[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
Available at: http: //www.fdsys.gov /
_____
U.S. GOVERNMENT PRINTING OFFICE
67-978 PDF WASHINGTON : 2011
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
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.
---------------------------------------------------------------------------
\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
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\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'.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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'.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.