Protecting the Public Interest: Selected Governance, Regulatory
Oversight, Auditing, Accounting, and Financial Reporting Issues
(05-MAR-02, GAO-02-483T).
The rapid failure and bankruptcy of Enron has prompted severe
criticism of the nation's financial reporting and auditing
systems, which are fundamental to maintaining investor confidence
in U.S. capital markets. This report focuses on four areas in
which the Enron failure revealed serious problems: corporate
governance, the independent audit of financial statements,
oversight of the accounting profession, and accounting and
financial reporting issues. Effectively addressing these issues
should be a shared responsibility between top management, boards
of directors, various board committees, stock exchanges, the
accounting profession, standard setters, regulatory/oversight
agencies, analysts, investors, and Congress.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-02-483T
ACCNO: A02856
TITLE: Protecting the Public Interest: Selected Governance,
Regulatory Oversight, Auditing, Accounting, and Financial
Reporting Issues
DATE: 03/05/2002
SUBJECT: Accounting procedures
Accounting standards
Auditing procedures
Auditing standards
Corporations
Financial statement audits
Regulatory agencies
Reporting requirements
California Public Employees Retirement
System
******************************************************************
** This file contains an ASCII representation of the text of a **
** GAO Product. **
** **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced. Tables are included, but **
** may not resemble those in the printed version. **
** **
** Please see the PDF (Portable Document Format) file, when **
** available, for a complete electronic file of the printed **
** document's contents. **
** **
******************************************************************
GAO-02-483T
United States General Accounting Office
Before the Committee on Banking, Housing, and UrbanGAO Affairs, U.S. Senate
For Release on Delivery Expected at 10 a.m. EST Tuesday, March 5, 2002
PROTECTING THE
PUBLIC INTEREST
Selected Governance, Regulatory Oversight, Auditing, Accounting, and
Financial Reporting Issues
Statement of David M. Walker Comptroller General of the United States
a
GAO-02-483T
Mr. Chairman and Members of the Committee:
I appreciate the opportunity to discuss with the committee my perspectives
on some of the issues that are now receiving extensive national interest
following the rapid and unexpected decline of Enron Corporation (Enron) and
the resulting huge losses suffered by Enron's shareholders and employees.
The rapid failure and bankruptcy of Enron has led to severe criticism of
virtually all areas of the nation's financial reporting and auditing
systems, which are fundamental to maintaining investor confidence in our
capital markets. At last count, 12 congressional committees, the Department
of Justice, the Securities and Exchange Commission (SEC), and the Department
of Labor's Pension and Welfare Administration all have ongoing
investigations of Enron. The individuals responsible for the Enron debacle
should be held accountable for any misdeeds. At GAO, accountability is one
of our core values and must be a critical component of any system in order
for it to function effectively.
The facts regarding Enron's failure are still being gathered to determine
the underlying problems and whether any civil and/or criminal laws have been
violated. Therefore, I will not comment on the specifics of the Enron
situation and who is at fault. At the same time, the Enron situation raises
a number of systemic issues for congressional consideration to better
protect the public interest. It is fair to say that other business failures
or restatements of financial statements have also sent signals that all is
not well with the current system of financial reporting and auditing. As the
largest corporation failure in U.S. history, Enron, however, provides a loud
alarm that the current system may be broken and in need of an overhaul.
I will focus on four overarching areas-corporate governance, the independent
audit of financial statements, oversight of the accounting profession, and
accounting and financial reporting issues-where the Enron failure has
already demonstrated that serious, deeply rooted problems may exist. It
should be recognized that these areas are the keystones to protecting the
public's interest and are interrelated. Failure in any of these areas places
a strain on the entire system. The overall focus of these areas should be
guided by the fundamental principles of having the right incentives for the
key parties to do the right thing, adequate transparency to provide
reasonable assurance that the right thing will be done, and full
accountability if the right thing is not done. These three overarching
principles represent a system of controls that should operate with a policy
of placing special attention on those areas of greatest risk. In addition,
an established code of ethics should set the "tone at the top" for
expected ethical behavior in performance of all key responsibilities. The
1980s savings and loan crisis, for which this committee was instrumental in
shaping the reforms to protect deposit insurance and the public interest, is
a prime example of the serious consequences that can result when one or more
components of an interrelated system breaks down.
My comments today are intended to frame the broad accountability issues and
provide our views on some of the questions and options that must be
addressed to better safeguard the public interest going forward. There will
no doubt be many views on what needs to be fixed and how to do it. We look
forward to working with the Congress to provide assistance in defining the
issues, exploring various options, and identifying their pros and cons in
order to repair any weaknesses that threaten confidence in our capital
markets and that inhibit improvements in the current system and appropriate
actions by the key players. In considering changes to the current system
that gave rise to Enron and other earlier financial reporting failures, it
will be important that the Congress consider a holistic approach to
addressing the range of interrelated issues. From all that has been heard
from the inquiries to date, it is clear that there is no single silver
bullet to fix the problems. It is also clear that many parties are focusing
on various elements of the issues but do not seem to be taking a
comprehensive approach to addressing the many interrelated issues. This is
what we are trying to do for the Congress.
On February 25, 2002, GAO held a forum on various governance, transparency,
and accountability issues that was attended by experts in each of these
areas. A summary of the results of the forum is being released today and is
available at our web site.1 Also, we have completed the study of the SEC's
resources that you requested and the report is being released today.2 I will
discuss the results of that work today as well.
Before discussing these matters, I would like to quickly provide an overview
of the current corporate governance system, the independent audit function,
regulatory oversight, and the accounting and financial reporting framework.
An attachment to my testimony graphically illustrates the interrelation and
complexity of these systems.
1Highlights of GAO's Forum on Corporate Governance, Transparency, and
Accountability (GAO-02-494SP, March 5, 2002).
2SEC Operations: Increased Workload Creates Challenges, (GAO-02-302, March
5, 2002).
Overview of the Current Governance, Auditing, Oversight Systems, and
Financial Reporting
Public and investor confidence in the fairness of financial reporting is
critical to the effective functioning of our capital markets. The SEC,
established in the 1930s following the stock market crash of 1929 and the
Great Depression, protects investors by administering and enforcing federal
securities laws, and its involvement with requirements for financial
disclosures and audits of financial statements for publicly traded
companies. In this respect, the public accounting profession, through its
independent audit function, has received a franchise to audit and attest to
the fair presentation of financial statements of publicly traded companies.
However, such a franchise brings with it not only the important role of
attesting to the reliability of financial statements and related data, but
also the concomitant responsibility of protecting the public interest and
ensuring public confidence through appropriate independence, professional
competence, and high ethical standards for auditors.
The SEC, the primary federal agency involved in accounting and auditing
requirements for publicly traded companies, has traditionally relied on the
private sector for setting standards for financial reporting and independent
audits, retaining a largely oversight role. Accordingly, the SEC has
accepted rules set by the Financial Accounting Standards Board (FASB)3-
generally accepted accounting principles (GAAP)-as the primary standard for
preparation of financial statements in the private sector. The SEC has
accepted rules set by the American Institute of Certified Public
Accountants' (AICPA) Auditing Standards Board-generally accepted auditing
standards(GAAS)-as the standard for conducting independent audits of
financial statements for private sector entities. The SEC monitors the
performance of the standard-setting bodies and also monitors the accounting
profession's system of peer review, which checks compliance with applicable
professional standards.
