[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
ARE CURRENT FINANCIAL ACCOUNTING STANDARDS PROTECTING INVESTORS?
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HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
FEBRUARY 14, 2002
__________
Serial No. 107-84
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
U.S. GOVERNMENT PRINTING OFFICE
77-990 WASHINGTON : 2002
________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan
JOE BARTON, Texas HENRY A. WAXMAN, California
FRED UPTON, Michigan EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia SHERROD BROWN, Ohio
STEVE LARGENT, Oklahoma BART GORDON, Tennessee
RICHARD BURR, North Carolina PETER DEUTSCH, Florida
ED WHITFIELD, Kentucky BOBBY L. RUSH, Illinois
GREG GANSKE, Iowa ANNA G. ESHOO, California
CHARLIE NORWOOD, Georgia BART STUPAK, Michigan
BARBARA CUBIN, Wyoming ELIOT L. ENGEL, New York
JOHN SHIMKUS, Illinois TOM SAWYER, Ohio
HEATHER WILSON, New Mexico ALBERT R. WYNN, Maryland
JOHN B. SHADEGG, Arizona GENE GREEN, Texas
CHARLES ``CHIP'' PICKERING, KAREN McCARTHY, Missouri
Mississippi TED STRICKLAND, Ohio
VITO FOSSELLA, New York DIANA DeGETTE, Colorado
ROY BLUNT, Missouri THOMAS M. BARRETT, Wisconsin
TOM DAVIS, Virginia BILL LUTHER, Minnesota
ED BRYANT, Tennessee LOIS CAPPS, California
ROBERT L. EHRLICH, Jr., Maryland MICHAEL F. DOYLE, Pennsylvania
STEVE BUYER, Indiana CHRISTOPHER JOHN, Louisiana
GEORGE RADANOVICH, California JANE HARMAN, California
CHARLES F. BASS, New Hampshire
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska
David V. Marventano, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Commerce, Trade, and Consumer Protection
CLIFF STEARNS, Florida, Chairman
NATHAN DEAL, Georgia EDOLPHUS TOWNS, New York
Vice Chairman DIANA DeGETTE, Colorado
ED WHITFIELD, Kentucky LOIS CAPPS, California
BARBARA CUBIN, Wyoming MICHAEL F. DOYLE, Pennsylvania
JOHN SHIMKUS, Illinois CHRISTOPHER JOHN, Louisiana
JOHN B. SHADEGG, Arizona JANE HARMAN, California
ED BRYANT, Tennessee HENRY A. WAXMAN, California
STEVE BUYER, Indiana EDWARD J. MARKEY, Massachusetts
GEORGE RADANOVICH, California BART GORDON, Tennessee
CHARLES F. BASS, New Hampshire PETER DEUTSCH, Florida
JOSEPH R. PITTS, Pennsylvania BOBBY L. RUSH, Illinois
GREG WALDEN, Oregon ANNA G. ESHOO, California
LEE TERRY, Nebraska JOHN D. DINGELL, Michigan,
W.J. ``BILLY'' TAUZIN, Louisiana (Ex Officio)
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Castellano, James G., Chairman of the Board, American
Institute of Certified Public Accountants.................. 27
Herdman, Robert K., Chief Accountant, U.S. Securities and
Exchange Commission........................................ 11
Hinchman, Grace L., Senior Vice President for Public Affairs,
Financial Executives International......................... 60
Jenkins, Edmund L., Chairman, Financial Accounting Standards
Board...................................................... 16
Linsmeier, Thomas J., Associate Professor of Accounting and
Information Systems, Eli Broad College of Business,
Michigan State University.................................. 62
Material submitted for the record by:
Markey, Hon. Edward J., a Representative in Congress from the
State of Massachusetts, letter dated March 7, 2002, to
Robert K. Herdman.......................................... 71
(iii)
ARE CURRENT FINANCIAL ACCOUNTING STANDARDS PROTECTING INVESTORS?
