposed for public comment a 
new auditing standard to replace the existing standard on 
communications with audit committees, and a series of related 
amendments to other PCAOB standards. On September 21, 2010, the 
Board held a public roundtable, which provided additional input 
on the proposed standard from representatives of audit 
committees, investors, auditors, issuers, and others.
    The proposed standard would strengthen the existing 
requirements for auditor communications with audit committees, 
and add several new requirements. The proposed standard 
includes a requirement for the auditor to establish a mutual 
understanding of the terms of the audit engagement with the 
audit committee and to document that understanding in an 
engagement letter. The proposal also includes requirements 
relating to:

    Communication of an overview of the audit strategy, 
        including a discussion of significant risks, the use of 
        the internal audit function; and the roles, 
        responsibilities, and location of firms participating 
        in the audit;

    Communication regarding critical accounting 
        polices, practices, and estimates;

    Communication regarding the auditor's evaluation of 
        a company's ability to continue as a going concern; and

    Evaluation by the auditor of the adequacy of the 
        two-way communications between the auditor and audit 
        committee to better achieve the objectives of the 
        audit.

    The proposed standard states that audit committee 
communications should occur in a timely manner, and that the 
appropriate timing of a particular communication depends on the 
significance of the matter to be communicated and the need for 
any corrective or follow-up action. As a backstop, the proposed 
standard also states, however, that all communications required 
by the standard should be made annually before the issuance of 
the auditor's report. \5\
---------------------------------------------------------------------------
     \5\ The proposed standard would provide certain exceptions for 
registered investment companies consistent with SEC Rule 2-07 of 
Regulation S-X, 17 CFR 210.2-07.
---------------------------------------------------------------------------
    The comment period for the proposal closed October 21, 
2010. The Board's staff is evaluating comments received and 
preparing its recommendations to the Board.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
                       FROM JAMES R. DOTY

Q.1. We need to make sure that American investors can have 
confidence in audits performed on U.S.-listed companies whose 
operations might be located someplace other than in the U.S. 
For example, the PCAOB released a Research Note on March 15 
detailing the extent to which hundreds of Chinese companies 
have listed on U.S. exchanges through ``reverse mergers'' with 
U.S.-based shell companies. Outside audits of these companies 
are often performed by audit firms based in China, and the 
Chinese Government has not allowed the PCAOB to inspect those 
firms to evaluate the quality of audit work being done.
    What more can the PCAOB be doing in this area to help give 
American investors the confidence they deserve and is there 
anything Congress can be doing to help you persuade the Chinese 
Government that it is in their own interest to have PCAOB 
inspectors evaluating the quality of audit work being done 
there?

A.1. The PCAOB takes seriously its obligation under the 
Sarbanes-Oxley Act (the ``Act'') to inspect non-U.S. public 
accounting firms that have registered with the PCAOB because 
they audit or play a substantial role in the audit of U.S. 
issuers, brokers, and dealers. To date, the PCAOB has conducted 
inspections in 35 jurisdictions around the world. In Asia in 
particular, the PCAOB has conducted inspections of firms 
located in India, Indonesia, Japan, Malaysia, Philippines, 
Taiwan, Thailand, Singapore, South Korea, and Hong Kong (albeit 
without access to the portions of the auditor's work papers 
covering mainland China operations and documents).
    As your question acknowledges, the PCAOB is currently 
prevented from inspecting the U.S.-related audit work and 
practices of PCAOB-registered firms in China as well as Hong 
Kong to the extent their audit clients have operations in 
mainland China. These obstacles undermine the auditor oversight 
system put in place by the Act and, in turn, threaten the 
public interest by impeding the PCAOB's ability to detect 
conduct that violates U.S. law and professional standards. As 
long as these obstacles persist, investors in U.S. markets are 
deprived of the benefits of PCAOB inspections and, in some 
cases, may rely on the mistaken belief that these auditors have 
been inspected.
    The PCAOB continues to work to resolve these obstacles and 
has been engaged in discussions with the relevant Chinese 
authorities for over 4 years. During that time, the PCAOB and 
Chinese authorities have participated in numerous bilateral 
meetings, dialogues, and workshops.
    In addition, in order to provide transparency to investors 
and the public about its international inspection efforts and 
the challenges we face, the PCAOB periodically updates certain 
disclosures about the status of inspections of registered non-
U.S. firms. Specifically, the Board has posted the following 
lists on its Web site:

    A cumulative list of the countries in which the 
        PCAOB has conducted inspections in the past.

    A list of the countries in which there are 
        registered non-U.S. firms that the PCAOB intends to 
        inspect in the current calendar year. The Board also 
        committed to publicly explaining the reason(s) for any 
        difference between the announced plan and the countries 
        in which inspections were actually conducted.

    A list of the registered firms for which the 
        inspection fieldwork has not been completed even though 
        more than four years have passed since the end of the 
        calendar year in which the firm first issued an audit 
        report while registered with the PCAOB.

    A list of the companies that, in 2009 or 2010 
        (through mid-April 2010), filed financial statements 
        with the SEC that were audited by a non-U.S. auditor 
        that is located in a jurisdiction where there are 
        obstacles to PCAOB inspections. Issuers located in 
        China (including Hong Kong issuers with significant 
        subsidiaries or operations in mainland China or audited 
        by mainland Chinese auditors) comprise the largest 
        group of issuers where the PCAOB has been denied access 
        to conduct inspections.

    In addition to these transparency measures, in July 2010, 
the PCAOB staff issued Staff Audit Practice Alert No. 6, 
``Auditor Considerations Regarding Using the Work of Other 
Auditors and Engaging Assistants From Outside the Firm'' (Staff 
Alert No. 6), noting that some U.S. audit firms, which are 
issuing audit reports for companies with substantially all of 
their operations outside of the U.S. based on work performed by 
non-U.S. firms, are not properly applying PCAOB standards. The 
alert reminds U.S. auditors of their obligations in these 
circumstances. In addition, the Board has ongoing 
investigations relating to the audits of Chinese issuers.
    Finally, in October 2010, the PCAOB announced that it was 
reevaluating its approach to new registration applications from 
firms in jurisdictions that deny access to PCAOB inspections. 
Going forward, the Board will no longer routinely register 
firms that are located in jurisdictions where the PCAOB cannot 
conduct inspections.
    While the PCAOB is currently considering a range of options 
to resolve the inspections issue, we very much appreciate your 
attention to this matter as well as the interest shown by other 
members of Congress. I believe that it is critical that 
Congress continue to remain interested in this issue as we 
focus on resolving the impasse with China in a manner that best 
serves the public interest and investing community. I recognize 
that members of Congress have their own relationships with many 
Chinese Government officials, or might have occasion to travel 
to China and discuss a wide range of important issues with 
them. Given the importance of this issue to the protection of 
American investors, I encourage members of Congress to raise 
this topic with them, and stress to the Chinese that it is in 
their own interest to agree to a system of joint inspections 
with the PCAOB this year.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON
                     FROM LESLIE F. SEIDMAN

Q.1. During Wednesday's hearing on ``The Role of the Accounting 
Profession in Preventing Another Financial Crisis'', comments 
were made by a witness testifying on the second panel on which 
I would appreciate your response and assessment.
    The comment dealt with the relative importance of 
materiality and transparency. The witness said, ``you cannot 
hide behind materiality if something is not transparent. And 
the FASB has for years been urged to adopt a rule that says if 
additional disclosure is necessary to keep the financials from 
being misleading, you need to make it . . . [U]ntil we put that 
standard in place . . . we are going to have a problem.''
    What would be the potential and probable impacts of the 
implementation of such a rule? What has been the history of 
consideration of such a rule, which was mentioned? What is the 
applicable FASB guidance regarding the disclosure of 
information necessary to keep a material part of the financial 
statement from being misleading?

A.1. In 2009, the FASB added a project to its agenda to 
establish an overarching framework intended to make financial 
statement disclosures more effective, coordinated, and less 
redundant. That project was added in response to requests and 
recommendations received from several stakeholders, including 
the ITAC (an advisory group to the FASB) and the CIFiR 
committee. Some of the concerns expressed by the investor 
community were centered on materiality and transparency. In 
addition, issuers of financial statements have requested relief 
from unnecessary, duplicative, and burdensome disclosures that 
they believe do not provide or enhance transparency.
    The project objective is not intended to be additive but, 
rather, to develop a framework for improved U.S. GAAP that 
promotes meaningful communication and logical presentation of 
disclosures and avoids unnecessary repetition. The project will 
also consider the need to specifically require a company to 
provide additional disclosures to keep its financial statements 
from being misleading. Notwithstanding the activities of the 
FASB to enhance transparency through the disclosure framework 
project, the SEC, in Exchange Act Rule 12b-20, already has a 
longstanding requirement for companies to disclose material 
information that may be necessary to make the required 
financial statements not misleading. \1\ Rule 12b-20 is an SEC 
rule applicable to companies subject to the 1934 Exchange Act.
---------------------------------------------------------------------------
     \1\ Exchange Act Rule 12b-20 states that ``In addition to the 
information expressly required to be included in a statement or report, 
there shall be added such further material information, if any, as may 
be necessary to make the required statements, in the light of the 
circumstances under which they are made not misleading.''
---------------------------------------------------------------------------
    To date, the disclosure framework project team has 
completed its categorization of existing disclosures and is 
currently analyzing ways to eliminate those disclosures that 
are not deemed useful and to add those disclosures that users 
need to better understand the prospects and risks faced by an 
entity. The FASB expects to issue a Discussion Paper on that 
framework in the second half of 2011.
    In recent standards, the FASB also has been identifying the 
objective of the disclosure requirements, rather than just 
enumerating specific disclosure items. Most recent standards 
include the notion that the objectives apply regardless of 
whether the standard requires specific disclosures. Those 
standards indicate that the specific disclosures required by 
the standard are minimum requirements and a company may need to 
supplement the required disclosures depending on the company's 
facts and circumstances.
    It is the FASB's responsibility to develop recognition, 
measurement, and disclosure principles that appropriately 
portray the economics of transactions entered into by a 
company. While the FASB is responsible for establishing 
accounting standards, the FASB does not have the authority to 
determine whether a company's financial report is presented 
fairly. The SEC has the ultimate authority to analyze whether 
public companies have complied with accounting and disclosure 
standards.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                     FROM LESLIE F. SEIDMAN

Q.1. In his written testimony, Mr. Valukas, noted that there 
are ``no clear rules for measurement and reporting of the 
critical metric of liquidity . . . '' What accounting 
pronouncements are in place or contemplated concerning the 
measurement and reporting of liquidity?