The SEC also oversees the activities of a variety of key market
participants. It does this using the principle of self-regulation. According
to this principle, the industry regulates itself through various
self-regulatory organizations (SROs) overseen by the SEC. SROs are groups of
industry professionals with quasi-governmental powers to adopt and enforce
standards of conduct for their members. They include the nine securities
3FASB, as part of the Financial Accounting Foundation (FAF), is a
not-for-profit organization supported by contributions from accounting
firms, corporations, and other entities that are interested in accounting
issues. FASB consists of seven full-time members who are selected and
approved by the FAF.
exchanges, such as the New York Stock Exchange (NYSE), which regulate their
marketplaces and the National Association of Securities Dealers (NASD) which
regulates the over-the-counter market. In addition to regulating member
broker dealers, the SROs establish listing standards for those firms that
list on their market.
The AICPA administers a self-regulatory system for the accounting profession
that includes setting auditing and independence standards, monitoring
compliance, and disciplining members for violations of ethic rules and
standards. The Public Oversight Board, administratively created by the AICPA
in consultation with the SEC in 1977, monitors public accounting firms'
compliance with professional standards and oversees the Auditing Standards
Board. State boards of accountancy license public accounting firms and
individuals to practice public accounting within each state's jurisdiction.
The audit is a critical element of the financial reporting structure because
it subjects information in the financial statements to independent and
objective scrutiny, increasing the reliability and assurance that can be
placed on those financial statements for efficient allocation of resources
in a capital market where investors are dependent on timely and reliable
information. Management of a public company is responsible for the
preparation and content of the financial statements, which are intended to
disclose information that accurately depicts the financial condition and
results of company activities. In addition, public companies registered with
the SEC must maintain an adequate system of internal accounting control. The
independent auditor is responsible for auditing the financial statements in
accordance with generally accepted auditing standards to provide reasonable
assurance that the financial statements are fairly presented in accordance
with GAAP. The auditor's opinion on the financial statements is like an
expert's stamp of approval to the public and the capital markets.
U.S. stock exchanges require listed companies to meet certain corporate
governance standards, including that boards of directors have independent
audit committees to oversee the accounting and financial controls of a
company and the financial reporting process. Audit committees can help
protect shareholder interests by providing sound leadership and oversight of
the financial reporting process by working with management and both internal
and external auditors.
The interrelation and complexity of the systems of corporate governance,
auditing, oversight, and accounting and financial reporting, which
cumulatively are the foundation for maintaining investor confidence in our
capital markets, is graphically illustrated in the charts attached to this
statement. The many links within and between the systems further illustrate
the strain that can be placed on the overall system when weaknesses occur
within any part of the system.
I would now like to focus on each of the four overarching areas I mentioned
earlier, starting with corporate governance.
Corporate Governance I want to acknowledge immediately that serving on the
Board of Directors of a public corporation is an important, difficult, and
challenging responsibility. That responsibility is especially challenging in
the current environment with increased globalization and rapidly evolving
technologies having to be addressed while at the same time meeting quarterly
earnings projections in order to maintain or raise the market value of the
corporation's stock. These pressures, and related executive compensation
arrangements, unfortunately often translate to a focus on short-term
business results. This can create the perverse incentives, such as managing
earnings to inappropriately report favorable financial results, and/or
failing to provide adequate transparency in financial reporting that
disguises risks, uncertainties, and/or commitments of the reporting entity.
On balance though, the difficulty of serving on a public corporation's board
of directors is not a valid reason for not doing the job right, which means
being knowledgeable of the corporation's business, asking the right
questions, and doing the right thing to protect the shareholders and the
public interest. A board member needs to have a clear understanding of who
is the client being served. Namely, their client should be the shareholders
of the company, and all their actions should be geared accordingly. Audit
committees have a particularly important role to play in assuring fair
presentation and appropriate accountability in connection with financial
reporting, internal control, compliance, and related matters.
Enron's failure has raised many questions about how its Board of Directors
and audit committee were performing their duties and responsibilities. These
questions include the following:
* Did the board of directors fulfill its fiduciary responsibility to
shareholders and protect the public interest in overseeing Enron's
management?
* Did the board operate in a proactive manner and raise the appropriate
questions designed to identify key problems and mitigate related risks?
* Did the board have the appropriate industry, financial, or other
appropriate expertise?
* Did board members have personal or business relationships that may have
either in fact or in appearance affected their independence?
* Did the board, especially its audit committee, have an active interface
and appropriate working relationship with Enron's internal and external
auditors?
* Did the board and its audit committee have appropriate resources to do the
job including staff and independent advisors?
* Did the board and its audit committee report meaningfully on their
activities?
These are fundamental questions that as I previously mentioned are being
addressed by various investigations and, therefore, I will not comment on
those issues. However, these issues are instructive and, as a minimum, call
for a review of the applicable rules and regulations that govern boards of
directors. In that respect, the Administration recently formed a group of
top financial policymakers and regulators to consider corporate governance
and disclosure reforms. The SEC has asked the NYSE and Nasdaq to review
corporate governance and listing standards, of public companies, including
the important issues of officer and director qualifications and the formal
codes of conduct. The SEC Chairman recently announced that the NYSE has
established a Special Committee on Corporate Accountability and Listing
Standards to examine corporate governance issues, including the possibility
of requiring continuing education programs for officers and directors, and
the Nasdaq also is taking similar steps. The corporate chief executives who
make up the Business Roundtable have stated that they are reviewing their
voluntary standards for corporate governance. The AFL-CIO has petitioned the
SEC to amend its proxy disclosure requirements regarding conflicts of
interest reportable by Board members. The California Public Employees'
Retirement System (CalPERS) is also reviewing definitions and standards for
independent corporate directors.
These examples are not intended to be a complete listing of reviews underway
on corporate governance requirements. We applaud these initiatives.
Hopefully, they will provide the opportunity for a thorough
review of corporate governance requirements. These efforts will help to
identify and frame the issues and to serve as a basis for determining
whether the fundamental underpinnings for effective performance of boards of
directors and audit committees are in place along with controls to monitor
performance. Some basic factors to consider in reviewing the various
requirements that govern membership and responsibilities of boards of
directors of public companies include the following:
* Is there a clear understanding of whom the board is serving and its
fiduciary responsibility to shareholders and related impact on the capital
markets?
* What type of relationship should the board have with management (for
example, constructive engagement)?
* What, if any, selection process changes are necessary in order to assure
the proper identification of qualified and independent board members?
* Is the nominating process for board membership designed to ensure that the
board is getting the right mix of talent to do the job?
* Do board membership rules address who other than management would nominate
Board members?
* Are the independence rules for outside directors and audit committee
members sufficient to ensure the objectivity of the members?
* Do board membership rules address whether the corporation's CEO should be
allowed to be the board chairman?
* Do board membership rules address whether independent board members should
nominate the chairman of the board?
* Do board membership rules address whether members of corporation
management, including the CEO, should be allowed to be board members, and if
so, what percentage of total board membership?
* Do board membership rules address whether corporation service providers,
such as major customers or other related parties, should be allowed to be
board members?
* Do requirements ensure that the board will have access to the resources
and staff necessary to do the job, including its own staff and access to
independent legal counsel and other experts?
* Do requirements ensure that the responsibilities of board members,
including the members who serve on audit committees and other committees,
such as the nominating, finance, and compensation committees, are required
to be committed to a charter that governs their operation?