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THURSDAY, FEBRUARY 14, 2002
House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Commerce, Trade,
and Consumer Protection,
Washington, DC.
The subcommittee met, pursuant to notice, at 9 a.m., in
room 2212, Rayburn House Office Building, Hon. Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns, Shimkus, Bryant,
Buyer, Terry, Bass, Towns, DeGette, Harman, Markey, Rush, and
Eshoo.
Staff present: Ramsen Betfarhad, majority counsel; David
Cavicke, majority counsel; Brian McCullough, majority
professional Staff; Brendan Williams, legislative clerk;
Consuela Washington, minority counsel; David Nelson, minority
investigator.
Mr. Stearns. Good morning, everybody. I think what we will
do, while members might be trickling in, I think I will start
with my opening statement and even start with some of the
witnesses and we can, as members come in, although it is not
the normal procedure, we can break after the witnesses, to have
some of the members' opening statements, but I would like to
continue on, since we were supposed to start at 9 o'clock.
Introspection abounds in many sectors of business following
the collapse of Enron. Boards of Directors are rethinking their
duties of loyalty and duties of care, auditing firms are
reviewing their client relationships with an eye toward
independence, and Wall Street is contemplating more diligent
company review rather than relying on market momentum.
Congress, too, is asking whether current accounting and
disclosure standards are adequate to protect investors. If not,
what Congress, the Securities and Exchange Commission, and the
Financial Accounting Standards Board should do to make
necessary changes.
Last week, Chairman Tauzin kicked off our review by holding
a full committee hearing examining accounting standards,
corporate disclosure, corporate governance, and the state of
the auditing industry.
We will follow up on that hearing today with an in-depth
look at the adequacy of current accounting standards. The
central tenet underlying financial reporting is fair and
transparent disclosure. All market participants benefit from
approved accounting standards and meaningful disclosure.
Counterparts can better understand the conditions of those with
whom they transact, investors can make informed investment
decisions, and companies themselves benefit from a cost-of-
capital that accurately reflects risk profiles.
Our look at financial reporting today will focus on two
main issues, off balance sheet accounting for special purposes
entities and accounting for derivatives and financial
contracts.
My colleagues, to qualify for off balance sheet treatment,
current accounting rules require 3 percent of total
capitalization of an SPE be an equity investment of an
unrelated third party. The Enron implosion highlighted
deficiency in the off balance sheet test even though for
various reasons Enron's SPEs failed to meet the requisite 3
percent threshold.
The 3 percent test is arbitrary and does not adequately
capture the economics of the transactions it records. It allows
liabilities to be moved off balance sheet, without a true
transfer of risk from the sponsoring company to the SPE.
FASB has been working on off balance sheet issues for some
10 years now. I look forward to an update on the progress of
that project and hope for discussion on how we can expedite a
resolution.
The second issue we will examine is the mark-to-market
issue for derivatives in financial contracts. Mark-to-market
accounting has increased transparency for liquid instruments in
short-term contracts. It has, however, presented difficulties
for valuing assets in long-term contracts. Valuation is
arbitrary where there is no ready market for an asset. To
assign a value to these assets, companies develop mathematical
evaluation models. However, there is significant leeway in the
assumptions underlying valuations, and since companies consider
the models proprietary, assumptions underlying valuations are
neither disclosed nor audited. Values assigned in this so-
called mark-to-model accounting can be misleading to investors.
So, I look forward to hearing what our witnesses have to say
about mark-to-market accounting and the disclosure necessary to
make the reported information transparent and meaningful to
investors.
Congress, the SEC and FASB must be diligent in assessing
the state of our financial reporting in the United States
today. While today is a good start, I assure you this is just
an ongoing process. With this, I urge the SEC to begin to
fulfill its responsibilities of ensuring adequate disclosure in
financial statements. If the SEC had reviewed Enron's filings
over the past 3 years, it may have discovered the lack of
disclosure and the problems the inadequate disclosure
concealed.