A.1. Several topic-specific pronouncements require companies to 
provide information about liquidity. For example, Topic 470 
requires a company to provide information about the nature and 
timing of its debt obligations. Topic 840 requires a company to 
provide information about its lease commitments. Topic 860 
requires a company to provide information about its obligations 
when a company has sold assets and has significant continuing 
involvement with those assets. The Securities and Exchange 
Commission (SEC) and the banking regulators require additional 
liquidity disclosures in ``Management Discussion'' and 
``Analysis and Call Reports'', respectively.
    One of the Financial Accounting Standards Board's (FASB or 
Board) current priorities is improving, simplifying, and 
achieving convergence of the accounting for financial 
instruments. As part of that project, the FASB staff is 
developing additional disclosures about risks relating to 
financial instruments, including liquidity risk, that would 
improve the information provided to users of financial 
statements about a company's financial instruments. When 
evaluating the need for additional disclosures, the FASB will 
consider existing reporting requirements established by other 
regulatory bodies, including the SEC and the banking 
regulators. The FASB plans to issue a proposal of these 
additional disclosures in 2011.

Q.2. Mr. Turner testified that the FASB has ``constantly 
refused'' to promulgate standards that address disclosures that 
may be necessary to provide financial statements that are not 
misleading. Has the FASB developed standards to address (1) the 
reporting of transactions that lack economic substance; and (2) 
whether the financial report is fairly presented? Are any such 
standards contemplated? If so, what is the estimated timeline 
for completion?

A.2. The FASB continually adds projects to our technical agenda 
that improve transparency of financial reporting for users of 
financial statements. The Board regularly solicits input from 
its advisory groups, including the Financial Crisis Advisory 
Group during 2009 and 2010, and through an annual survey 
conducted by our Financial Accounting Standards Advisory 
Council (FASAC). On the basis of that input, the Board has 
undertaken work in several specific areas that require 
transactions to be reported in accordance with their economic 
substance instead of their legal form (for example, standards 
on transfers of financial assets and consolidation of special-
purpose entities (SPEs)). The Board completed a targeted 
project in 2009 to provide greater transparency about transfers 
(sales) of financial assets and a company's continuing 
involvement with such assets (FAS 166). \1\ The final standards 
improve disclosures about a company's involvements with SPEs 
and tighten the requirements governing when such entities 
should be consolidated (FAS 167). \2\
---------------------------------------------------------------------------
     \1\ FASB Statement No. 166, Accounting for Transfers of Financial 
Assets--an amendment of FASB Statement No. 140 (June 2009), now 
codified in Topic 860 of the FASB Accounting Standards 
Codification'.
     \2\ FASB Statement No. 167, Amendments to FASB Interpretation No. 
46(R) (June 2009), now codified in Topic 810 of the Accounting 
Standards Codification'.
---------------------------------------------------------------------------
    As noted in our response to Question 4, the FASB recently 
revised FAS 166 to address accounting for repurchase 
agreements, and is proposing guidance to clarify certain 
provisions about consolidation in FAS 167. Our response to 
Question 4 also describes our lease accounting project that is 
currently under way.
    With respect to a company's fair presentation of its 
economic condition in its financial reports, it is important to 
remember the FASB's role as an accounting standard setter. It 
is the FASB's responsibility to develop recognition, 
measurement, and disclosure principles that appropriately 
portray the economics of transactions entered into by a 
company. While the FASB is responsible for establishing 
accounting standards, the FASB does not have the authority to 
determine whether a company's financial report is presented 
fairly. Instead, officers and directors of a company are 
responsible for preparing financial reports in accordance with 
accounting standards. Auditors provide an opinion as to whether 
those officers and directors appropriately applied the 
accounting standards. The Public Company Accounting Oversight 
Board (PCAOB) is charged with ensuring that auditors of public 
companies have performed an audit in accordance with generally 
accepted auditing standards, which include an auditor's 
analysis of whether a public company has complied with 
appropriate accounting standards. Finally, the SEC has the 
ultimate authority to analyze whether public companies have 
complied with accounting standards.
    Additionally, the SEC, in Exchange Act Rule 12b-20, has a 
long-standing requirement for companies to disclose material 
information that may be necessary to make the required 
financial statements not misleading. \3\ Rule 12b-20 is an SEC 
rule applicable to companies subject to the 1934 Exchange Act.
---------------------------------------------------------------------------
     \3\ Exchange Act Rule 12b-20 states that ``In addition to the 
information expressly required to be included in a statement or report, 
there shall be added such further material information, if any, as may 
be necessary to make the required statements, in the light of the 
circumstances under which they are made not misleading''

Q.3. A recent report of the Economic Affairs Committee of the 
House of Lords of the British Parliament expressed concerns 
that the International Financial Reporting Standards (IFRS) is 
an ``inferior system'' that encourages ``box-ticking'' and does 
not properly account for expected losses. What has the FASB 
done to evaluate this report and what impact does it have on 
---------------------------------------------------------------------------
the FASB's agenda?

A.3. We have read and considered the report issued by the 
Economic Affairs Committee (EAC). During the last several 
years, the FASB has aimed to improve its standards through a 
focus on clear objectives and principles, supported by a 
sufficient level of implementation guidance. We believe that 
this improved approach for establishing accounting standards 
further emphasizes the need for practitioners to exercise 
professional judgment when applying U.S. generally accepted 
accounting principles (GAAP). The FASB's work on pending 
convergence projects with International Accounting Standards 
Board (IASB) is informed by this standard-setting philosophy.
    With regard to the EAC's specific concerns about the 
accounting for a bank's expected losses under IFRS, the FASB 
has a project on its agenda to address the model for 
recognizing loan impairments. The FASB is working jointly with 
the International Accounting Standards Board (IASB) to develop 
a converged and improved impairment model in 2011. While the 
FASB is committed to working hard to develop converged 
standards, we are committed first and foremost to ensuring that 
the standards result in improved financial information for 
investors.

Q.4. With respect to off-balance sheet transactions, please 
indicate what accounting standards address the accounting for, 
and disclosure of, off-balance sheet transactions. Please 
include when the FASB initially promulgated related standards; 
when the FASB evaluated the implementation and assessed the 
effectiveness of such standards; and the current status of any 
projects. Please include a timeline of when the relevant issue 
was first added to the FASB's agenda and any anticipated 
activities through completion of the project.

A.4. There are a number of FASB standards that address the 
accounting for and disclosure of off-balance sheet 
transactions. The recent financial crisis revealed that 
accounting standards governing when a ``true sale'' has 
occurred and when a company must recognize and report interests 
in SPEs did not adequately reveal risks relating to transfers 
with continuing involvement, and various roles in 
securitization activities. To address these problems, the FASB 
in 2008 issued enhanced disclosure requirements, \4\ which 
became effective immediately, and then proceeded to complete a 
targeted project in 2009 to provide greater transparency about 
transfers (sales) of financial assets and a company's 
continuing involvement with such assets (FAS 166). These 
standards improve disclosures about a company's involvements 
with SPEs and tighten the accounting requirements governing 
when such entities should be consolidated (FAS 167). Below we 
discuss the most significant accounting standards related to 
off-balance sheet disclosures.
---------------------------------------------------------------------------
     \4\ FASB Staff Position FAS 140-4 and FIN 46(R)-8, Disclosures by 
Public Entities (Enterprises) about Transfers of Financial Assets and 
Interests in Variable Interest Entities (December 2008).
---------------------------------------------------------------------------

Transfers of Financial Assets

    Accounting standards applicable to transfers of financial 
assets and the use of SPEs have been in place for many years 
and have been revised as structured finance arrangements have 
evolved. In the 1980s, the FASB issued guidance to address 
diversity in practice for transfers of financial assets, 
including securitization transactions. However, as new 
securitization structures developed, diversity in accounting 
continued. FAS 77, issued in 1983, addressed the reporting of 
transferred loans. \5\ FASB Technical Bulletin 85-2 was issued 
in 1985 to provide guidance on the securitization of 
collateralized mortgage obligations. \6\ Other guidance was 
periodically issued through various audit and accounting guides 
of the American Institute of Certified Public Accountants 
(AICPA) and consensuses of the FASB's Emerging Issues Task 
Force (EITF).
---------------------------------------------------------------------------
     \5\ FASB Statement No. 77, Reporting by Transferors for Transfers 
of Receivables with Recourse (December 1983).
     \6\ FASB Technical Bulletin No. 85-2, Accounting for 
Collateralized Mortgage Obligations (CMOs) (March 1985).
---------------------------------------------------------------------------
    In 1996, the FASB issued FAS 125 to improve the accounting 
for transfers of financial assets and to eliminate 
inconsistencies that resulted from the various guidance 
developed over the years. \7\ After the issuance of FAS 125, 
stakeholders asked the Board to reconsider or clarify certain 
provisions. In 2000, the FASB issued FAS 140 to address those 
matters. \8\ After the issuance of FAS 140, the FASB received a 
number of requests from financial statement users and 
regulators to reconsider or clarify certain provisions. The 
FASB issued three proposals to revise FAS 140, which resulted 
in the issuance of FAS 166 in 2009.
---------------------------------------------------------------------------
     \7\ FASB Statement No. 125, Accounting for Transfers and Servicing 
of Financial Assets and Extinguishments of Liabilities (June 1996).
     \8\ FASB Statement No. 140, Accounting for Transfers and Servicing 
of Financial Assets and Extinguishments of Liabilities--a replacement 
of FASB Statement No. 125 (September 2000).
---------------------------------------------------------------------------
    The FASB issued a narrowly focused revision to FAS 166 in 
April 2011. \9\ That revision affects the accounting guidance 
for determining when a repurchase agreement should be accounted 
for as a sale or as a financing. The Board determined that the 
existing criterion pertaining to an exchange of collateral 
should not be a determining factor when accounting for a 
repurchase agreement transaction. This project is also 
discussed in the response to Question 2.
---------------------------------------------------------------------------
     \9\ Accounting Standards Update No. 2011-03, Transfers and 
Servicing (Topic 860): Reconsideration of Effective Control for 
Repurchase Agreements (April 2011).
---------------------------------------------------------------------------

