Chairman Sarbanes. Senator Gramm. Members of the Committee.
Thank you for inviting me to share my thoughts on the issues raised by recent high-profile business failures, in particular the issues of financial reporting by public companies, the efficacy of accounting standards, and oversight of the accounting profession.
Let me begin with a few brief comments about my background and experience. I was Chief Accountant of the Securities and Exchange Commission from June 1995 to January 1998. Prior to holding that office, I was a senior partner in the firm of Deloitte & Touche, responsible for developing and implementing firm policy on technical and professional matters relating to accounting, auditing, and practice before the SEC. My career with Deloitte & Touche spanned from 1963 to 1995. As a retired partner, I receive a fixed retirement benefit from that firm. Presently, I undertake from time to time independent consulting and other assignments in the field of accounting and auditing regulation and related professional issues. The comments I offer today are my personal views.
As we gather today, the institutions responsible for financial reporting in our capital markets are reeling from the fall-out of a financial reporting scandal of colossal proportions. Reports on the collapse of Enron to date have exposed massive manipulations of financial reporting by management, inexplicable breakdowns in the independent audit process, astonishing revelations of holes in our financial reporting standards and practices, and stunning lapses of corporate governance. Indeed, the Enron debacle has become a poster child for a system that seems to be out of control.
We have witnessed high profile failures of our financial reporting system in the past and have encountered similar questions about the performance of the key players in our financial reporting system. Clearly, however, Enron is a cataclysmic event that has changed the worlds view of a system that we have often touted as "the best in the world." This time, the damage to the reputation of our financial reporting system and its critical guardians is so severe that the investing public can be expected, rightly so, to demand answers and meaningful reforms.
So, we are now once again at a crossroad. As we re-examine the partnership between the public and private sectors that has been the basis for oversight of our capital markets, we must confront candidly and honestly some challenging questions. Can we any longer believe in and rely on the independent audit? Can we any longer believe that our accounting and disclosure standards provide the transparency that is essential to investors and the public? Can we rely on self-regulatory systems to ensure audit quality and to root out and discipline substandard performance? Can we rely on corporate governance processes oversight by boards of directors and audit committees to ride herd on management and to see to it that auditors do their job? Enron has changed, perhaps for decades to come, how we look at and think about those questions.
The road ahead seems awesomely challenging. Where do we begin to reform a system that suddenly seems very fragile, and perhaps seriously flawed? What are the essential changes that we need to make? Today, I would like to offer some perspectives and insights drawn from my nearly 40 years in accounting practice and public service. I also will share some thoughts on needed reforms.
I begin with some essential views that I think all who have important roles in and benefit from a vibrant capital market system can agree on business, government, auditors, standards setters, investment bankers, analysts, and the investing public. We all share a common, linked starting point:
As we look at the issues today, it should be abundantly clear that there is no higher goal for
financial reporting than providing useful and reliable information that promotes informed investment decisions and confidence in the system. Sometimes, however, we hear arguments that financial reporting should take into account other policy goals in the name promoting various economic benefits or market efficiency. That view of the world is based on a curious, upside down logic. The truth is, without investor confidence, arguments about how financial reporting does or does not contribute to economic goals or market efficiency simply are moot they are a waste of time. If investors dont have confidence or lose confidence in the integrity of the information they receive, they will flee the markets, and we all will pay a devastating price.
In the past, the auditing profession has responded to challenges to its performance with arguments that, on the whole, audits are effective and that public expectations of the independent audit are unrealistic. As the dialogue continues, attention turns to the standards that govern financial reporting and auditor performance. After extended debate, changes are proposed, and some are adopted. Opinion about whether the changes will improve auditor performance or enhance investor confidence, however, is mixed, and the ensuing periods of peace and adjustment are uneasy. Investors and the public, who understand little about how audits and auditors work, are left to wonder what the future holds.
Today, in the light of all that has happened, we must find more substantive and lasting remedies. Now is the time to design and implement essential reforms, both through regulatory processes and by re-examining and, if necessary, redefining relationships and reporting responsibilities.
I believe that the road to a more lasting resolution begins with full acknowledgement by the auditing profession of the reality that seems so clear today. Failures in our financial reporting system are more than aberrations. They seriously undermine the confidence of investors and the public in the institutions that are supposed to protect them. They "poison the well." Pleas that the vast majority of financial reports are of high quality, that most audits are effective, and that financial reporting failures are few miss the point. In capital markets, a single catastrophic reporting failure is a disaster in which losses to investors and the public can be, and often are, overwhelming, wiping out decades of hard work, planning, and saving. Debates about how many failures are tolerable are not only not productive, they are nonsense.
The urgent challenge is to find ways to restore and maintain confidence in the independent audit. To achieve that goal, I believe that the auditing profession will need to do three things:
Regulatory processes that will build confidence in the auditing profession will be truly independent; they will be open; they will actively engage, inform, and involve the public; they will be adequately resourced and empowered to accomplish their mission; and they will be amenable to change as events dictate. I believe that the critical ingredients of an effective regulatory process that can restore and maintain public trust include:
Specifically, I believe that those goals can best be accomplished through an independent statutory regulatory organization operating under the oversight of the Securities and Exchange Commission. That organization should be empowered to require registration of independent auditors of public companies, establish quality control, independence, and auditing standards applicable to registered independent auditors, conduct continuing inspections of the accounting and auditing practices of registered firms, undertake investigations of possible financial reporting failures, and conduct proceedings to determine whether disciplinary or remedial actions, including fines, are warranted. To carry out these responsibilities the statutory regulatory organization will need appropriate subpoena and disciplinary powers. As a starting point to implementation, we might consider reconstituting the existing Public Oversight Board as a statutory regulatory organization and expanding its mandate and powers to include the elements I have outlined.