Also, I am troubled by the SEC's recent assertion that one
can violate SEC law even while fully complying with GAAP. It is
clear that companies and their auditors have an obligation to
comply with both the letter and the intent of GAAP. However,
the SEC's comments go too far. The SEC seems to be ducking its
responsibility to fix problems with GAAP and corporate
disclosure by using its enforcement authority to impose
burdensome standards on public companies and their auditors. As
in a planned economy of old, that which is not explicitly
permitted is prohibited. This is not a proper standard for a
flourishing market economy.
I also urge FASB to be more expeditious in its review of
financial standards. While I commend the fair process by which
FASB has produced standards, I suggest FASB work with this
committee to come up with a way to ensure due process while
fixing deficiencies in a timely fashion.
As for this committee, it is clear we must start with the
issues that have been highlighted by the Enron implosion, but
our work cannot stop there. Improving financial reporting is a
full-time job. As the markets evolve, we must keep pace with
them to assure a robust and transparent reporting system.
So, I look forward to hearing from our distinguished panel
today, and working with them to improve accounting standards
and, obviously, financial reporting.
With that, for an opening statement, the gentlelady from
California.
Ms. Eshoo. Good morning, Mr. Chairman.
Mr. Stearns. Good morning.
Ms. Eshoo. It seems as if the morning came very quickly.
Well, I want to thank you for having this hearing. It is an
important one, and welcome to the gentlemen at the table. We
have a few chairs between us, but I think it is because the
hearing room, our main hearing room downstairs, is being
redone. So, we are kind of scuttling all over the place to find
a place to have these hearings but, nonetheless, it is
important that we are here this morning on this issue of
financial accounting standards.
We have had many hearings on the issue of financial
accounting standards over the years. Now, because of the Enron
implosion, as the chairman said, we need to examine very, very
carefully what went wrong, and the steps that we need to take
in order to make things right.
We know that there has been expanded participation by
investors in our financial markets, and that is really based on
their having informed--being able to make informed decisions,
and informed decisions are really more important than ever. But
when information provided by companies is false, investors, of
course, are deprived of the opportunity to make these informed
decisions. False information, bad information, can destroy the
wealth, what employees are accumulating, and that leads to--
obviously, has led to severe losses.
Investor confidence is really the ``coin of the realm.''
If, in fact, investors have confidence--and our markets depend
on that--then they will make good decisions. If that is not the
case, then that is undermined, and timely information is very
important as well.
We are also all dependent upon the decisions of accountants
being accurate, that they are timely, that they are
comprehensible, and that they are complete. The collapse of
Enron, of course, has shaken investor confidence. It has shaken
all of us.
I think, on September 12, Americans said, ``How could this
have happened to us?'' With the failure, with the collapse of
Enron, we are now all saying, ``How could this have happened?''
How could this have happened in the corporate world?
So, we have to be really vigilant in terms of examining the
extensive financial knowledge and how it was applied, how it
was misapplied, and the complex accounting schemes that were
developed, and I think this is very important to the American
people.
I don't think, at the end of our examination and at the end
of our legislating, that everyone in the country is going to
understand complex accounting standards, but we can, indeed, I
think, bring more transparency, and we need to weed out what
went wrong with what is right in America. What I am concerned
about is that we are going to be throwing the baby out with the
bathwater in this. And our job as legislators is to be very
prudent, to be tough, to be fair, and at the end of this,
really come out with standards that are going to be fit for the
nobility of the American people because that is what we are
here for.
So, this hearing, Mr. Chairman, provides us with the first
opportunity to assess what investor protections should be
bolstered, and also where better enforcement, much better
enforcement, will serve future employees and future generations
because that is what we are here for.
So, again, I thank the witnesses for being here. I thank
the chairman for calling this hearing. And I will stay on it
and stay with you to make the system better. Thank you, Mr.
Chairman.