* Do requirements address the appropriate working relationship between the
audit committee and the internal and external auditors?
* Do requirements provide for the board of directors to establish a formal
code of conduct to set the tone for expected personal and business ethical
behavior within the corporation?
* Do requirements provide that waivers of the code of conduct are not
expected and should such circumstances arise, which should be extremely
rare, that any exceptions must be approved by the board of directors and
publicly reported?
* Do requirements provide for public reporting on the effectiveness of
internal control by management and independent assurances on the
effectiveness of internal control by the corporation's independent auditors?
* Do requirements provide for public reporting by the board of directors,
the audit committee, and other committees of the board on their membership,
responsibilities, and activities to fulfill those responsibilities?
* Do the stock exchanges and the SEC have sufficient authority to enforce
requirements governing boards of directors and audit committees and to take
meaningful enforcement actions, including imposing effective sanctions when
requirements are violated?
* Does the SEC have sufficient resources and authority to fulfill its
responsibilities under the federal securities laws and regulations to
operate proactively in monitoring SEC registrants for compliance and to take
timely and effective actions when noncompliance may exist?
* Is the SEC efficiently and effectively using technology to manage its
regulatory responsibilities under the federal securities laws by assessing
risks, screening financial reports and other required filings, and
accordingly prioritizing the use of its available resources?
Boards of directors and their audit committees are a critical link to fair
and reliable financial reporting. A weak board of directors will also likely
translate into an ineffective audit committee. That combination makes the
difficult job of auditing the financial statements of large corporations,
which usually have vast, complex and diversified operations, much more
challenging.
Regulation and The model for regulation and oversight of the accounting
profession
involves federal and state regulators and a complex system of self-Oversight
of the regulation by the accounting profession. The functions of the model
are Accounting Profession interrelated and their effectiveness is ultimately
dependent upon each
component working well. Basically, the model includes the functions of
* licensing members of the accounting profession to practice within the
jurisdiction of a state, as well as issuing rules and regulations governing
member conduct, which is done by the state boards of accountancy;
* setting accounting and auditing standards, which is done by the Financial
Accounting Standards Board and the Auditing Standards Board, respectively,
through acceptance of the standards by the SEC; * setting auditor
independence rules, which within their various areas of
responsibility, have been issued by the AIPCA, the SEC, and GAO; and *
oversight and discipline, which is done through systems of self-regulation
by the accounting profession and the public regulators (the SEC and state
boards of accountancy).
The Enron failure has brought a direct focus on how well the systems of
regulation and oversight of the accounting profession are working in
achieving their ultimate objective that the opinions of independent auditors
on the fair presentation of financial statements can be relied upon by
investors, creditors, and the various other users of financial reports.
The issues currently being raised about the effectiveness of the accounting
profession's self-regulatory system are not unique to the collapse of Enron.
Other business failures or restatements of financial statements over the
past several years have called into question the effectiveness of the
system. A continuing message is that the current self-regulatory system is
fragmented, is not well coordinated, and has a discipline function that is
not timely nor does it contain effective sanctions, all of which create a
public image of ineffectiveness. Reviews of the system should consider
whether overall the system creates the right incentives, transparency, and
accountability, and operates proactively to protect the public interest.
Also, the links within the self-regulatory system and with the SEC and the
state boards of accountancy (the public regulatory systems) should be
considered as these systems are interrelated and weaknesses in one component
can put strain on the other components of the overall system.
I would now like to address some of the more specific areas of the
accounting profession's self-regulatory system that should be considered in
forming and evaluating proposals to reshape or overhaul the current system.
Accounting Profession's The accounting profession's current self-regulatory
system is largely
Self-Regulatory System operated by the AICPA through a system, largely
composed of volunteers from the accounting profession. This system is used
to set auditing
standards and auditor independence rules, monitor member public accounting
firms for compliance with professional standards, and discipline members who
violate auditing standards or independence rules. AICPA staff support the
volunteers in conducting their responsibilities. The Public Oversight Board
oversees the peer review system established to monitor member public
accounting firms for compliance with professional standards. In 2001, the
oversight authority of the Public Oversight Board was expanded to include
oversight of the Auditing Standards Board. The Public Oversight Board has
five public members and professional staff, and receives its funding from
the AICPA.
On January 17, 2002, the SEC Chairman outlined a proposed new
self-regulatory structure to oversee the accounting profession. On January
20, 2002, the Public Oversight Board passed a resolution of intent to
terminate its existence no later than March 31, 2002. The Public Oversight
Board's Chairman was critical of the SEC's proposal and expressed concern
that the Board was not consulted about the proposal. The SEC's proposal
provided for creating an oversight body that would include monitoring and
discipline functions, have a majority of public members, and be funded
through private sources. No further details have been announced.
The authority for the oversight body is a basic but critical factor that can
influence its operating philosophy, its independence, and, ultimately, its
effectiveness. Related factors to consider include
* determining whether the body should be created by statute or
administratively, such as is the case for the current Public Oversight
Board;
* deciding the basic scope of the body's enabling authority, such as whether
oversight authority should be limited to coverage of the public accounting
firms that audit SEC registrants, which is the authority of the current
Public Oversight Board, or whether it should be expanded to other public
accounting firms that also provide audit services to a broader range of
entities; and
* determining mission objectives clearly to ensure that protecting the
public interest is paramount.
Membership of the oversight body and its funding may also influence the
body's operating philosophy (proactive as opposed to reactive),
independence, and resolve to actively assess and minimize risks within the
system that affect protecting the public interest. Factors to consider
include
* whether the membership should be limited to public members (exclude
practicing members of the accounting profession), such as is the case for
current Public Oversight Board, or whether membership should allow some
practicing members of the accounting profession to sit on the board;
* how the members will be selected, including the chair, their term limits,
and compensation; and
* how the amount and source of funding will be established since a problem
with either may present potential conflicts or limit the oversight body's
ability to effectively protect the public interest.
The responsibilities of the oversight body and its powers to perform those
responsibilities will largely define whether the oversight body is set up
with a sufficient span of responsibility to oversee the activities of the
accounting profession and to take appropriate actions when problems are
identified. Related factors to consider include
* whether the current system of peer review should be continued in its
present form and monitored by the oversight body, such as was done by the
Public Oversight Board, with oversight by the SEC;
* whether the oversight body should have more control over the peer review
function, such as selecting and hiring peer reviewers, managing the peer
review, and being the client for the peer review report;
* whether the oversight body's authority should extend to all
standard-setting bodies within the accounting profession so that accounting,
auditing, quality control and assurance, and independence standards are
subject to oversight (currently the Public Oversight Board does not oversee
the setting of accounting standards or auditor independence rules);
* whether the oversight body's authority related to standard setting should
be expanded to direct standard-setting bodies to address any problems with
standards and approve the adequacy of revised standards (currently the
Public Oversight Board does not have such direct authority);
* whether the oversight body's authority should extend to the discipline
function (currently the Public Oversight Board does not oversee the
discipline function);
* whether the oversight body should have investigative authority over
disciplinary matters (currently this function is housed within another
component of the AICPA) or authority to request investigations; and
* whether the body within the self-regulatory system responsible for
investigations of disciplinary matters should have power to protect
investigative files from discovery during litigation to facilitate
cooperation and timeliness in resolving cases.
Accountability requirements can provide for stewardship of resources, help
to set the operating philosophy of the oversight body, and provide a means
of monitoring the oversight body's performance. The current Public Oversight
Board issues an annual report and its financial statements are audited.