Consolidation of Special-Purpose Entities

    Guidance issued in the mid-1980s addressed the 
consolidation of SPEs used in securitizations involving 
collateralized mortgage obligations. \10\ However, 
securitization transactions continued to evolve and diversity 
in accounting continued when determining whether to consolidate 
SPEs. After the collapse of Enron, the FASB determined that the 
consolidation guidance as it related to securitization vehicles 
and other thinly capitalized entities was fragmented and 
incomplete. As a result, the FASB developed a new consolidation 
model applicable to such entities. That model was issued in 
January 2003 as FIN 46. \11\ The FASB issued revisions to FIN 
46 in December 2003. That revised guidance, FIN 46(R), remained 
in effect until the issuance of FAS 167 in 2009. \12\
---------------------------------------------------------------------------
     \10\ FASB Technical Bulletin 85-2.
     \11\ FASB Interpretation No. 46, Consolidation of Variable 
Interest Entities--an interpretation of ARB No. 51 (January 2003).
     \12\ FASB Interpretation No. 46(R), Consolidation of Variable 
Interest Entities--an interpretation of ARB No. 51 (December 2003).
---------------------------------------------------------------------------
    Currently, the FASB has a narrowly focused project on our 
technical agenda to revise FAS 167. The FASB plans to issue a 
proposal in May 2011 that would amend the consolidation 
guidance to address concerns about applying FAS 167 to 
investment companies and other similar companies. This project 
is also discussed in the response to Question 2.

Leasing

    Lease obligations are widely considered a significant 
source of off-balance sheet financing. Under the current lease 
accounting guidance, a company leasing an asset will either 
recognize the entire leased asset on its books and a liability 
for all of its contractually required payments or recognize no 
asset and no liability. FAS 13, issued in 1976, established the 
current accounting guidance for leases for both lessors and 
lessees. \13\ Following the issuance of FAS 13, the FASB, EITF, 
SEC, and AICPA issued numerous standards that addressed various 
issues relating to the application of that Statement.
---------------------------------------------------------------------------
     \13\ FASB Statement No. 13, Accounting for Leases (November 1976).
---------------------------------------------------------------------------
    Many of the FASB's stakeholders criticized the current 
lease accounting guidance and urged the FASB to undertake a 
lease accounting project. In July 2006, the FASB and the IASB 
decided to add a joint leasing project to their respective 
agendas because of their concern that the current accounting in 
this area does not clearly portray the resources and 
obligations arising from lease transactions. The FASB and the 
IASB (the Boards) have been working to revise the existing 
lease accounting guidance since that time. The Boards have 
issued proposed revisions to lease accounting guidance and are 
currently considering the feedback received from comment 
letters and the Boards' extensive outreach activities. We 
expect to issue guidance in the latter half of 2011.
    The response to Question 7 more fully describes the FASB's 
processes for evaluating the effectiveness of its standards.

Q.5. The Financial Crisis Inquiry Commission refers to certain 
practices that occurred leading up to and during the financial 
crisis as ``window dressing.'' What steps has the FASB taken to 
address this concept in the current financial reporting 
environment?

A.5. ``Window dressing'' results from a variety of actions that 
a company may take to affect its financial statements as of a 
particular reporting date. In its report, the Financial Crisis 
Inquiry Commission describes some companies that would sell 
assets before the end of a reporting period to reduce the 
amount of the company's assets and lower its leverage ratio. 
Those companies would buy those assets back at the beginning of 
the next quarter. The FASB has recently improved the accounting 
guidance for repurchase transactions. In June 2008, the FASB 
issued guidance to require a company to link together certain 
repurchase transactions when determining whether those 
transactions should be reported as sales or financings. \14\ In 
2009, the FASB issued FAS 166, which requires a company to 
disclose its continuing involvement, if any, with financial 
assets that it reports as having sold. In addition, in April 
2011, the FASB revised the accounting standard for determining 
when such a repurchase agreement should be accounted for as a 
sale or as a financing. \15\ The Board determined that one of 
the existing criteria pertaining to an exchange of collateral 
should not be a determining factor when accounting for a 
repurchase agreement transaction.
---------------------------------------------------------------------------
     \14\ FASB Staff Position 140-3, Accounting for Transfers of 
Financial Assets and Repurchase Financing Transactions (February 2008), 
now codified in Topic 860 of the Accounting Standards 
Codification'.
     \15\ FASB Accounting Standards Update No. 2011-3.

Q.6. What standards have been issued to address the need to 
eliminate or reduce accounting-motivated structured 
transactions? What has FASB concluded about the operating 
---------------------------------------------------------------------------
effectiveness of such standards?

A.6. During the last several years, the FASB has aimed to 
improve its standards through a focus on clear objectives and 
principles, supported by a sufficient level of implementation 
guidance. We believe that this improved approach for 
establishing accounting standards further emphasizes the need 
for practitioners to exercise professional judgment when 
applying U.S. GAAP and reduces opportunities for similar 
economic transactions to be reported differently.
    Accounting-motivated structured transactions can take many 
forms. As noted above in the response to Question 4, a number 
of FASB standards address the accounting for and disclosure of 
off-balance sheet transactions. The recent financial crisis 
revealed that accounting standards governing when a ``true 
sale'' had occurred and when a company must recognize and 
report interests in SPEs did not adequately reveal risks 
relating to transfers with continuing involvement and various 
roles in securitization activities. As discussed in response to 
Question 4, in 2008, the FASB issued enhanced disclosure 
requirements to address these problems and imposed an immediate 
effective date for such enhanced disclosures. In 2009, the 
Board issued FAS 166, which provided greater transparency about 
transfers (sales) of financial assets and a company's 
continuing involvement with such assets. In 2009, the Board 
also issued FAS 167, which improved disclosures of a company's 
involvements with SPEs and tightened the accounting 
requirements governing when such entities should be 
consolidated.
    Also noted in our response to Question 4, the FASB 
currently has a joint project with the IASB under way to 
develop improved lease accounting standards that are intended 
to minimize off-balance-sheet reporting of lease transactions.
    The FASB actively seeks input from all of its stakeholders 
on proposals and processes. The Board's broad-based outreach 
helps us to assess each standard's effectiveness and whether 
the benefits to users of improved information from proposed 
changes outweigh the costs of the changes to preparers and 
others. Broad consultation also provides the opportunity for 
all stakeholder voices to be heard and considered, facilitates 
the identification of unintended consequences, and, ultimately, 
enables the widespread acceptance of the standards that are 
adopted. The response to Question 7 more fully describes the 
FASB's processes for evaluating the effectiveness of its 
standards.

Q.7. Some commentators have expressed concern about whether the 
FASB's focus on convergence has diverted attention away from 
the timely assessment of U.S. GAAP. What is the FASB doing to 
ensure that U.S. GAAP is assessed in a timely fashion?

A.7. While the FASB is committed to working hard to develop 
improved, converged, and sustainable standards, we are equally 
committed to making sure that, first and foremost, U.S. GAAP 
standards continue to provide the highest quality of financial 
information to investors. The projects that we conduct jointly 
with the IASB include topics in U.S. GAAP that the FASB has 
identified as areas that need improvement. Those projects were 
added to the FASB's technical agenda as part of the FASB's 
commitment to improve the effectiveness of existing U.S. GAAP.
    The FASB engages in extensive due process to ensure that 
U.S. GAAP is assessed in a timely fashion, including public 
meetings, public roundtables, field visits or field tests, 
liaison meetings with interested parties, and the exposure of 
our proposed standards for public comment. We proactively reach 
out to meet with stakeholders, including a wide range of 
investors and reporting entities, to discuss current and 
proposed standards. Those meetings with stakeholders help us to 
assess whether U.S. GAAP standards are providing useful 
information and also to assess the related costs. The FASB 
works diligently to conduct outreach on a frequent and regular 
basis with the FASB's eight advisory groups. The primary role 
of advisory group members is to share their views and 
experience with the Board on matters related to practice and 
implementation of new standards, projects on the Board's 
agenda, possible new agenda items, and strategic and other 
matters.
    In addition to the FASB's eight advisory groups, the EITF 
assists the FASB in improving financial reporting through the 
timely identification, discussion, and resolution of financial 
accounting issues relating to U.S. GAAP. The EITF was also 
designed to promulgate implementation guidance for accounting 
standards to reduce diversity in accounting practice on a 
timely basis. The EITF assists the FASB in addressing narrow 
implementation, application, or other emerging issues that can 
be analyzed within existing U.S. GAAP. Task Force members are 
drawn from a cross section of the FASB's stakeholders, 
including auditors, preparers, and users of financial 
statements. The chief accountant or the deputy chief accountant 
of the SEC attends Task Force meetings regularly as an observer 
with the privilege of the floor. Make-up of the EITF is 
designed to include persons in a position to be aware of 
emerging issues before they become widespread and before 
divergent practices become entrenched.
    The FASB also meets regularly with the staff of the SEC and 
the PCAOB. Additionally, because banking regulators have a keen 
interest in U.S. GAAP financial statements as a starting point 
in assessing the safety and soundness of financial 
institutions, we meet with them at least on a quarterly basis 
and more frequently, if needed. The FASB's extensive due 
process ensures that U.S. GAAP is assessed in a timely and 
complete fashion.
    Further, the Office of the Chief Accountant of the SEC is 
undertaking a new initiative involving a series of roundtable 
sessions (Financial Reporting Series) in its oversight capacity 
to facilitate a balanced discussion of existing pressures or 
emerging issues within the financial reporting system. The 
Financial Reporting Series is designed to assist in the 
proactive identification of risks related to, and areas for 
potential improvements in, the reliability and usefulness of 
financial information provided to investors. The chairs of the 
FASB and the PCAOB will attend all sessions as observers and 
will have the opportunity to make statements and ask questions 
of participants.

