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United States General Accounting Office:
GAO:
Before the Committee on Banking, Housing, and Urban 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:
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.[Footnote 1] Also, we
have completed the study of the SEC’s resources that you requested and
the report is being released today.[Footnote 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.
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)[Footnote 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 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 Oversight of the Accounting Profession:
The model for regulation and oversight of the accounting profession
involves federal and state regulators and a complex system of self-
regulation by the accounting profession. The functions of the model are
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 Self-Regulatory System:
The accounting profession’s current self-regulatory system is largely
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,[Footnote 4] which GAO recently issued as part of
Government Auditing Standards. [Footnote 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.[Footnote 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 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.[Footnote 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 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.[Footnote 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.
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.[Footnote 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
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.[Footnote 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,[Footnote
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,[Footnote 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 on the basis of historical costs, which do
not fully meet the broad range of user needs for financial
information.[Footnote 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 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.[Footnote 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.[Footnote 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 complete certain enforcement investigations.
[Footnote 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 Systems[Footnote 17]
(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 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.[Footnote 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.
[Footnote 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 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 Acknowledgments:
For further information regarding this testimony, please contact Robert
W. Gramling, Financial Management and Assurance, at (202) 512-6535.
Individuals making key contributions to this testimony include Cheryl
E. Clark, Michael C. Hrapsky, Thomas J. McCool, Jeffrey C. Steinhoff,
and Orice M. Williams.
[End of section]
Attachment I: Overview of Regulatory and Private Sector Structure:
{Refer to PDF for image]
This attachment contains a rather complex diagram of regulatory and
private sector structure. Included in the diagram are lines of
responsibility between various agencies indicating their
interrelationships.
[End of figure]
[End of section]
Footnotes:
[1] Highlights of GAO’s Forum on Corporate Governance, Transparency,
and Accountability [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-
494SP], March 5, 2002.
[2] SEC Operations: Increased Workload Creates Challenges, (GAO-02-302,
March 5, 2002).
[3] FASB, 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.
[4] Government Auditing Standards, Amendment No. 3, Independence
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/A-GAGAS-3], January
2002.
[5] Government 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.
[6] The 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.
[7] Testimony of AICPA Chairman before the House Energy and Commerce
Committee (Subcommittee on Communications, Trade and Consumer
Protection), February 14, 2002.
[8] Federal, 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.
[9] The 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.
[10] See footnote 7.
[11] The Accounting Profession Major Issues: Progress and Concerns
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/AIMD-96-98],
September 24, 1996.
[12] See footnote 11.
[13] The 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.
[14] Staff resources are measured in this report in terms of full-time
equivalent staff years.
[15] A company files an exemptive application when it seeks an SEC
decision to exempt a new activity from existing rules and laws.
[16] The 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.
[17] An ATS is an entity that performs functions commonly performed by
a stock exchange.
[18] High 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.
[19] Securities and Exchange Commission: Human Capital Challenges
Require Management Oversight [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-01-947], September 17, 2001.
[End of section]
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