Related factors to consider include
* whether the oversight body should prepare strategic and annual performance
plans;
* whether the oversight body should have an annual public reporting
requirement and what information should be included in the report, such as
whether the report should be limited to the oversight body's activities or
whether the report should provide more comprehensive information about the
activities of the entire self-regulatory system, and whether the oversight
body should have audited financial statements; and
* whether and, if so, how the Congress should exercise periodic oversight of
the performance of the self-regulatory system and the performance of the
oversight body.
At this time, the outcome of the SEC's proposal to establish a body for
overseeing the accounting profession that would include monitoring and
discipline functions is uncertain. There is considerable overlap in the
functions of the current self-regulatory system and the functions of the SEC
related to the accounting profession. For example, the AICPA sets auditor
independence rules applicable to its membership, and the SEC sets auditor
independence rules for those auditors who audit SEC registrants. Also, the
AICPA disciplines its members for noncompliance with independence rules or
auditing standards. The SEC, through its enforcement actions, disciplines
auditors of SEC registrants who violate its laws and regulations, which
include noncompliance with independence rules and auditing standards. In
addition, the SEC also conducts various activities to oversee the peer
review function of the self-regulatory system.
As proposals are considered for reshaping or overhauling the self-regulatory
system, the overlap of functions with the SEC's responsibilities should be
considered to provide for oversight of the accounting profession that is
both efficient and effective. Related factors to consider include the
following:
* whether current independence rules are adequate to protect the public
interest;
* whether independence rules for auditors should be consistent and set by
the government or private sector, or whether the status quo is acceptable;
* whether the current system of peer review is acceptable or whether the SEC
should play a role that exercises more direct control or oversight of the
accounting profession's compliance with standards; and
* how the investigative/enforcement functions of the self-regulatory system
and the SEC can be jointly used to efficiently and effectively achieve their
common objectives to resolve allegations of audit failure.
Similarly, the discipline functions of the SEC and the self-regulatory
system overlap with the state boards of accountancy, which are the only
authorities that can issue or revoke a license to practice within their
jurisdictions. The communication and working relationship opportunities for
efficiency and effectiveness that exist between the SEC and the
self-regulatory system also exist for their relationship with the state
boards of accountancy in resolving allegations of audit failure.
The Independent Audit Function
For over 70 years, the public accounting profession, through its independent
audit function, has played a critical role in enhancing a financial
reporting process that facilitates the effective functioning of our domestic
capital markets as well as international markets. The public confidence in
the reliability of issuers' financial statements that is provided by the
performance of independent audits encourages investment in securities issued
by public companies. This sense of confidence depends on reasonable
investors perceiving auditors as independent expert professionals who have
neither mutual nor conflicts of interests in connection with the entities
they are auditing. Accordingly, investors and other users expect auditors to
bring to the financial reporting process integrity, independence,
objectivity, and technical competence, and to prevent the issuance of
misleading financial statements.
The Enron failure has raised questions concerning whether auditors are
living up to the expectations of the investing public; however, similar
questions have been repeatedly raised over the past three decades by
significant restatements of financial statements and unexpected costly
business failures. Issues debated over the years continue to focus on
auditor independence concerns and the auditor's role and responsibilities,
particularly in detecting and reporting fraud and assessing the
effectiveness of and reporting on internal control.
Auditor Independence Concerns
The independence of public accountants-both in fact and in appearance- is
crucial to the credibility of financial reporting and, in turn, the capital
formation process. Auditor independence standards require that the audit
organization and the auditor be independent in fact and in appearance. These
standards place responsibility on the auditor and the audit organization to
maintain independence so that opinions, conclusions, judgments, and
recommendations will be impartial and will be viewed as being impartial by
knowledgeable third parties.
Since the mid-1970s, many observers of the auditing profession have
expressed concern about the expanding scope of professional services
provided by the public accounting profession. Specifically, questions have
been raised by the media, the Congress, and others concerning the propriety
of performing both audit and certain nonaudit services for the same client.
While these services and their perceived impact on accounting firms'
independence have been the subject of many studies and while actions have
been taken to strengthen auditor independence, the Enron failure has brought
this issue once again to the forefront and has sparked new proposals to
prohibit or limit auditors from providing nonaudit services to audit
clients. A common concern is that when auditor fees for consulting services
are a substantial part of total auditor fees, this situation can create
pressures to keep the client happy and can threaten auditor independence.
Auditors have the capability of performing a range of valuable services for
their clients, and providing certain nonaudit services can ultimately be
beneficial to investors and other interested parties. However, in some
circumstances, it is not appropriate for auditors to perform both audit and
certain nonaudit services for the same client. In these circumstances, the
auditor, the client, or both will have to make a choice as to which of these
services the auditor will provide. These concepts, which I strongly believe
are in the public interest, are reflected in the revisions to auditor
independence requirements for government audits,4 which GAO recently
4Government Auditing Standards, Amendment No. 3, Independence
(GAO/A-GAGAS-3, January 2002).
issued as part of Government Auditing Standards. 5 The new independence
standard has gone through an extensive deliberative process over several
years, including extensive public comments and input from my Advisory
Council on Government Auditing Standards.6 The standard, among other things,
toughens the rules associated with providing nonaudit services and includes
a principle-based approach to addressing this issue, supplemented with
certain safeguards. The two overarching principles in the standard for
nonaudit services are that
* auditors should not perform management functions or make management
decisions, and
* auditors should not audit their own work or provide nonaudit services in
situations where the amounts or services involved are significant or
material to the subject matter of the audit.
Both of the above principles should be applied using a substance over form
determination. Under the revised standard, auditors are allowed to perform
certain nonaudit services provided the services do not violate the above
principles; however, in most circumstances certain additional safeguards
would have to be met. For example: (1) personnel who perform allowable
nonaudit services would be precluded from performing any related audit work,
(2) the auditor's work could not be reduced beyond the level that would be
appropriate if the nonaudit work were performed by another unrelated party;
and (3) certain documentation and quality assurance requirements must be
met. The new standard includes an express prohibition regarding auditors
providing certain bookkeeping or record keeping services and limits payroll
processing and certain other services, all of which are presently permitted
under current independence rules of the AICPA.
The focus of these changes to the government auditing standards is to better
serve the public interest and to maintain a high degree of integrity,
objectivity, and independence for audits of government entities and entities
5Government Auditing Standards were first published in 1972 and are commonly
referred to as the "Yellow Book," and cover federal entities and those
organizations receiving federal funds. Various laws require compliance with
the standards in connection with audits of federal entities and funds.
Furthermore, many states and local governments and other entities, both
domestically and internationally, have voluntarily adopted these standards.
6The Advisory Council includes 20 experts in financial and performance
auditing and reporting drawn from all levels of government, academia,
private enterprise, and public accounting, who advise the Comptroller
General on Government Auditing Standards.
that receive federal funding. However, these standards apply only to audits
of federal entities and those organizations receiving federal funds, and not
to audits of public companies. In the transmittal letter issuing the new
independence standard, we expressed our hope that the AICPA will raise its
independence standards to those contained in this new standard in order to
eliminate any inconsistency between this standard and their current
standards. The AICPA's recent statement before another congressional
committee that the AICPA will not oppose prohibitions on auditors providing
certain nonaudit services seems to be a step in the right direction.7 In
2000, the SEC considered a principle-based approach for auditor independence
rules applicable to auditors of SEC registrants, but decided in the end to
set specific rules by types of nonaudit services. We believe a
principle-based approach is more effective given the wide variety of
nonaudit services provided by auditors and the continuing evolution of the
market.