Q.8. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

A.8. While the FASB is responsible for establishing accounting 
standards, the PCAOB ensures that auditors of public companies 
have performed an audit in accordance with generally accepted 
auditing standards. This includes oversight over an auditor's 
analysis of whether a public company has complied with 
appropriate accounting standards and whether they have made the 
appropriate communications to a company's audit committee. The 
FASB does not have the authority to oversee audit firms and 
does not make recommendations to the PCAOB on issues within the 
PCAOB's purview.

Q.9. Mr. Doty recommended that Congress consider changes to 
permit the PCAOB to disclose its decision to institute 
disciplinary hearings, which is currently prohibited by Section 
105(c)(2) of the Sarbanes-Oxley Act of 2002. Please give us 
your detailed thoughts regarding the strengths and weaknesses 
of this proposal.

A.9. While the FASB is responsible for establishing accounting 
standards, the PCAOB ensures that auditors of public companies 
have performed an audit in accordance with generally accepted 
auditing standards. This includes oversight over an auditor's 
analysis of whether a public company has complied with 
appropriate accounting standards. The FASB does not have the 
authority to oversee audit firms and does not make 
recommendations to the PCAOB on issues within the PCAOB's 
purview.

Q.10. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four potential areas of 
improvement in auditor communications:

  a.  assessments of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement, and other significant 
        changes; and

  d.  assessments of the quality of the issuer's accounting 
        policies and practices.

    What work has the FASB done to support transparency to 
financial statement users in each of the areas noted above?

A.10. The FASB's mission is to establish and improve standards 
of financial accounting and reporting for the guidance and 
education of the public, including users of financial 
information. However, the FASB does not have authority to 
oversee management's (or its auditor's) qualitative assessment 
of a company's financial reporting.
    The FASB, however, does recognize the importance of 
improving transparency about a company's judgments and 
estimates and areas of high financial statement risk. 
Accordingly, the FASB has recently issued guidance to improve 
disclosures about the following:

  a.  Fair value measurements \16\
---------------------------------------------------------------------------
     \16\ FASB Statement No. 157, Fair Value Measurements (September 
2006), as codified in Topic 820 of the Accounting Standards 
Codification'; FASB Staff Position FAS 107-1 and APB28-1, 
Interim Disclosures about Fair Value of Financial Instruments (April 
2009), now codified in various Topics of the Accounting Standards 
Codification'; FASB Staff Position FAS 157-4, Determining 
Fair Value When the Volume and Level of Activity for the Asset or 
Liability Have Significantly Decreased and Identifying Transactions 
That Are Not Orderly (April 2009), now codified in Topic 820 of the 
Accounting Standards Codification'; and FASB Accounting 
Standards Update No. 2010-6, Fair Value Measurements and Disclosures 
(Topic 820): Improving Disclosures about Fair Value Measurements 
(January 2010).

  b.  Asset impairments \17\
---------------------------------------------------------------------------
     \17\ FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and 
Presentation of Other-Than-Temporary Impairments (April 2009), now 
codified in various Topics of the Accounting Standards 
Codification'.

  c.  Credit risk \18\
---------------------------------------------------------------------------
     \18\ FASB Staff Position SOP 94-6-1, Terms of Loan Products That 
May Give Rise to a Concentration of Credit Risk (December 2005), now 
codified in Topics 825 and 310 of the Accounting Standards 
Codification'; and FASB Accounting Standards Update No. 
2010-20, Receivables (Topic 310): Disclosures about the Credit Quality 
of Financing Receivables and the Allowance for Credit Losses (July 
2010).

  d.  Derivative instruments and hedging activities, including 
        credit derivatives \19\
---------------------------------------------------------------------------
     \19\ FASB Statement No. 161, Disclosures about Derivative 
Instruments and Hedging Activities--an amendment of FASB Statement No. 
133 (March 2008), now codified in Topic 815 of the Accounting Standards 
Codification'; and FASB Staff Position FAS 133-1 and FIN 45-
4, Disclosures about Credit Derivatives and Certain Guarantees: An 
Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and 
Clarification of the Effective Date of FASB Statement No. 161, now 
codified in Topics 815 and 460 of the Accounting Standards 
Codification'.

  e.  Transfers of financial assets and continuing involvement 
        with those assets \20\
---------------------------------------------------------------------------
     \20\ FASB Staff Position FAS 140-4 and FIN 46(R)-8 and FASB 
Statement No. 166, now codified in Topic 860 of the Accounting 
Standards Codification'.

  f.  Involvements in SPEs \21\
---------------------------------------------------------------------------
     \21\ FASB Staff Position FAS 140-4 and FIN 46(R)-8 and FASB 
Statement No. 167, now codified in Topic 860 of the Accounting 
Standards Codification'.

  g.  Financial guarantee insurance products. \22\
---------------------------------------------------------------------------
     \22\ FASB Statement No. 163, Accounting for Financial Guarantee 
Insurance Contracts--an interpretation of FASB Statement No. 60 (May 
2008), now codified in Topic 944 of the Accounting Standards 
Codification'.

Q.11. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Has the FASB considered a 
project to promulgate accounting standards specific to 
---------------------------------------------------------------------------
accounting firms? If not, why not?

A.11. As discussed above, although the FASB is responsible for 
establishing accounting standards, it does not have authority 
to require an audit firm (or any other firm) to prepare its 
financial statements in accordance with U.S. GAAP. 
Additionally, the FASB also does not have the authority to 
oversee or regulate audit firms; such authority rests with the 
PCAOB and the State licensing boards.
    Although, in limited circumstances, the FASB has issued 
industry-specific accounting guidance, the FASB is generally 
charged with establishing general purpose standards of 
financial accounting and reporting focused on the nature of the 
business activities and not specific industries. General 
purpose standards are in most instances preferable to industry-
specific standards because the same activities may be carried 
out by companies from different industries. This was reinforced 
in the Final Report of the Advisory Committee on Improvements 
to Financial Reporting to the United States Securities and 
Exchange Commission, in which the committee generally advocated 
a move away from industry-specific guidance in authoritative 
accounting literature. \23\
---------------------------------------------------------------------------
     \23\ The Advisory Committee on Improvements to Financial Reporting 
(CIFiR) to the SEC states the following in Recommendation 1.6 of their 
Final Report (August 2008): U.S. GAAP should be presumptively based on 
business activities, rather than industries. As such, the SEC should 
recommend that any new projects undertaken jointly or separately by the 
FASB be scoped on the basis of business activities, except in rare 
circumstances. Any new projects should include the elimination of 
existing industry-specific guidance--particularly that which conflicts 
with generalized U.S. GAAP--in relevant areas as a specific objective 
of those projects, except in rare circumstances.

Q.12. Please describe the process whereby FASB reviews each new 
standard to determine whether it has met the needs of financial 
statement users or whether additional guidance should be 
promulgated. What assessments have been performed within the 
---------------------------------------------------------------------------
last 2 years and what additional assessments are scheduled?

A.12. In November 2010, the Financial Accounting Foundation 
(FAF) Board of Trustees, the oversight body of the FASB and the 
Governmental Accounting Standards Board (GASB), announced a 
process for conducting post-implementation reviews (PIR) of 
financial accounting and reporting standards issued by the FASB 
and the GASB.
    The PIR process is part of the FAF Trustee's oversight 
activities and is independent of the FASB and GASB standard-
setting processes. Accordingly, the PIR team reports directly 
to the FAF President & CEO, and the FAF Trustees.
    The primary objective of the PIR process is to determine 
whether a standard is accomplishing its stated purpose and to 
provide feedback to the FASB that could improve the standard-
setting process. The PIR team evaluates whether decision-useful 
information is being reported and if investors, creditors, and 
other users of financial statements are using the reported 
information as intended. The review team also evaluates whether 
there are any significant unintended changes to financial 
reporting and operating practices or any significant economic 
consequences that the FASB did not consider in setting the 
standard. The review process also evaluates the implementation 
and continuing compliance costs of a standard compared to the 
intended benefits of the standard.
    The PIR team has initiated the review of its first selected 
standard and will be completing that review during the second 
half of 2011. Following completion of that review, the FAF will 
proceed with the review of additional significant standards 
that have been issued for a minimum period of 2 to 3 years. FAF 
intends to conduct post-implementation reviews of significant 
FASB standards. There are two principal criteria in deciding 
whether an FASB standard should be subjected to a post-
implementation review. First, the standard should have 
represented a significant change from existing financial 
reporting when it was issued. Second, there should be a 
significant amount of stakeholder input requesting additional 
guidance or indicating that the standard may not be meeting its 
stated objective(s). The PIR team will not review standards 
that are currently the subject of a significant technical 
project or are under reconsideration by the FASB.
    It is important to note that the PIR function is in 
addition to the procedures that the FASB has in place to 
identify emerging issues and potential agenda items. Those 
procedures are described in response to Question 7. It was 
through those procedures that the Board added projects relating 
to securitizations, consolidation, repurchase agreements, 
credit quality disclosures, multi-employer pension plans, and 
numerous other matters in recent years.

Q.13. Please describe the Financial Accounting Foundation's 
policies and practices to evaluate the efficiency and 
effectiveness of the FASB. Please provide any reports that have 
been conducted within the last 2 years.