Mr. Stearns. I thank you for also coming on this early
time. The gentleman from Nebraska, Mr. Terry.
Mr. Terry. Thank you, Mr. Chairman, for calling this
hearing. When I received notice of this hearing, I thought the
9 o'clock start was completely appropriate. Now, since it is 6
hours after our last vote, it doesn't seem so much that way.
But this is an important matter and we need to get as much
information, so I appreciate you calling this hearing.
Last week, Mr. Chairman, as you may recall, we had the
opportunity to listen to many distinguished accounting
professors from some of the most esteemed business colleges
from this country, and they were asked one question, and that
was if they thought an MBA graduate from their institution
would be able to understand Enron's financial statements, and
they answered no.
The Wall Street Journal recently published a story
characterizing the byzantine financial procedures as the
``black box'' of accounting. The article went on to state that
``in some instances, these black-box methods are so difficult
to comprehend that even audit committees and CFOs have
difficulty deciphering them.'' At least in the Omaha World
Herald, one of the most renowned papers in the Nation, or at
least the one I read mostly, there was an article about Warren
Buffett saying a similar thing, that many of the financial
statements that he reads are so complex that he concludes that
``sometimes they are trying to tell him nothing,'' and maybe
that is the point.
In light of these very complicated methods of accounting, I
was interested to read in Mr. Jenkins' testimony, the listing
of some of FASB's recent initiatives, which include issuance of
standards that improved the transparency of business
combinations; issuance of a standard that improved the
transparency of purchased good will and tangible assets;
issuance of a standard that improved the transparency of asset
retirement obligations; issuance of standards that improve the
transparency of impairment or disposal of long-lived assets;
and the issuance of a report that encourages companies to
continue improving their business reporting and to experiment
with the types of information disclosed in the manner by which
it is disclosed. That is why we are here today, is to discuss
those types of solutions to the problems that face our economy
and businesses today.
Ms. Eshoo, you echoed a concern of mine that was echoed by
at least one witness to our full hearing last week, and that
is, we have to restore the confidence back into the capital
market system, the investors have to have confidence that what
they read is accurate and true.
So, I appreciate you holding this hearing, Mr. Chairman.
Mr. Stearns. I thank the gentleman. The gentlelady from
Colorado, Ms. DeGette.
Ms. DeGette. Thank you, Mr. Chairman. Most of my
constituents think that accounting is easy, you just add up the
numbers and then you check the bottom. I know one corporate
accounting office, for example, that has teeshirts that say
``Go figure,'' and that is what they do. But the complexities
of regulatory requirements and interpretations of corporate
practice make accounting these days difficult in the best of
times.
One practitioner I talked to said that ``accounting is a
combination of basic math, medieval alchemy, and religious
insight.'' Accounting is an imperfect practice requiring the
judgment of individual accountants and auditors. Of course,
difficulties multiply when the auditor faces an inherent
conflict of interest and when the bottom line of the consulting
practice is more lucrative than the full disclosure and
transparency for investors.
We learned about the failure of adequate accounting at
Enron last week from the Power's report, and 2 weeks ago in the
Oversight and Investigations Committee on which I sit. Our
hearings on Arthur Andersen's accounting practices in Enron
were illuminating because what we found is there was nothing
inherently wrong in Andersen's accounting rules that would stop
document shredding, for example, and, of course, if you shred
the documents, it becomes that much harder for investors to
find out what is going on.
Now, Congress has the duty to determine how the system
failed and what, if any, actions Congress can take to restore
public trust through more transparency safeguards, more public
accountability, and better public oversight.
We have heard a number of proposals for reforms, including
more shareholder involvement with auditors, more regulations to
prevent conflicts of interest, more rigorous and independent
peer review, and full disclosure of partnership interactions
among others.
I hope that we will, Mr. Chairman, examine many of these
potential reforms in detail because there is no magic bullet in
this instance. We cannot fix with one swoop all the problems
that we have encountered from the Enron collapse.