The new independence standard is the first of several steps GAO has planned
in connection with nonaudit services covered by government auditing
standards. In May 2002, we plan to issue a question and answer document
concerning our independence standard, and I will ask my Advisory Council on
Government Auditing Standards to review and monitor this area to determine
what, if any, additional steps may be appropriate. In addition, the
Principals of the Joint Financial Management Improvement Program, who are
the Comptroller General, the Secretary of the Treasury, and the Director,
Office of Management and Budget, have agreed that the 24 major federal
departments and agencies covered by the Chief Financial Officers Act should
have audit committees. The scope, structure, and timing of this new
requirement will be determined over the next several months. This will
include determining what role these audit committees might play in
connection with nonaudit services.
Another auditor independence issue, which also existed with Enron, concerns
the employment by the client of its former auditor. The revolving door
between auditors and the companies they audit has existed for years. This is
due in part to the mandatory retirement of partners from public accounting
firms, often before the partners are ready to leave the profession. Another
contributing factor that entices auditors to work for audit clients is the
lucrative compensation for executives in public
7Testimony of AICPA Chairman before the House Energy and Commerce Committee
(Subcommittee on Communications, Trade and Consumer Protection), February
14, 2002.
companies. Employment by the client of its former auditor can have a clear
implication on the quality of audits and has been cited as a factor in the
savings and loan scandal of the late 1980s. The AICPA asked the SEC in 1993
to prohibit public companies from hiring their audit partner for a year
after an audit. The SEC rejected the proposal as too difficult to enforce.
However, Enron has resurfaced the issue. One congressional proposal would
prohibit an accounting firm from providing audit services to a company whose
controller or chief financial officer had worked for that public accounting
firm. This issue again raises the auditor independence perception problem
and provides another opportunity to further enhance auditor independence. A
factor to consider in this debate includes mandating a "cooling off period"
in which a partner or senior auditor from a firm cannot go to work for a
former audit client for a period of time after separating from their firm.
A related issue is whether an audit firm should be allowed to serve as the
client's auditor of record without a limit on the period of time. Currently,
there are no time limits for rotation of audit firms, although the AICPA
requirements for member firms that audit SEC registrants require partner
rotation every 7 years. The concerns are that the auditor may become too
close to management over a period of years and, therefore, threaten the
auditor's objectivity. Also, the auditor's familiarity with the business
operations of the client may result in a less than thorough audit. Opposing
arguments against auditor rotation include that there is a significant
learning curve for a new auditor and, during that time, there is a greater
risk of the auditor overlooking transactions that may result in misleading
financial statements. Also, auditor rotations can increase audit costs for
the client.8 Building on the current AICPA requirement for rotating the
audit engagement partner every 7 years, rotating addition key members of the
audit team is another alternative to consider. Rotating addition key members
of the audit team should have less of an impact of the auditor's learning
curve and not increase audit costs, although this option would still leave
open the appearance of an independence issue for the firm.
8Federal, state, and local government auditors generally have their
responsibilities defined by law or regulation. Therefore, rotation of
government auditors raises different considerations than in the private
sector. However, the rationale behind rotation of auditors (enhancing
auditor independence) is addressed in Government Auditing Standards. The
standards add organizational criteria that consider factors in the
appointment, removal, and reporting responsibilities of the head of the
audit organization to ensure independence. The organizational criteria for
determining auditor independence are in addition to personal and external
requirements that are considered in judging the independence of government
auditors.
Study groups over the years have recognized that corporate boards and their
audit committees could and should play a more significant role in
strengthening the independence of audits. The situation with Enron and its
auditors is another event that highlights the necessity to reexamine
relationships of boards of directors, audit committees, and management with
the independent auditor in order to strengthen the objectivity and
professionalism of the independent auditor and to enhance the independent
audit. Factors to consider in making changes include the following:
* Who should be the client for the audit?
* Should the audit committee be actively responsible for hiring, determining
fees, and terminating the auditor?
* Should there be more required communication and interaction between the
auditor and the audit committee?
* Should the audit committee preapprove the provision of certain nonaudit
services by audit firms?
* Should the audit committee be required to review and approve the staffing
of audit firm personnel?
Auditor's Roles and Responsibilities for Fraud and Internal Control
Under current auditing standards, auditors are responsible for planning and
performing the audit to obtain reasonable, but not absolute, assurance about
whether the financial statements are free of material misstatement, whether
caused by error, illegal acts, or fraud. As stated over the years by many
who have studied the profession, no major aspect of the independent
auditor's role has caused more difficulty than the auditor's responsibility
for detecting fraud. In August 2000, the Panel on Audit Effectiveness
concluded that the auditing profession needs to address vigorously the issue
of fraudulent financial reporting, including fraud in the form of
illegitimate earnings management.9 The study expressed concern that auditors
may not be requiring enough evidence, that is, they have reduced the scope
of their audits and level of testing, to achieve reasonable assurance about
the reliability of financial information that the capital markets need for
their proper functioning. The study recommended that auditing standards be
strengthened to effect a substantial change in auditors' performance and
thereby improve the likelihood that auditors will
9The Panel on Audit Effectiveness Report and Recommendations (August 31,
2000). The Panel was formed by the Public Oversight Board at the request of
the SEC to study the effectiveness of the audit model and other issues
affecting the accounting profession.
detect fraudulent financial reporting. The AICPA is working on a new
auditing standard to improve auditor performance in this area, which it
expects to issue by the end of this year.
We have long believed that expanding auditors' responsibilities to report on
the effectiveness of internal control over financial reporting would assist
auditors in assessing risks for the opportunity of fraudulent financial
reporting or misappropriation of business assets. Currently, the auditor's
report on a public company's financial statements does not address internal
control or purport to give any assurance about it, and auditors are not
required to assess the overall effectiveness of internal control or search
for control deficiencies. The important issues of the auditor's
responsibility for detecting and reporting fraud and for reporting on
internal control overlap since effective internal control is the major line
of defense in preventing and detecting fraud. Taken together, these issues
raise the broader question of determining the proper scope of the auditor's
work in auditing financial statements of publicly owned companies. The
auditor would be more successful in preventing and detecting fraud if
auditors were required to accept more responsibility for reporting on the
effectiveness of internal control. The Congress recognized the link between
past failures of financial institutions and weak internal control when it
enacted the Federal Deposit Insurance Corporation Improvement Act of 1991
that grew out of the savings and loan crisis. The act requires an
independent public auditor to report on the effectiveness of internal
control for large financial institutions.
For all of the financial statements audits that we conduct, which include
the consolidated financial statements of the federal government, and the
financial statements of the Internal Revenue Service, the Bureau of Public
Debt, the Federal Deposit Insurance Corporation, and numerous smaller
entities' operations and funds, we issue separate opinions on the
effectiveness of internal control over financial reporting and compliance
with applicable laws and regulations. We require extensive testing of
controls and compliance in our audits. We have done this for years because
of the importance of internal control to protecting the public interest. Our
reports have engendered major improvements in internal control. As you might
expect, as part of the annual audit of our own financial statements, we
practice what we recommend to others and contract with a CPA firm for both
an opinion on our financial statements and an opinion on the effectiveness
of our internal control over financial reporting and compliance with
applicable laws and regulations. We believe strongly that the AICPA should
follow suit and work with the SEC to
require expanded auditor involvement with internal control of public
companies.