A.13. The FAF's Board of Trustees regularly monitors and 
evaluates the efficiency and effectiveness of the FASB. The 
full Board of Trustees undertakes these functions directly and 
also through its Standard-Setting Process Oversight Committee 
(Oversight Committee) and its Appointments & Evaluations 
Committee.
    The full Board of Trustees formally meets a minimum of four 
times per year with the FASB Chairman and Technical Director 
for an in-depth review and understanding of the FASB's 
technical agenda, project plans, and priorities on both 
domestic projects and joint projects with the IASB. These 
reviews include discussion about, among other things: the 
timing of projects; the level, means, and scope of stakeholder 
outreach; and the FASB's due process. The Trustees also meet 
quarterly with the Chairman of the FASAC for, among other 
things, FASAC's views on the effectiveness and efficiency of 
the FASB.
    Trustees and executives of the FAF also regularly engage in 
nontechnical stakeholder outreach activities, including 
meetings with the SEC, banking and finance regulators, members 
of Congress, investor organizations, business and trade 
associations, and audit firm leaders. These meetings are 
intended to educate stakeholders on the activities of the FAF 
and FASB, solicit stakeholder involvement in the FASB's due 
process, and enable the FAF to obtain an understanding of the 
issues and concerns of stakeholders and gain insights from them 
on the effectiveness of the FASB and how the FAF and the FASB 
can continue to meet the needs of financial statement users and 
fulfill our mission.
    The Oversight Committee was formed as an advisory committee 
to the Board of Trustees in 2008. In 2009, the Oversight 
Committee was raised to a standing committee of the Board of 
Trustees and in 2011 became the first committee of the Board of 
Trustees designated with cochairs. The Oversight Committee 
meets as often as six times per year and, on most of those 
occasions, meets with the FASB Chairman and Technical Director. 
The primary responsibilities of the Oversight Committee are 
monitoring and fostering thorough and effective due process by 
the FASB and the GASB. As discussed in the response to Question 
12 above, in 2010, the Board of Trustees formalized a post-
implementation review team and procedures under the direction 
and supervision of the Oversight Committee. The Oversight 
Committee also reviews the cost-benefit procedures followed by 
the FASB and GASB in establishing standards.
    The Appointments & Evaluations Committee conducts annual 
reviews of the performance of all FASB members.
    Accompanying this response letter are the Annual Reports of 
the FAF for 2010 and 2009.




                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON
                     FROM JAMES L. KROEKER

Q.1. During Wednesday's hearing on ``The Role of the Accounting 
Profession in Preventing Another Financial Crisis'', comments 
were made by a witness testifying on the second panel on which 
I would appreciate your response and assessment.
    The comment dealt with the relative importance of 
materiality and transparency. The witness said, ``you cannot 
hide behind materiality if something is not transparent. And 
the FASB has for years been urged to adopt a rule that says if 
additional disclosure is necessary to keep the financials from 
being misleading, you need to make it . . . [U]ntil we put that 
standard in place . . . we are going to have a problem.''
    What would be the potential and probable impacts of the 
implementation of such a rule? What has been the history of 
consideration of such a rule, which was mentioned? What is the 
applicable FASB guidance regarding the disclosure of 
information necessary to keep a material part of the financial 
statement from being misleading?

A.1. It is already a requirement under Securities Act Rule 408 
(for filings under the Securities Act of 1933) and Exchange Act 
Rule 12b-20 (for filings under the Exchange Act) that, in 
addition to the information expressly required to be included 
in a statement or report, there shall be added such further 
material information, if any, as may be necessary to make the 
required statements, in the light of the circumstances under 
which they are made, not misleading.
    In this context, it is useful to differentiate between FASB 
standards and SEC requirements. Generally, financial statements 
filed with the SEC must be prepared in accordance with 
generally accepted accounting principles. \1\ The Commission 
has recognized the standards of the FASB as ``generally 
accepted'' for purposes of the Federal securities laws. \2\ The 
SEC also has its own rules and requirements relating to the 
financial statements and to disclosures that must accompany the 
financial statements.
---------------------------------------------------------------------------
     \1\ See, Rule 4-01(a)(1) of Regulation S-X. Rule 4-01(a) also 
prescribes that ``The information required with respect to any 
statement shall be furnished as a minimum requirement to which shall be 
added such further material information as is necessary to make the 
required statements, in the light of the circumstances under which they 
are made, not misleading.''
     \2\ See, Rel. No. 33-8832 (Apr. 25, 2003).
---------------------------------------------------------------------------
    The Commission has brought enforcement actions where 
filings were materially misleading to investors even though the 
financial statements may have technically complied with GAAP. 
For example, in a settled matter involving Edison Schools Inc., 
the Commission alleged that Edison, a private manager of 
elementary and secondary public schools, failed to disclose 
significant information regarding its business operations. \3\ 
The Commission alleged that Edison failed to disclose that a 
substantial portion of its reported revenues consisted of 
payments that never reached Edison. These funds were instead 
expended by school districts (Edison's clients) to pay teacher 
salaries and other costs of operating schools that were managed 
by Edison. The Commission did not find that Edison's revenue 
recognition practices contravened GAAP or that earnings were 
misstated. However, the Commission nonetheless found that 
Edison committed violations by failing to provide accurate 
disclosure, thus showing that technical compliance with GAAP in 
the financial statements will not insulate an issuer from 
enforcement action. \4\
---------------------------------------------------------------------------
     \3\ See, In re Edison Schools, Inc., A.A.E.R. No. 1555 (May 14, 
2002).
     \4\ See, also In re Coca-Cola Company, A.A.E.R. No. 2232 (Apr. 18, 
2005).
---------------------------------------------------------------------------
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                     FROM JAMES L. KROEKER

Q.1. During your remarks, you noted that there are projects 
regarding assessing an entity's ability to continue as a going 
concern. What is SEC's role in these projects? What is the 
estimated timeline to completion?

A.1. Section 10A of the Securities Exchange Act of 1934 
(Exchange Act) requires that each audit of the financial 
statements of an issuer include an evaluation of whether there 
is substantial doubt about the ability of the issuer to 
continue as a going concern. \5\ The PCAOB's current auditing 
standards (i.e., AU 341, ``An Entity's Ability To Continue as a 
Going Concern'') require auditors to evaluate, based on 
information obtained during the course of the audit, whether 
there is substantial doubt about an entity's ability to 
continue as a going concern for a reasonable period of time, 
not to exceed one year beyond the date of the financial 
statements being audited. If, after considering identified 
conditions and events that gave rise to the substantial doubt 
(and gathering additional information about them if 
appropriate), and management's plan to mitigate the effect of 
the conditions and events (as well as the likelihood that the 
plan could be effectively implemented), an auditor concludes 
that substantial doubt about the entity's ability to continue 
as a going concern for a reasonable period remains, then the 
auditor's report is required to contain an explanatory 
paragraph describing this condition.
---------------------------------------------------------------------------
     \5\ Exchange Act 10A(a)(3).
---------------------------------------------------------------------------
    These specific rules are directed only at an auditor; they 
do not speak to the duty that a company may have to make 
disclosures that are relevant to its ability to continue as a 
going concern. For example, the SEC requires that issuers 
disclose information about their financial circumstances, 
including negative trends in cash flows, liquidity, capital 
resources, or results of operations; risk factors; and various 
indicators of financial distress, such as loan defaults. \6\
---------------------------------------------------------------------------
     \6\ See, e.g., Item 303 of Regulation S-K; Item 2.04 of Form 8-K; 
Codification of Financial Reporting Policies Section 501.01-.13.
---------------------------------------------------------------------------
    Recognizing, however, that some investors have expressed a 
desire for additional or more focused disclosures in this area, 
the FASB has an active project on disclosures about risks and 
uncertainties. \7\ The FASB originally undertook this project 
to determine what analysis and disclosures management should be 
required to make in financial statements about whether there is 
substantial doubt about an entity's ability to continue as a 
going concern. The FASB decided to broaden the scope of this 
project to address concerns about the ability of investors and 
other users of financial statements to understand the risks and 
uncertainties about an entity's ability to continue as a going 
concern and to meet its obligations when they become due. Some 
of the key considerations that the FASB is deliberating include 
the threshold for disclosure requirements, the nature of the 
disclosures, and the time frame of the evaluation period.
---------------------------------------------------------------------------
     \7\ For a more detailed discussion, refer to the FASB Project 
Update on Disclosures about Risks and Uncertainties and the Liquidation 
Basis of Accounting (Formerly Going Concern) at http://www.fasb.org.
---------------------------------------------------------------------------
    Given the existing requirements in the Exchange Act and 
PCAOB standards as well as the importance of the FASB's 
project, the SEC is working closely with both the FASB and the 
PCAOB to improve the provision of useful and reliable 
information to investors and other financial statement users in 
a timely manner and to ensure that the roles and 
responsibilities of preparers and auditors are properly 
aligned.
    We anticipate that substantial progress will be made on 
this project before the end of 2011.

Q.2. Without providing specifics of the Commission's nonpublic 
investigations, how many cases has the Commission investigated 
concerning (1) the conduct of issuers and executives and (2) 
the conduct of auditors relating to financial reporting related 
to the financial crisis. When does the staff estimate that its 
investigative process will conclude with respect to all of the 
related financial crisis cases?