Today, I would like to focus on ways to ensure adequate
disclosure of financial risks on company statements, which is
really the heart of the problem here, I think. One of Enron's
failings was its ability to engage in highly volatile
transactions while not disclosing the risk involved. Enron, and
probably their auditors, will argue that disclosure was made in
the footnotes of these financial statements. However, these
financial statements were dense, opaque, and difficult to
understand.
In today's marketplace, with increasing ease of investment
and increasingly less sophisticated investors, it is necessary
to devise accounting standards that will provide average
investors with their stock in 401(k) programs, as well as Wall
Street analysts, with a truthful snapshot of a particular
company's risk. This story is still unfolding.
As Congress continues to investigate the collapse of Enron,
we will likely encounter additional accounting and auditing
issues. This is a unique time for Congress to review accounting
standards and assure that we have protection and transparency
for the investor.
I am glad you are having this hearing, Mr. Chairman, even
at 9 o'clock, and I look forward to hearing all the witnesses
today, and yield back my time.
Mr. Stearns. Thank the gentlelady. The gentleman from New
Hampshire, Mr. Bass, is recognized.
Mr. Bass. Thank you very much, Mr. Chairman. I guess there
is a theme this morning, however, I had a meeting at 8, so this
is my second event of the day.
I guess the old saying ``show me the money'' is certainly
more applicable now than ever before, with respect to
accounting and business practices of investors, and I have
learned a lot about accounting even as a small business person
myself over the last few months, and I have come to understand
the old saying ``cash is fact, everything else is opinion''
certainly applies more than I ever thought it might.
Others have said today that re-establishing confidence in
the capital market through good new accounting standards and
enforcement tools are certainly going to be one of the biggest
opportunities and challenges for this subcommittee and the
whole committee, and I will be looking to our panelists today
to amplify on what areas of our accounting reviews need to be
re-examined and what potentially new enforcement standards may
be required from Congress.
So, with that, Mr. Chairman, I will yield back to you, and
I think we are ready to listen to the panel.
Mr. Stearns. Thank the gentleman. We have the distinguished
ranking member, Mr. Towns, from New York, and I welcome his
opening statement this morning. Good morning.
Mr. Towns. Thank you very much, Mr. Chairman. Fourteen
years ago, then Chairman of this Commerce Committee was a
gentleman by the name of John Dingell, held a number of
oversight hearings on some of the very same accounting
standards that confront us today. In response to these
hearings, the Financial Accounting Standards Board was
established. Unfortunately, it seems that this well-intentioned
measure has failed the American people and the American
investor. Of course, I am referring to the example of the Enron
Corporation, the once seventh largest corporations in America.
Two of the main reasons that this corporation filed for
bankruptcy was a combination of bad accounting practices and
conflict of interest between consultant services and auditing
services.
The collapse and related scrutiny of its accounting
practices has increased investors' awareness of a number of
accounting standards that previously had been ignored by
investors. The American investor is all too aware that many of
these standards are being abused by many in corporate America
and industries. These standards include the following:
Nonconsolidation of the so-called ``special purpose entity,''
the disclosure of related party transactions, issues of equity
securities for something other than cash mark-to-market
accounting, accounting for contracts involving energy trading
and risk management activities, and restatements of previously
issued financial statements.
Members of the accounting industry must improve these
standards and prove to the American public that their industry
and membership can, and should, be trusted once again.
I look forward, Mr. Chairman, to the hearing of the
witnesses today, and I yield back.
Mr. Stearns. Thank the gentleman. The gentlelady from
California is recognized for an opening statement.
Ms. Harman. Thank you, Mr. Chairman. Happy Valentine's Day,
everyone. Let us hope that on this day and on following days,
we both have improved national security and economic security.
This hearing is really about how to improve our economic
security and now to assess whether accounting practices that
have been employed by Enron and other firms are what they need
to be or, whether in the interest of economic security for
America, we need to make some changes.