The AICPA Chairman recently expressed the accounting profession's support
for auditor reporting on the effectiveness of internal control.10 Auditors
can better serve their business clients and other financial statements users
and protect the public interest by having a greater role in providing
assurances of the effectiveness of internal control in deterring fraudulent
financial reporting, protecting assets, and providing an early warning of
internal control weaknesses that could lead to business failures. The SEC,
the AICPA, and corporate boards of directors are major stakeholders in
achieving realistic auditing standards for fraud and internal control.
However, as we stated in our 1996 report on the accounting profession,11 the
SEC is the key player in providing the leadership and in bringing these
parties together to enhance auditor reporting requirements on the
effectiveness of internal control. We believe it would be difficult for the
AICPA to unilaterally expand audit requirements without SEC support.
Accounting and Financial Reporting Model
Business financial reporting is critical in promoting an effective
allocation of capital among companies. Financial statements, which are at
the center of present-day business reporting, must be relevant and reliable
to be useful for decision-making. In our 1996 report on the accounting
profession,12 we reported that the current financial reporting model does
not fully meet users' needs.
We found that despite the continuing efforts of standard setters and the SEC
to enhance financial reporting, changes in the business environment, such as
the growth in information technology, new types of relationships between
companies, and the increasing use of complex business transactions and
financial instruments, constantly threaten the relevance of financial
statements and pose a formidable challenge for standard setters. A basic
limitation of the model is that financial statements present the business
entity's financial position and results of its operations largely
10See footnote 7.
11 The Accounting Profession Major Issues: Progress and Concerns
(GAO/AIMD-96-98, September 24, 1996).
12See footnote 11.
on the basis of historical costs, which do not fully meet the broad range of
user needs for financial information.13
In 1994, the AICPA's Special Committee on Financial Reporting, after
studying the concerns over the relevance and usefulness of financial
reporting and the information needs of professional investors and creditors,
concluded that the current model is useful as a reliable information basis
for analysts, but concluded that a more comprehensive model is needed that
includes both financial information and nonfinancial information. In
addition to financial statements and related disclosures, the model
recommended by the study would include
* high-level operating data and performance measures that management uses to
manage the business;
* management's analysis of changes in financial and nonfinancial data;
* forward-looking information about opportunities, risks, and management's
plans, including discussions about critical success factors, as well as
information about management and shareholders; and
* background about the company, including a description of the business, its
industry, and its objectives and strategies.
The Committee acknowledged that many business entities do report
nonfinancial information, but it stressed the need to develop a
comprehensive reporting package that would promote consistent reporting and
the need to have auditors involved in providing some level of assurance for
each of the model's elements. Opposing views generally cite liability
concerns as a risk to reporting forward-looking and other related
nonfinancial information, concerns over cost of preparing the information,
and concerns whether more specific disclosures would put business entities
at a competitive disadvantage. Although standard setters have addressed
certain issues to improve the financial reporting model, a project
13The accounting and reporting model under generally accepted accounting
principles is actually a mixed-attribute model. Although most transactions
and balances are measured on the basis of historical cost, which is the
amount of cash or its equivalent originally paid to acquire an asset,
certain assets and liabilities are reported at current values either in the
financial statements or related notes. For example, certain investments in
debt and equity securities are currently reported at fair value, receivables
are reported at net realizable value, and inventories are reported at the
lower of cost or market value. Further, certain industries such as brokerage
houses and mutual funds prepare financial statements on a fair value basis.
to develop a more comprehensive reporting model has not been undertaken.
Enron's failure and the inquiries that have followed have raised many of the
same issues about the adequacy of the financial reporting model, such the
need for transparency, clarity, and risk-oriented financial reporting,
addressed by the AICPA's Special Committee on Financial Reporting. The
limitations of the historical cost-based model were made more severe in the
case of the Enron failure by accounting rules and reports designed for a
pipeline operator that transitioned into a company using numerous offshore,
off balance sheet, quasi-affiliated, tax shelter entities to operate, invest
in, trade or make a market for contracts involving water, electricity,
natural gas, and broadband capacity. However, criticism of the financial
reporting model should also consider the criticisms of the corporate
governance system, the auditing profession, and the regulatory and
self-regulatory oversight models which may impact the quality of financial
reporting. Also, human failure to effectively perform responsibilities in
any one or all four of these areas has been raised by the many inquiries
following Enron's sudden failure. Also, Enron's November 8, 2001, reporting
to the SEC (Form 8-K filing), which restated its financial statements for
the years ended December 31, 1997 through 2002, and the quarters ended March
31 and June 30, 2001, acknowledges that the financial reports did not follow
generally accepted accounting principles and, therefore, should not be
relied upon.
Among other actions to address the Enron-specific accounting issues, the SEC
has requested that the FASB address the specific accounting rules related to
Enron's special purpose entities and related party disclosures. The SEC is
expecting the FASB to revise and finalize the special purpose accounting
rules by the end of this year. The FASB has stated its is committed to
proceed expeditiously to address any financial accounting and reporting
issues that may arise as a result of Enron's bankruptcy. In that respect,
the FASB at a recent board meeting set a goal of publishing an exposure
draft by the end of April 2002 and a final statement by the end of August
2002 that would revise the accounting rules for special purpose entities.
The SEC has also announced specific areas for improving disclosures,
including
* more current disclosure, including "real-time" disclosure of
unquestionable material information;
* disclosure of significant trend data and more "evaluative" data;
* financial statements that are clearer and more informative for investors;
* disclosure of the accounting principles that are most critical to the
company's financial status and that involve complex or subjective decisions
by management; and
* private-sector standards setting that is more responsive to the current
and immediate needs of investors.
In addition, the SEC has announced plans to propose new corporate disclosure
rules that will
* provide accelerated reporting by companies of transactions by company
insiders in company securities, including transactions with the company;
* accelerate filing by companies of their quarterly and annual reports;
* expand the list of significant events requiring current disclosure on
existing Form 8-K filings (such events could include changes in rating
agency decisions, obligations that are not currently disclosed, and lock-out
periods affecting certain employee plans with employer stock);
* add a requirement that public companies post their Exchange Act reports on
their Web sites at the same time they are filed with the SEC; and
* require disclosure of critical accounting policies in Management's
Discussion and Analysis of Financial Condition and Results of Operations
contained in annual reports.
The SEC Chief Accountant has also raised concerns that the current
standard-setting process is too cumbersome and slow and that much of the
FASB's guidance is rule-based and too complex. He believes that (1)
principle-based standards will yield a less complex financial reporting
paradigm that is more responsive to emerging issues, (2) the FASB needs to
be more responsive to accounting standards problems identified by the SEC,
and (3) the SEC needs to give the FASB freedom to address the problems, but
the SEC needs to monitor projects and, if they are languishing, determine
why.
We support the SEC's stated plans to specifically address the accounting
issues raised by the Enron failure and the broader-based planned initiatives
that begin to address some of the overarching issues with the current
financial reporting model. It will be important that these initiatives be
aimed at the end result of having a financial reporting model that is more
comprehensive while, at the same time, more understandable and timely in
providing current value financial information and nonfinancial information
that will provide users with data on the reporting entity's business risks,
uncertainties, and outlook, including significant assumptions underlying the
nonfinancial information. We also support a more direct partnering between
the SEC and the FASB to facilitate a mutual understanding of priorities for
standard-setting and realistic goals for achieving expectations.