A.2. In the last 2 years, the SEC has assigned very high 
priority to cases arising from the financial crisis. During 
that time, the SEC has filed enforcement actions involving 
issues generally associated with the financial crisis against 
20 corporate defendants, including related corporate entities, 
and 40 individual defendants, including 26 CEOs, CFOs, and 
other senior officers. Many of these cases have been resolved 
in whole or in part, resulting in more than $1.3 billion in 
penalties, disgorgement, and other monetary relief.
    Specifically, the SEC has filed financial crisis-related 
matters involving conduct at:

    Bank of America;

    American Home Mortgage;

    Reserve Management Company, Inc.;

    Brookstreet Securities Corp.;

    Countrywide Financial;

    Evergreen Investment Management Co.;

    New Century Financial;

    State Street Bank and Trust Company;

    Morgan Keegan;

    Goldman Sachs & Co.;

    Taylor, Bean & Whitaker;

    Colonial Bank;

    ICP Asset Management;

    Citigroup;

    Charles Schwab & Co.;

    TD Ameritrade, Inc.;

    IndyMac Bancorp; and

    Wachovia Capital Markets LC (n/k/a Wells Fargo 
        Securities LLC).

    Although none of the filed cases described above resulted 
in charges against an auditor, several of those maters--
including New Century Financial, Citigroup, and IndyMac 
Bancorp--alleged reporting violations related to exposure to 
losses from subprime mortgages and subprime mortgage-backed 
assets or false and misleading statements concerning capital 
and liquidity positions. Others--including Brookstreet 
Securities, State Street Bank and Trust Company, and Charles 
Schwab & Co.--alleged misrepresentations to investors 
describing certain subprime-related structured products or 
subprime-concentrated investment funds as safe and secure when 
in fact they were risky, illiquid, and highly leveraged. As 
part of their investigation of these filed matters, attorneys 
and accountants in the Division of Enforcement carefully 
scrutinized the role of auditors and coordinated, where 
appropriate, with the PCAOB to facilitate information sharing 
and analysis.
    In addition to its filed cases, the Division of Enforcement 
has a number of active ongoing investigations related to the 
financial crisis, including investigations concerning mortgage 
foreclosure practices, practices related to the securitization 
and sale of residential mortgage backed securities (RMBS), the 
structuring and marketing of certain collateralized debt 
obligation (CDO) transactions, and the accuracy of issuer 
disclosures related to exposure to subprime mortgages or other 
subprime mortgage-backed assets. Auditor conduct certainly is 
within the scope of many of these ongoing investigations.
    While it is difficult to estimate when the investigative 
process will conclude, the Division of Enforcement has 
designated financial crisis-related cases as national priority 
matters and will continue aggressively pursuing evidence of 
securities laws violations connected to the financial crisis.

Q.3. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

A.3. An effective and engaged audit committee is a key 
component of our financial reporting system and much has been 
done over the past decade to strengthen the role and 
effectiveness of audit committees. To some extent, an audit 
committee relies on discussions and other communications with 
the auditor to become informed not only about the audit but 
also the financial reporting process of the company. Therefore, 
the more robust, timely, and effective the auditor's 
communications with the audit committee are, the better 
prepared the audit committee can be to perform its governance 
responsibilities.
    Recently, the PCAOB has been working on a new auditing 
standard to update and replace its current standard on auditor 
communications with audit committees. The PCAOB has performed a 
significant amount of work pertaining to this project; in 
particular, it:

    proposed a new auditing standard for public comment 
        in March 2010;

    held a discussion with the Board's Standing 
        Advisory Group (SAG) in July 2010. Topics included 
        existing communication requirements, best practices, 
        potential additional requirements and responses 
        received from the public on the March 2010 proposed 
        standard; and

    held a roundtable in September 2010 with various 
        audit committee members to explore further the proposed 
        standard from the viewpoint of audit committee members.

    The PCAOB is currently analyzing the information received 
from its outreach as part of its efforts to finalize the new 
standard. The SEC staff has worked closely with the PCAOB 
throughout its efforts and will continue to do so. I support 
and commend the PCAOB for the extent of its outreach and also 
believe that it is exploring areas where the provision of 
additional information might be useful.
    Although the proposed standard builds upon existing 
requirements, the nature and extent of required communications 
in the proposed standard would, in my view, enhance the 
existing standard. The primary objectives of the new standard 
are: (1) to enhance the relevance and effectiveness of 
communication between the auditor and the audit committee; and 
(2) to emphasize the importance of effective two-way 
communication between the auditor and audit committee to 
achieve better the objectives of the audit.
    Although this project is ongoing, I believe the items 
below, if included in the final standard, have the potential to 
improve audit quality and the audit committee's understanding 
of both the audit process and company-specific financial 
reporting exposures:

    improved communication about the auditor's 
        assessment of significant risks;

    improved communication about the importance of 
        accounting policies, practices and estimates as well as 
        the underlying judgments and assumptions used by 
        management;

    communication about situations where the auditor is 
        aware of complaints or concerns raised regarding 
        accounting or auditing matters; and

    an evaluation of the audit committee's 
        communications with the auditor.

    The additional requirements are designed to facilitate 
effective two-way dialogue, which would ultimately improve 
audit quality.
    Further, the proposed standard discusses the timing of 
auditor communications. The proposed standard would require 
that all communications occur in a timely manner, which would 
be determined by factors such as the significance of the matter 
to be communicated and corrective or follow-up action needed, 
but never later than the issuance of the auditor's report.
    The Board's intent is to finalize the standard during 2011 
at which time the standard would be subject to approval by the 
Commission.

Q.4. Mr. Doty recommended that Congress consider changes to 
permit the PCAOB to disclose its decision to institute 
disciplinary hearings, which is currently prohibited by Section 
105(c)(2) of the Sarbanes-Oxley Act of 2002. Please give us 
your detailed thoughts regarding the strengths and weaknesses 
of this proposal.

A.4. I take seriously the PCAOB's suggestion that its 
disciplinary system is not functioning as it should, and I 
support the further exploration of the PCAOB's proposal.
    Since August 2010, the PCAOB has been advocating for a 
change to SOX that would make its disciplinary proceedings 
public. \8\ The drafters of SOX made a policy choice to keep 
the PCAOB's disciplinary proceedings private. \9\ But the PCAOB 
has several times articulated arguments why that policy choice 
should be revisited: (1) investors, audit committees, and other 
interested parties are kept in the dark about an auditor's 
alleged misconduct--no matter how serious; (2) nonpublic 
proceedings provide an incentive for respondents to litigate 
rather than settle Board cases, thus consuming considerable 
PCAOB resources; (3) because of the lack of transparency, the 
public cannot evaluate the Board's enforcement program; and (4) 
the nonpublic nature of contested proceedings limits the 
Board's ability to use its enforcement authority as a tool to 
improve audit quality and deter violations.
---------------------------------------------------------------------------
     \8\ In August 2010, then-Acting Chairman Goelzer sent a letter to 
the Senate Committee on Banking, Housing, and Urban Affairs, urging 
that SOX be amended to make the PCAOB's disciplinary proceedings 
public. A letter was also sent to the PCAOB's oversight committee in 
the U.S. House of Representatives.
     \9\ Compare Section 203(c)(2) of S. 2004, the Investor Confidence 
in Public Accounting Act of 2002, with Section 105(c)(2) of S. 2673, 
the Public Company Accounting Reform and Investor Protection Act of 
2002. S. 2673, which went on to become SOX, borrowed extensively from 
S. 2004. See, ``Accounting Reform and Investor Protection'', S. Hrg. 
107-948, at 1213 (statement of Senator Sarbanes). However, while S. 
2004 provided that ``[a]ll hearings under this section shall be public, 
unless otherwise ordered by the Board on its own motion or after 
considering the motion of a party,'' S. 2673 incorporated the opposite 
rule: ``Hearings under this section shall not be public, unless 
otherwise ordered by the Board for good cause shown, with the consent 
of the parties to such hearing'' (emphasis added). Cf. id. at 1219 
(statement of Senator Dorgan, hoping for an amendment to make 
disciplinary proceedings public).
---------------------------------------------------------------------------
    The SEC debated similar policy issues in the 1980s, when it 
adopted a change to its Rules of Practice to make public its 
formal proceedings against professionals. \10\ Several of the 
factors in support of the change are similar to those 
articulated by the PCAOB in support of its proposal. The SEC at 
the time also considered the potential negative ramifications 
of the decision, including those that were raised by commenters 
at the time.
---------------------------------------------------------------------------
     \10\ See, Disciplinary Proceedings Involving Professionals 
Appearing or Practicing Before the Commission, Rel. No. 34-25893 (July 
7, 1988) [53 FR 26427 (July 13, 1988)].
---------------------------------------------------------------------------
    Further, it may be useful to consider the provisions 
governing the disciplinary processes of SROs (e.g., FINRA) to 
determine if their rules would provide a helpful analogy for 
the PCAOB, as the regulation of SROs were, in many ways, a 
model for the structure of the PCAOB \11\ and disciplinary 
proceedings of SROs and the PCAOB are both overseen by the SEC. 
\12\
---------------------------------------------------------------------------
     \11\ See, e.g., SOX 107(b)(4) and (c)(2).
     \12\ Existing FINRA rules govern the timing and extent of public 
disclosures of disciplinary proceedings. See, e.g., FINRA Rules 8312 
and 8313.
---------------------------------------------------------------------------
    I support the PCAOB's continued consideration of ways in 
which it can improve the effectiveness of its disciplinary 
system, as well as continued dialogue on the specific question 
of whether SOX should be amended to make the PCAOB's 
disciplinary procedures public. In the meantime, I encourage 
the PCAOB to explore actions and efficiencies using its 
existing authority to improve the disciplinary process.

Q.5. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four potential areas of 
improvement in auditor communications:

  a.  assessments of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement, and other significant 
        changes; and

  d.  assessments of the quality of the issuer's accounting 
        policies and practices.

    Please give us your detailed thoughts concerning whether 
there should be increased communications in each of the areas 
noted. Has the SEC issued any guidance to increase the 
communication with respect to each of the above areas? If not, 
why not? What additional areas of communication should be 
improved?