In particular, today I hope our witnesses will focus on
whether deficiencies of current accounting standards, or their
implementation or lack thereof, allow the shortcomings and
failures that led to the bankruptcy of Enron and perhaps a few
other recent entities.
The Enron bankruptcy has all the elements for scandal--
avarice, deceit, hubris, obfuscation, malfeasance, self-
dealing, influence peddling, manipulation, indifference and,
unfortunately, even suicide. But it has at its core--and this
is the saddest, I think, observation--dereliction of duty:
dereliction of the duty board members have to shareholders;
dereliction of the duty corporate management has to investors,
employees and customers; dereliction of the duty auditors have
to market analysts, the public and regulators; and even
dereliction of duty that lawyers--and I happen to be a lawyer--
have both to our clients and our system of justice. To be sure
we have in place a system of checks-and-balances to protect
investors in the public, but whatever the checks-and-balances
in place at the time came for naught as those expected to
exercise their responsibilities violated them or, worse,
ignored them.
We may learn that there were many motivations for the
behavior we have observed at Enron, Andersen, and elsewhere
but, more importantly, what does that say for any additional
checks-and-balances Congress or regulators may impose in the
future? We may never be completely successful in changing
behavior or the corporate environment that nurtured it, but we
can, and we must, try.
We must, as legislators, as parents, and as citizens,
respect the obligations we assume as members of society. We
must also work to ensure that collateral damage is limited, and
that those responsible are brought to a full accounting, and
that public confidence in our markets, in our government
institutions and our regulatory agencies, and in American
business is restored as quickly as possible.
Thank you again, Mr. Chairman, for convening today's
hearings. I look forward to participating as this committee
seriously, professionally, and completely fulfills its
obligations.
Mr. Stearns. I thank the gentlelady. Mr. Buyer is
recognized for an opening statement.
Mr. Buyer. I will pass.
Mr. Stearns. The gentleman will pass. The gentleman from
Tennessee, Mr. Bryant.
Mr. Bryant. Thank you, Mr. Chairman. I want to thank you
also for holding this hearing today, and the panelists for
coming to testify before us today.
One of the most amazing aspects of Enron's collapse was
that virtually no one saw it coming. And, of course, the
question now is, or did they. It certainly seems that Enron had
built a complex house of cards, seemingly over-valued for
massive amounts of hidden debt and manipulative bookkeeping.
That is why this hearing is so important today.
We have the opportunity to roll up our sleeves and take a
look at the complexities of accounting standards. It is now
evident that Enron violated existing accounting standards set
by the national Accounting Standards Board, however, the rule
on mark-to-market accounting is hard to enforce because the
formula has so many factors. Enron was able to move its debts
off the books by using special purpose entities. I understand
that the rules regarding SPEs have been under review for
sometime now, and I look for to hearing from the panelists
today on this issue.
The fear of many of my constituents invested in the stock
market is that you no longer can trust corporate financial
statements. It is a legitimate worry that more companies may
have Enron-type accounting bombshells to drop. I think
certainly we can see that with the reaction of the stock market
almost on a daily basis.
Large corporations with complex business models are
susceptible to investor fears because their exact financial
position is difficult to measure. Investors have been fraught
amid questions about the market's biggest players' profits
being the result of creative accounting. Our fragile economy
does not need mass hysteria in the market resulting from
innuendo and hearsay about a corporation's accounting
standards. We must restore investor confidence in the
accounting profession.
I am interested in hearing from the accountants on the
panel regarding regulatory reforms of the accounting
profession. Shareholders deserve better disclosure of
accounting information and financial reports prepared in plain
English.
I look forward to today's hearing, and again thank the
chairman for holding this important hearing.
Mr. Stearns. I thank the gentleman. I think we are complete
with the opening statements.