Strengthening the independent audit, though vital, is only part of the needed reform of our financial reporting system. We also need to examine critically and take action to strengthen the processes by which our accounting standards are developed. As we have seen in the Enron case, poor accounting standards and guidelines can exact their own toll. They can be extremely costly to investors and the public. We simply can't tolerate financial reporting standards that enable those who come to the markets seeking investor capital to "hide the ball."
Further, we cant tolerate processes that fail to produce accounting standards that are responsive to critical financial reporting issues as they arise in the market place and that fail to do so on a timely basis. Current rules for accounting for SPEs, for example, are nonsensical they can only be explained by accountants to accountants or more disturbingly, perhaps, by accountants to deal makers. Yet, the Financial Accounting Standards Board has studied consolidation issues for years, and has done little more than tinker around the edges. We have a right to insist that accounting rules be clearly responsive to the underlying economics of transactions and events. And, it is not acceptable to sit by while financial market innovations outstrip the development of needed guidance.
There seems to be a great deal of finger pointing today about what is wrong with US accounting standards. Some have placed the blame for Enron-like financial reporting failures on an accounting model that is out of date. The popular rhetoric asserts that the essential problem is that we are trying to apply an industrial age accounting model to an information age economy. The solutions offered include such things as more timely reporting, reporting that seeks to avoid impenetrable complexity by requiring more understandable disclosures, and a greater recognition in the financial statements of intangible assets. While there are very real problems with our accounting model, and while the ideas that have been offered may be well intended, they would do little to remedy the challenges presented by an Enron.
Additional criticism is beginning to focus on the fact that US standards have become increasingly detailed, and suggestions have been made that they should be broader statements of principle, applied with good judgment and respect for the substance of underlying transactions and events. I have sympathy for the desire to break the cycle of the mind-numbingly complex accounting rules that have become the norm, but to do that I think we have to confront realistically the reasons why our standards have evolved the way they have, and what will be required to avoid the same pitfalls in the future.
What the capital markets need and demand is accounting and disclosure that provides a clear picture of the underlying economics and furnishes information that is comparable among companies and consistently presented over time. The issue and debate should not be about whether accounting standards should be detailed or broad, but rather about what formulation of standards and standards-setting approaches best accomplish the goals to which financial reporting should aspire.
To fully appreciate the challenges of improving financial reporting, it is useful to look for a moment at the forces at work in shaping our accounting standards, and to reflect on the obstacles they present. Here are some of the underlying pressures:
Effectively meeting the expectations of investors and the public in that environment requires a standards-setting process that has the independence to withstand the myriad of constituent pressures that it inevitably will face and to make the tough decisions that inevitably are required.
Now is the time for a critical re-examination of our standards-setting processes, and the willingness and commitment of capital market participants to support a fully effective, independent standards setter. If the public-private sector partnership for improving financial reporting is to continue, we need to reenergize our commitment to the needs of investors. Of critical importance is the urgent need for those who have the greatest stake in transparent financial reporting buy side analysts, those who invest for retirees and manage their funds, and other institutional investors to take a more active role in the standards-setting and rule-making processes.
To restore confidence in our standards setters, we should take immediate steps to secure independent funding for the FASB funding that does not depend on contributions from constituents that have a stake in the outcome of the process. We also should take immediate steps to establish an independent governance process to replace the current constituent-based foundation board. The leadership for implementing these changes should come from leaders of unquestioned objectivity and demonstrated commitment to the goals of high quality financial reporting and the public interest. Perhaps the needed reforms could be best developed and implemented under the auspices of an independent commission made up of leading lights within the corporate governance movement, heads of investment funds and retirement systems responsible for managing and investing the nations savings and pension assets, academic leaders who are grounded in business and economics, and former leaders of institutions responsible for capital market regulation.
Perhaps one of the most practical and effective first steps in reforming the financial reporting system would be to immediately revisit and rewrite our corporate governance policies and guidelines to clearly break the bonds between management and the independent auditor, and to unmistakably spell out the responsibilities of boards of directors and audit committees to shareholders and the investing public. Management should be the subject of, not the manager of, the independent audit relationship and process. The ultimate responsibility for full and fair disclosure to shareholders, and the direct responsibility for the independent audit relationship and the quality of the audit process, should be clearly fixed with the board of directors and its audit committee. The audit committee should be made up entirely of independent directors.
Ensuring a relationship with the independent auditor that best protects audit quality may require further measures such as periodic rotation of auditing firms, limitations on hiring personnel from the independent auditing firm, and further restrictions on non-auditing services that an independent auditor may provide to audit clients. As we confront those issues, it is important to keep in mind that investor confidence is influenced by both the fact and the appearance of the independence of the auditor. At the end of the day, governance of the financial reporting process should provide comfort to the investing public that the financial statements they receive have been subjected to an effective and truly independent audit.
So yes, we are once again at a crossroad. As we re-examine the partnership between the public and private sectors that has been the basis for oversight of our capital markets in the past, we must confront candidly and honestly some challenging questions. Are we willing to fulfill, with commitment and enthusiasm, our clear responsibilities to serve investors and the public? Are we willing to exercise discipline to assure that we faithfully fulfill that commitment? Are we willing to be spirited participants in regulatory and governance processes that are essential to provide comfort to investors that our capital markets can be trusted? Only clear affirmative answers to these questions will assure that the partnership can continue and flourish.
At the outset, I suggested that the common interest in preserving and maintaining healthy capital markets far outweighs the concerns or goals of any particular group or special interest. We have to keep focusing on that fundamental tenet and on the goal of assuring that confidence in our capital markets is preserved and that confidence in our financial reporting and disclosure system is restored. Only a continuing commitment to that goal will guarantee that we continue to enjoy the best capital markets in the world.
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