On balance, standard setting is inherently difficult and subject to
pressures by those parties most affected by proposed changes. Today's
business environment that includes increased globalization, rapid
technological advances, real-time communication, and extremely sophisticated
financial engineering is a difficult challenge for accounting
standard-setters as our commercial world moves from an industrial base to an
information base. Further more, creative use of financial reports, such as
the recent phenomenon of using "pro forma" financial statements to present a
"rosier picture" than GAAP may otherwise allow, adds another challenge for
standard-setters and regulators. On December 4, 2001, the SEC issued FRR No.
59, Cautionary Advice Regarding the Use of "Pro Forma" Financial Information
in Earnings Releases. One of the key points in the cautionary advice release
was that the antifraud provisions of the federal securities laws apply to a
company issuing "pro forma" financial information.
With that said, we believe that the underlying principles of accounting and
financial reporting are still valid, namely, that financial reporting must
reflect the economic substance of transactions, be consistently applied, and
provide fair representation in accordance with generally accepted accounting
principles. In applying these underlying principles, it is important to
recognize the variety of users of financial information and their financial
acumen. One size will not likely fit all, and targeted audiences for
reported financial information may need to be identified, such as
sophisticated investors, analysts, and creditors versus the general public.
We also believe that the auditors need to be active players in developing a
more comprehensive model with the objective of adding value to the
information through independent assurances. Finally, effective corporate
governance, independent auditors, and regulatory oversight must accompany
accounting standards and financial reporting. For meaningful and reliable
financial reporting, it is not enough to say the rules were followed, which
is the minimum expectation. Those with responsibilities for financial
reporting and their auditor must ensure that the economic substance of
business transactions is, in fact, fairly reported.
I would now like to turn to the results of the work that you requested in
asking us to look at the resource issues at the SEC.
The SEC's Ability to Fulfill Its Mission
Over the last decade, securities markets have experienced unprecedented
growth and change. Moreover, technology has fundamentally changed the way
markets operate and how investors access markets. These changes have made
the markets more complex. In addition, the markets have become more
international, and legislative changes have resulted in a regulatory
framework that requires increased coordination among financial regulators
and requires that the SEC regulate a greater range of products. Moreover, as
I discussed earlier, the recent, sudden collapse of Enron and other
corporate failures have stimulated an intense debate on the need for
broad-based reform in such areas as financial reporting and accounting
standards, oversight of the accounting profession, and corporate governance,
all of which could have significant repercussions on the SEC's role and
oversight challenges. At the same time, the SEC has been faced with an
ever-increasing workload and ongoing human capital challenges, most notably
high staff turnover and numerous vacancies.
In our work requested by this Committee, for which our report is being
released at this hearing, we found that the SEC's ability to fulfill its
mission has become increasingly strained due in part to imbalances between
the SEC's workload (such as filings, complaints, inquiries, investigations,
examinations, and inspections) and staff resources.14 Although industry
officials complimented the SEC's regulation of the industry given its staff
size and budget, both the SEC and industry officials identified several
challenges that the SEC faces. First, resource constraints have contributed
to substantial delays in the turnaround time for many SEC regulatory and
oversight activities, such as approvals for rule filings and exemptive
applications.15 Second, resource constraints have contributed to bottlenecks
in the examination and inspection area as the SEC's workload has grown.
Third, limited resources have forced the SEC to be selective in its
enforcement activities and have lengthened the time required to
14 Staff resources are measured in this report in terms of full-time
equivalent staff years.
15A company files an exemptive application when it seeks an SEC decision to
exempt a new activity from existing rules and laws.
complete certain enforcement investigations.16 Fourth, certain filings were
subject to less frequent and less complete reviews as workloads increased.
Fifth, today's technology-driven markets have created ongoing budgetary and
staff challenges. Finally, the SEC and industry officials said that the SEC
has been increasingly challenged in addressing emerging issues, such as the
ongoing internationalization of securities markets and technology-driven
innovations like Alternative Trading Systems17 (ATSs), and exchange-traded
funds.
The SEC routinely prioritizes and allocates resources to meet workload
demands, but faces increasing pressure in managing its mounting workload and
staffing imbalances that resulted from its workload growing much faster than
its staff. Critical regulatory activities, such as reviewing rule filings
and exemptive applications and issuing guidance, have suffered from delays
due to limited staffing. According to industry officials, these delays have
resulted in forgone revenue and have hampered market innovation. Oversight
and supervisory functions have also been affected. For example, staffing
limitations and increased workload have resulted in the SEC reviewing a
smaller percentage of corporate filings, an important investor protection
function. In 2001, the SEC reviewed about 16 percent of the annual corporate
filings, or about half of its annual goal of 30 to 35 percent. Although the
SEC is revamping its review process to make it more risk-based, recent
financial disclosure and accounting scandals illustrate how important it is
that the SEC rise to the challenge of providing effective market oversight
to help maintain investor confidence in securities markets.
SEC Staff Turnover In addition to the staff and workload imbalances, other
factors also contribute to the challenges the SEC currently faces. SEC
officials said that although additional resources could help the SEC do
more, additional
16The SEC Chairman has recently announced an initiative called real-time
enforcement, which is intended to protect investors by (1) obtaining
emergency relief in federal court to stop illegal conduct expeditiously, (2)
filing enforcement actions more quickly, thereby compelling disclosure of
questionable conduct so that the public can make informed investment
decisions, and (3) deterring future misconduct through imposing swift and
stiff sanctions on those who commit egregious frauds, repeatedly abuse
investor trust, or attempt to impede the SEC's investigatory processes.
According to the SEC, insufficient resources may inhibit the effectiveness
of this initiative, which depends upon prompt action by enforcement staff.
17An ATS is an entity that performs functions commonly performed by a stock
exchange.
resources alone would not help the SEC address its high staff turnover,
which continues to be a problem. Furthermore, in recent years the staff
turnover and large differentials in pay between the SEC and other financial
regulators and industry employers resulted in many staff positions remaining
vacant as staff left at a faster rate than the SEC could hire new staff.
Although the SEC now has the authority to provide pay parity, its success
will depend upon the SEC designing an effective implementation approach and
the agency receiving sufficient budgetary resources. We also found that the
SEC's budget and strategic planning processes could be improved to better
enable the SEC to determine the resources needed to fulfill its mission. For
example, unlike recognized high performing organizations, the SEC has not
systematically utilized its strategic planning process to ensure that (1)
resources are best used to accomplish its basic statutorily mandated duties
and (2) workforce development addresses the resource needs that are
necessary to fulfill the full scope of its mission, including activities to
address emerging issues. 18
As we noted in our 2001 report on the SEC's human capital practices, about
one-third of the SEC's staff left the agency from 1998 to 2000.19 The SEC's
turnover rate for attorneys, accountants, and examiners averaged 15 percent
in 2000, more than twice the rate for comparable positions government-wide.
Although the rate had decreased to 9 percent in 2001, turnover at the SEC
was still almost twice as high as the rate governmentwide. Further, as a
result of this turnover and inability to hire qualified staff quickly
enough, about 250 positions remained unfilled in September 2001, which
represents about 8.5 percent of the SEC's authorized positions. SEC
officials said that they could do more if they had more staff, but all cited
the SEC's high turnover rate as a major challenge in managing its workload.