A.5. The requirement to have an independent audit of financial 
statements has long been an integral part of our financial 
reporting system. The independent auditor's opinion that a 
company's financial statements are fairly presented in 
conformity with accounting principles generally accepted in the 
United States gives investors confidence that the company's 
financial statements--prepared by the company's management--are 
reliable.
    However, the auditor's report has remained largely 
unchanged for several decades, except for changes to reflect 
the auditor's responsibility to report on internal control over 
financial reporting for companies that are subject to Section 
404(b) of SOX. Some investors believe that the auditor's report 
could be enhanced to provide investors with additional 
information that may help them better understand either the 
financial statements or the audit of the financial statements. 
The PCAOB has therefore undertaken a standard-setting project 
to explore possible improvements to the auditor's reporting 
model. I am supportive of the PCAOB's efforts in this area, and 
I believe that changes to the auditor's reporting model may 
serve as an appropriate avenue to provide investors with at 
least some of that additional information.
    The scope of the PCAOB's project includes consideration of 
each of the four potential areas of improvement noted by the 
Investor Advisory Group. I believe that these are the 
appropriate areas to be discussed as part of this project. For 
possible changes to the auditor's reporting model to be most 
effective, it will be key for the PCAOB and the SEC to obtain a 
fuller understanding of the nature of information investors 
would find most meaningful, the intended use of such 
information and whether that information is appropriately 
suited for its intended use, who the appropriate party is to 
provide such information (e.g., auditors, audit committees, 
and/or management), and in what form the information should be 
provided.
    Given the stage of the project, it is premature to reach a 
conclusion about which particular areas should ultimately 
require increased communications within the auditor's report. 
However, I believe that the PCAOB is exploring the appropriate 
areas for potential improvement and has been commendable in its 
extensive efforts to seek input from the appropriate 
constituencies. The PCAOB has announced that its next step is 
the issuance of a concept release that will offer an 
opportunity for the PCAOB to receive feedback from a wide range 
of constituents. The SEC staff will continue to work actively 
with the PCAOB as it pursues this project further.

Q.6. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Should audit firms publish 
annual audited financial statements?
    What do you believe are the strengths and weaknesses of 
such a proposal? What additional information should be 
disclosed? What work has the SEC done concerning the issue of 
increasing the transparency into large accounting firms? What 
additional work is being done? What additional work should be 
done?

A.6. Transparency is an important component of a well-
functioning financial reporting system. The EU's Article 40 
Transparency Report requires annual transparency reporting that 
includes many required items, \13\ from a description of legal 
structure and ownership, to a description of the internal 
quality control system of the audit firm, to financial 
information comparing revenues from audit services compared to 
revenues earned from other assurance services, tax services, 
and other nonaudit services. I generally support this type of 
transparency and support many of the principles that underlie 
the specific reporting requirements set forth by Article 40.
---------------------------------------------------------------------------
     \13\ For more detail about the items required by Article 40 of 
Directive 2006/43/EC of the European Parliament and of the Council on 
statutory audits of annual accounts and consolidated accounts (May 17, 
2006) (commonly known as the ``8th Company Law Directive'' or the 
``Statutory Audit Directive''), the text of the Directive is available 
at http://eur-lex.europa.eu/LexUriServ/
LexUriServ.do?uri=OJ:L:2006:157:0087:0087:EN:PDF.
---------------------------------------------------------------------------
    In fact, certain aspects of the U.S. audit oversight regime 
already incorporate many of those same principles. For example, 
the PCAOB requires that registered firms report certain matters 
to it on at least an annual basis, and in the case of 
``reportable events'' the PCAOB requires reporting within 30 
days. \14\ The reports that are filed by the firms with the 
PCAOB are made publicly available on the PCAOB's Web site. The 
reporting includes information about the firm's ownership, 
associated persons, disciplinary proceedings, issuers for which 
the firm issued audit reports, and information about the firm's 
quality controls, among other things. I believe that much of 
the reporting that is currently made public by the PCAOB has a 
linkage to consideration of audit quality. The linkage to audit 
quality is important to consider when weighing the strengths 
and weaknesses of proposals to increase further transparency 
into accounting firms. I believe that information that assists 
decision makers in drawing inferences regarding audit quality 
should be the primary focus of any effort to enhance 
transparency.
---------------------------------------------------------------------------
     \14\ For more detail about reporting requirements and what 
constitutes a ``reportable event,'' see, http://pcaobus.org/
Registration/rasr/Pages/RASR_Search.aspx.
---------------------------------------------------------------------------
    To address your specific question about requiring audit 
firms to publish annual audited financial statements, it is my 
understanding that the PCAOB has been provided access to a 
broad range of financial information, including the information 
required by Article 40, on a nonpublic basis in connection with 
its inspection process. This disclosure is consistent with the 
recommendation of the Advisory Committee on the Auditing 
Profession (ACAP). \15\ ACAP studied the issue of whether to 
require firms to publish annual audited financial statements, 
and they received testimony on potential positive and negative 
effects of such a proposal. Although there were differing views 
on this topic which precluded ACAP from reaching consensus on 
this matter, ACAP ultimately recommended against requiring 
audit firms to publish annual audited financial statements and 
instead recommended that the PCAOB have access to such 
information.
---------------------------------------------------------------------------
     \15\ See, ACAP, Final Report, Recommendation 7 at VII.20, 
available at http://www.treasury.gov/about/organizational-structure/
offices/Documents/final-report.pdf.
---------------------------------------------------------------------------
    The SEC staff will continue to work with the PCAOB to 
explore how to achieve greater transparency of information that 
informs the public about audit quality.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM JAMES L. KROEKER

Q.1. Last year the SEC settled with the State of New Jersey 
regarding pension fraud charges and according to newspapers is 
investigating public statements by Illinois officials about the 
State's underfunded pension fund. What additional steps should 
the SEC and the Governmental Accounting Standards Board (GASB) 
be taking to reveal more about the status of public pension 
funds which some estimate have unfunded liabilities ranging 
from $700 billion to $3 trillion?
    Should States have to follow similar forecasted rates of 
return as is required by private sector pension plans under 
ERISA?

A.1. While conceptually I see no compelling reason for a 
difference between the forecasted rates of return of State and 
private pension plans, the Commission does not have authority 
to oversee the GASB and plays no role in the GASB's standard-
setting processes. Therefore, I do not have detailed comments 
about particular GASB standards or the GASB's rulemaking 
agenda.
    Moreover, the Commission's statutory authority to regulate 
issuers and many other participants in the municipal securities 
market is closely circumscribed. Municipal securities 
themselves are exempt securities under both the Securities Act 
and the Exchange Act and, therefore, are not subject to the 
Securities Act registration requirements or the Exchange Act 
periodic disclosure obligations applicable to public companies. 
Furthermore, the Commission's statutory authority is limited 
with regard to securities offerings and other actions of many 
municipal market participants, including issuers, issuer 
officials, conduit borrowers, independent municipal financial 
advisors, and bond lawyers. While the Exchange Act gives the 
Commission regulatory authority over brokers and dealers who 
underwrite issuances or otherwise engage in municipal 
securities transactions, the Commission's authority over 
issuers of municipal securities is specifically limited by 
Section 15B(d) of the Exchange Act (commonly called the Tower 
Amendment).
    Thus, in many circumstances, the Commission's only 
authority over persons engaged in the issuance or distribution 
of municipal securities is its authority to bring enforcement 
actions against any person or entity, including issuers of 
municipal securities, who violate the antifraud provisions of 
the Federal securities laws. If a particular accounting 
treatment for pension liabilities were determined to be 
fraudulent, the use of that treatment by an issuer would be 
subject to the Commission's antifraud jurisdiction.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                     FROM ANTON R. VALUKAS

Q.1. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

A.1. Thank you for your e-mail requesting that Tony Valukas 
answer certain questions for the record. We have reviewed the 
questions, and we believe that they ask for opinions on issues 
and topics beyond the scope of Tony's assignment as Lehman 
Examiner. Tony has not actually formulated a opinion on some of 
these questions, and any opinions he does have or might come to 
are as a private citizen. Expressing those opinions might give 
the incorrect impression that they were informed by his work on 
the Lehman matter. We therefore respectfully believe that it is 
not appropriate for him to respond.
    Please convey to the Chairman and Ranking Member, as well 
as all of the Committee Members, Tony's appreciation for the 
Committee's consideration of his testimony.

    Sincerely,

Robert L. Byman
Jenner & Block LLP
Chicago, IL 60654-3456

Q.2. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four potential areas of 
improvement in auditor communications:

  a.  assessments of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement, and other significant 
        changes; and

  d.  assessments of the quality of the issuer's accounting 
        policies and practices.

    Please give us your detailed thoughts concerning whether 
there should be increased communications in each of the areas 
noted.

A.2. Response not provided.

Q.3. Mr. Doty recommended that Congress consider changes to 
permit the PCOAB to disclose its decision to institute 
disciplinary hearings, which is currently prohibited by Section 
105(c)(2) of the Sarbanes-Oxley Act of 2002. Please give us 
your detailed thoughts regarding the strengths and weaknesses 
of this proposal.

A.3. Response not provided.

Q.4. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Should audit firms publish 
annual audited financial statements? What do you believe are 
the strengths and weaknesses of such a proposal? What 
additional information should be disclosed?

A.4. Response not provided.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                    FROM CYNTHIA M. FORNELLI

Q.1. Mr. Doty recommended that Congress consider changes to 
permit the PCAOB to disclose its decision to institute 
disciplinary hearings, which is currently prohibited by Section 
105(c)(2) of the Sarbanes-Oxley Act of 2002. Please give us 
your detailed thoughts regarding the strengths and weaknesses 
of this proposal.

A.1. The Center for Audit Quality is committed to the public 
interest role that auditors play in our markets and supports 
effective independent oversight of public company audits. To be 
effective, it is, without question, important for regulators to 
be able to protect the public from a threat to the public 
interest. And we most certainly support independent audit 
regulators such as the PCAOB in their ability to intervene when 
they identify a threat to the public interest posed by the 
continuation of practice by an individual auditor or audit firm 
in situations in which potential harm to the public has been 
demonstrated. In addition, any abuse of process by regulated 
individuals and entities who engage in bad-faith, 
noncooperative conduct should not be tolerated or facilitated. 
We also agree with the PCAOB that there should be mechanisms 
for ensuring that substandard auditing is dealt with promptly 
and effectively. But we believe there are other and more 
expeditious means than amending the law to achieve the PCAOB's 
goals, particularly in instances when there is a threat to the 
public interest, including under the existing authority of the 
PCAOB and SEC.

Q.2. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

A.2. The audit committee serves an important role in protecting 
investors by assisting the board of directors in fulfilling its 
responsibility to shareholders and others to oversee the 
integrity of a company's financial statements and in overseeing 
the independent audit. The PCAOB currently is considering a 
proposed auditing standard to enhance existing auditing 
standards relative to communications with audit committees. The 
Center for Audit Quality supports efforts to continue to 
strengthen the communications between auditors and audit 
committees given the important role audit committees play in 
protecting the interests of investors. Specifically, we believe 
effective two-way communications between auditors and audit 
committees is critical to the effective conduct of the audit 
committee's oversight responsibilities, and that improvements 
can continue to be made in this important area.
    With respect to additional information that should be 
communicated by auditors to the audit committee, we believe the 
PCAOB's proposed requirements will generally result in 
information being provided to audit committees that is of more 
use. We support the efforts of the PCAOB to gather additional 
perspectives on its proposal from audit committee members, 
board members, and others on information that is meaningful to 
an audit committee's responsibilities. In addition, we believe 
it is important for the auditor to consider management's 
communications to the audit committee, and we believe that any 
new guidance should emphasize that the auditor's role should be 
focused on providing an objective evaluation of management's 
judgments involved in the preparation of the company's 
financial statements.
    Timing of communications between the auditor and the audit 
committee is also an important factor to consider in any new 
guidance. The CAQ supports the PCAOB's proposal to require 
timely communication by the auditor to the audit committee of 
the matters required by the proposed standard prior to the 
filing of an entity's year-end or interim financial statements 
with the SEC. The CAQ and the profession are supportive of 
robust communications between auditors and the audit committee.

Q.3. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four potential areas of 
improvement in auditor communications:

  a.  assessments of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement, and other significant 
        changes; and

  d.  assessments of the quality of the issuer's accounting 
        policies and practices.

    Please give us your detailed thoughts concerning whether 
there should be increased communications in each of the areas 
noted. Has the Center for Audit Quality issued any industry 
guidance to the auditing profession to increase communication? 
If not, why not?

A.3. A number of regulators and policy makers here and abroad 
are looking at the subject of auditor communication. With 
respect to work underway in the United States, the PCAOB has 
completed extensive outreach to stakeholder groups (including 
investors) on whether the PCAOB should modify the auditor's 
reporting model. The CAQ supports providing investors with more 
information about the audit. Toward that, the CAQ met several 
times with PCAOB staff and suggested a number of areas where 
the auditor's report could be clarified or expanded to provide 
more information to investors about the audit process and key 
areas of audit focus. These include:

    Auditor association with critical accounting 
        estimates disclosed in Management's Discussion and 
        Analysis (or alternatively a separate supplemental 
        auditor communication on critical accounting 
        estimates).

    Additional information communicating audit scope 
        and procedures, such as providing a ``link'' within the 
        auditor's report to a separate document that describes 
        the audit process including a discussion of the 
        responsibilities of auditors, management and audit 
        committees.

    Additional wording in the standard audit report to 
        include:

      Reference to ``related disclosures in the notes 
        to financial statements'' in both the scope and opinion 
        paragraphs; and

      New language related to the auditor's 
        responsibility for information outside the financial 
        statements.

    The PCAOB will publish a concept release based on all of 
the feedback it received, and the CAQ plans to comment on the 
proposals and continue to provide the PCAOB input and support 
as it goes about this important initiative.
    As a membership and public policy organization, the CAQ 
does not issue guidance. However, after the PCAOB and other 
regulators issue a new standard or regulation, the CAQ 
typically offers educational tools (via member alerts, white 
papers, and/or webcasts) for our approximately 650 member 
firms, and I envision that we would do the same with respect to 
any new PCAOB standard on the auditor's reporting model.
    In addition, the CAQ is sponsoring a series of discussions 
with all stakeholders, including investors, to consider what 
additional work auditors might perform with respect to public 
companies separate from performing and reporting on the audit. 
A key issue is how the delivery of information can be improved 
without ``piling on'' more disclosures that overwhelm users. 
Some of the issues we plan to discuss are:

    What information, beyond current information 
        provided by management and auditors, would be useful to 
        assist users in assessing the quality of a company's 
        financial accounting and who should provide it to 
        users? For example, would it be useful to provide 
        information relative to choice of accounting policies 
        or the most important elements of the financial 
        statements (i.e., the company's key financial estimates 
        and accounting judgments)?

    Should there be some form of auditor association 
        with certain other information disclosed in the annual 
        report or annual proxy statement (e.g., MD&A, 
        management's risk discussion)?

    Should there be some form of auditor association 
        with matters outside of the annual report (e.g., 
        earnings press releases)?

    Our hope is that these discussions will expose stakeholders 
to these potentially paradigm-changing issues, encourage hard 
thinking around the cost-benefits of various proposals, whether 
they require modification to current standards and regulatory 
frameworks, and, hopefully, find consensus.

Q.4. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Should audit firms publish 
annual audited financial statements? What do you believe are 
the strengths and weaknesses of such a proposal? What 
additional information should be disclosed? What work has the 
Center for Audit Quality done concerning the issue of 
increasing the transparency into large accounting firms? What 
additional work is being done? What additional work should be 
done?

A.4. The CAQ supports increasing transparency of information 
that is relevant to particular audiences. The information needs 
of regulators, audit committees, and the public are all 
different and, the needs of particular audiences should dictate 
the type of information made available. In my mind, there are 
two basic categories of audit firm information, serving two 
basic needs. First, there is information that is relevant to 
the quality of audits performed by public company audit firms 
(of relevance to regulators, investors, and audit committees). 
The PCAOB currently requires audit firms to supply it with 
information of such a nature and in such a format as the PCAOB 
requests and that fits its needs. Second, there is additional 
information that may inform regulators charged with executing 
independent oversight in furtherance and protection of the 
public interest. To that end, the CAQ is supportive of a 
workable set of key indicators similar to those found in 
Article 40 of the European Union's Eighth Company Law 
Directive. We also believe it is appropriate for public company 
audit firms--particularly the largest firms subject to annual 
PCAOB inspections--to make information publicly available 
regarding firm quality controls, structure, governance, 
approach to audits, and the risk assessment regime.
    With respect to the specific question of firms publishing 
audited financial statements, I do not believe that there is a 
compelling public policy reason for doing so, nor do I believe 
such information would inform readers about a firm's ability to 
provide quality audits. Audit firms are not public companies 
and do not access the public capital markets. There also could 
be adverse unintended consequences to smaller public company 
auditing firms that could exacerbate public company audit 
market concentration. Smaller audit firms with a public company 
auditing practice which also compete fiercely in the private 
company auditing space could be at a disadvantage with their 
competitors which do not perform public company audits and 
rather than comply, may opt out of the public company auditing 
arena altogether. This is especially likely because, unlike 
with large audit firms, public company auditing often 
represents a small portion of a smaller firm's revenue stream. 
The Treasury Department's Advisory Committee on the Auditing 
Profession heard testimony from representatives of smaller 
firms to this effect during its hearings.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                      FROM THOMAS QUAADMAN

Q.1. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Should audit firms publish 
annual audited financial statements? What do you believe are 
the strengths and weaknesses of such a proposal? What 
additional information should be disclosed?

A.1. Response not provided.

Q.2. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four potential areas of 
improvement in auditor communications:

  a.  assessments of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement, and other significant 
        changes; and

  d.  assessments of the quality of the issuer's accounting 
        policies and practices.

    Please give us your detailed thoughts concerning whether 
there should be increased communications in each of the areas 
noted.

A.2. Response not provided.

Q.3. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

A.3. Response not provided.

Q.4. Mr. Doty recommended that Congress consider changes to 
permit the PCOAB to disclose its decision to institute 
disciplinary hearings, which is currently prohibited by Section 
105(c)(2) of the Sarbanes-Oxley Act of 2002. Please give us 
your detailed thoughts regarding the strengths and weaknesses 
of this proposal.

A.4. Response not provided.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                      FROM LYNN E. TURNER

Q.1. What additional information do you believe should be 
communicated by auditors to the audit committee? When should 
the communication occur (e.g., during the performance of an 
audit or review, during the performance of an audit, after an 
audit has concluded, or at another time)?

A.1. Response not provided.

Q.2. Mr. Doty recommended that Congress consider changes to 
permit the PCOAB to disclose its decision to institute 
disciplinary hearings, which is currently prohibited by Section 
105(c)(2) of the Sarbanes-Oxley Act of 2002. Please give us 
your detailed thoughts regarding the strengths and weaknesses 
of this proposal.

A.2. Response not provided.

Q.3. Auditing firms and investors have publicly expressed the 
need for increased transparency into large firms and their 
complex networks. Foreign regulators have adopted transparency 
standards that exceed those in the U.S., such as the EU's 
Article 40 Transparency Report. Should audit firms publish 
annual audited financial statements? What do you believe are 
the strengths and weaknesses of such a proposal? What 
additional information should be disclosed?

A.3. Response not provided.

Q.4. The Investor Advocacy Group of the PCAOB recently 
discussed a survey and noted four potential areas of 
improvement in auditor communications:

  a.  assessments of management's estimates and judgments;

  b.  areas of high financial statement and audit risk;

  c.  unusual transactions, restatement, and other significant 
        changes; and

  d.  assessments of the quality of the issuer's accounting 
        policies and practices.

    Please give us your detailed thoughts concerning whether 
there should be increased communications in each of the areas 
noted.

A.4. Response not provided.