Likewise industry officials agreed that many of the challenges that the SEC
faces today are exacerbated by its high turnover rate, which results in more
inexperienced staff and slower, often less efficient, regulatory processes.
Although the SEC and industry officials said that the SEC would always have
a certain amount of turnover because staff can significantly increase
18High performing organizations are organizations that have been recognized
in the current literature or by GAO as being innovative or effective in
strategically managing their human capital.
19Securities and Exchange Commission: Human Capital Challenges Require
Management Oversight (GAO-01-947, September 17, 2001).
their salaries in the private sector and some staff only plan to stay at the
SEC for a period of time, many said pay parity with other financial
regulators could enable the SEC to attract and retain staff for a few
additional years. The SEC estimated that a new employee generally takes
about 2 years to become fully productive and that pay parity could help them
keep staff a year or two beyond the initial 2 years. Although industry
officials said they were generally impressed by the caliber of staff that
the SEC hires and the amount of work they do, they said that staff
inexperience often requires senior SEC officials to become more involved in
basic activities. Industry officials also said that certain divisions, such
as Market Regulation, could benefit from staff with a fundamental
understanding of how markets work and market experience. They said that such
experience could help speed rulemaking and review processes. However, SEC
officials said that they have a difficult time attracting staff with market
experience, given the government's pay structure.
Some officials said that the SEC's turnover rate should decrease after pay
parity is implemented. Presently, the SEC professional staff are paid
according to federal general pay rates. On January 16, 2002, the President
signed legislation that exempted the SEC from federal pay restrictions and
provided it with the authority necessary to bring salaries in line with
those of other federal financial regulators. That legislation also mandated
that we conduct a study to look at the feasibility of the SEC becoming a
fully self-funded agency. Although the SEC now has the authority to
implement pay parity, as of March 1, 2002, the SEC has not received an
additional appropriation to fund its implementation. In addition, the SEC
has to take a number of steps to effectively implement this new authority.
Although the SEC's workload and staffing imbalances have challenged the
SEC's ability to protect investors and maintain the integrity of securities
markets, the SEC has generally managed the gap between workload and staff by
determining what basic statutorily mandated duties it could accomplish with
existing resource levels. This approach, while practical, under the
circumstances, has forced the SEC's activities to be largely reactive rather
than proactive. For instance, the SEC has not put mechanisms in place to
identify what it must do to address emerging and evolving issues. Although
the SEC has a strategic plan and has periodically adjusted staffing or
program priorities to fulfill basic obligations, the SEC has not engaged in
a much needed, systematic reevaluation of its programs and activities in
light of current and emerging challenges. Given the regulatory pressures
facing the SEC and its ongoing human capital challenges, it is clear that
the SEC could benefit from an infusion of funding
and possibly additional resources. However, a comprehensive, agency wide
planning effort, including planning for use of technology to leverage
available resources, could help the SEC better determine the optimum human
capital and funding needed to fulfill its mission.
Closing Comments A number of witnesses who have recently appeared before
this Committee and other congressional committees to discuss Enron's failure
have stated that our nation's system of capital markets is recognized around
the world as the best. I share that view. Our capital markets enjoy a
reputation of integrity that promotes investor confidence that is critical
to our economy and the economies of other nations given the globalization of
commerce. This reputation is now being challenged. The effectiveness of our
systems of corporate governance, independent audits, regulatory oversight,
and accounting and financial reporting, which are the underpinnings of our
capital markets, to protect the public interest has been called into
question by the failure of Enron. Many of the issues that are being raised
have previously surfaced from other business failures and/or restatements of
financial statements that significantly reduced previously reported earnings
or equity. Although the human element factor, and the basic failure to
always do what is right, are factors that can override systems of controls,
it is clear that there are a range of actions that are critical to the
effective functioning of the system underlying our capital markets that need
attention. In addition, a strong enforcement function with appropriate civil
and criminal sanctions is also needed to deal with noncompliance.
The results of the forum that we held last week on governance, transparency,
and accountability identified major issues in each of the areas, which I
have addressed in my remarks today, that endanger their effective
functioning to protect the public interest. As is usually the case in issues
of this magnitude and importance, there is no single silver bullet to
quickly make the repairs needed to the systems supporting our capital
markets. The fundamental principles of having the right incentives, adequate
transparency, and full accountability provide a good sounding board to
evaluate proposals that are advanced. A holistic approach is also important
as the systems are interrelated and weak links can severely strain their
effective functioning. I have framed a number of the key issues today for
congressional consideration. As always, we look forward to working with you
to further refine the issues, and develop and analyze options and take other
steps designed to repair the system weaknesses that today pose a threat to
investor confidence in our capital markets.
In summary, Enron's recent decline and fall coupled with other recent
business failures pose a range of serious systemic issues that must be
addressed. Effectively addressing these issues should be a shared
responsibility involving a number of parties including top management,
boards of directors, various board committees, stock exchanges, the
accounting profession, standard setters, regulatory/oversight agencies,
analysts, investors, and the Congress. In the end, no matter what system
exists, bad actors will do bad things with bad results. We must strive to
take steps to minimize the number of such situations and to hold any
violators of the system fully accountable for their actions.
Mr. Chairman, this concludes my statement. I would be please to answer any
questions you or other members of the committee may have at this time.
Contacts and For further information regarding this testimony, please
contact Robert W. Gramling, Financial Management and Assurance, at (202)
512-6535.
Acknowledgments Individuals making key contributions to this testimony
include Cheryl E. Clark, Michael C. Hrapsky, Thomas J. McCool, Jeffrey C.
Steinhoff, and Orice M. Williams.
Attachment I: Overview of Regulatory and Private Sector Structure
GAO's Mission The General Accounting Office, the investigative arm of
Congress, exists to support Congress in meeting its constitutional
responsibilities and to help improve the performance and accountability of
the federal government for the American people. GAO examines the use of
public funds; evaluates federal programs and policies; and provides
analyses, recommendations, and other assistance to help Congress make
informed oversight, policy, and funding decisions. GAO's commitment to good
government is reflected in its core values of accountability, integrity, and
reliability.
Obtaining Copies of GAO Reports and Testimony
The fastest and easiest way to obtain copies of GAO documents is through the
Internet. GAO's Web site (www.gao.gov) contains abstracts and full-text
files of current reports and testimony and an expanding archive of older
products. The Web site features a search engine to help you locate documents
using key words and phrases. You can print these documents in their
entirety, including charts and other graphics.
Each day, GAO issues a list of newly released reports, testimony, and
correspondence. GAO posts this list, known as "Today's Reports," on its Web
site daily. The list contains links to the full-text document files. To have
GAO E-mail this list to you every afternoon, go to www.gao.gov and select
"Subscribe to daily e-mail alert for newly released products" under the GAO
Reports heading.
To Report Fraud, Contact:
Web site: www.gao.gov/fraudnet/fraudnet.htm,Waste, and Abuse in E-mail:
[email protected], orFederal Programs 1-800-424-5454 or (202) 512-7470
(automated answering system).
Public Affairs Jeff Nelligan, Managing Director, [email protected] (202)
512-4800 U.S. General Accounting Office, 441 G. Street NW, Room 7149,
Washington, D.C. 20548
Presorted Standard
Postage & Fees Paid
GAO
Permit No. GI00
United States
General Accounting Office
Washington, D.C. 20548-0001
Official Business
Penalty for Private Use $300
Address Correction Requested
*** End of document. ***