[Additional statements submitted for the record follow:]
Prepared Statement of Hon. George Radanovich, a Representative in
Congress from the State of California
Mr. Chairman, today's hearing is a vital step in protecting our
nation's capital markets. The integrity and stability of our capital
markets are heavily dependent on the accuracy and proficiency of our
financial accounting system. If corrupt business executives continue to
find ways to bypass financial accounting rules, investor confidence
will deteriorate.
The special purpose entities (SPEs) that were designed to enrich
top Enron executives and defraud stockholders have raised public
concern about whether the current accounting standards are
insufficient. Investors of Enron were not provided the correct
information needed to properly review the complex financial instruments
and structures that were set up by Enron executives. We need to find
out if the accounting standards are capable of extracting the
transparency required by investors or whether corrupt companies are
breaking the rules.
The Enron Special Investigation Committee uncovered dozens of
transactions with special purpose entities effectively controlled by
the company to hide bad investments. In California, Enron used one of
their SPEs to form Azurix, a water trading company that dissolved this
year, but not before a handful of executives made millions. In
aggregate these transactions were used to report over $1 billion of
false income through mark-to-market accounting and hide the decline in
Enron's asset value. Such transactions should reflect true market
conditions, and not false predictions made up of twenty-year forecast.
In the end, I hope we can answer these troubling questions raised
by Enron regarding the efficacy and relevance of the existing financial
accounting standards. Thank you, Mr. Chairman, for holding this hearing
today. I look forward to the witnesses' testimony.
______
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee
on Energy and Commerce
Today we are continuing to explore the policy implications of the
Enron collapse--specifically whether accounting standards are adequate
to present meaningful and transparent views of the financial health of
our publicly traded companies.
We have learned that Enron filed false and misleading accounting
statements that were not in accordance with GAAP. We have seen that
some of Enron's management engaged in self-dealing that amounted to
theft of shareholder assets and that the Directors and auditors who
were suppose to supervise the corporation failed to prevent this theft.
We have also learned that Enron had a tangled web of off-balance
sheet partnerships serving to hide billions of dollars in debt and
other liabilities from public accounting statements and the market.
Today we will consider whether rules that facilitate off-balance
sheet accounting need revision. Under current accounting practice, if
an outside person owns as little as 3% of the equity of a company, that
company's assets and liabilities can be taken off the books of the
sponsoring company.
A test of real economic control makes more sense than the 3% rule.
The Financial Accounting Standards Board has a long running project on
off-balance sheet accounting. We will be looking for a status report on
that project, and want to encourage FASB to expedite its consideration.
I understand, yesterday, as an interim measure, FASB has proposed
raising the 3% level to 10%.
We also want to consider issues like market-to-market accounting,
and the use of pro forma statements rather than GAAP.
I have a message for the SEC officials here for you to deliver to
Chairman Pitt. We have learned the SEC conducted no meaningful review
of Enron's financial statements and required SEC disclosure from 1997
to 2001. The SEC should be taking steps under existing law to prevent
additional Enrons. Such steps would include reviewing filed financial
disclosure. Yesterday, an SEC official was quoted in the press as
saying a company could comply completely with GAAP and still commit
securities fraud. Such grandstanding is unhelpful. The SEC has not
provided adequate guidance on what constitutes materiality for purposes
of disclosure. Although this stance preserves all bureaucratic options
in the event of a collapse like Enron, it does little to guide the
overwhelming majority of honest companies who want to provide complete
disclosure to the markets.
Chairman Pitt has also called for the creation of an oversight
mechanism for auditors. This proposal appears to be a continuance of
the status quo in which oversight is conducted by the accounting trade
association. This hasty proposal appears to have little substance and
provides us with little comfort that meaningful change is coming. We in
Congress will have to take a look at this question.
I commend Chairman Stearns and Ranking Member Towns for holding
this hearing. I commend my friend John Dingell for the continuing
bipartisan cooperation we have had in the Enron investigation. We have
important issues to consider today. I yield back the balance of my
time.
______
Prepared Statement of Hon. John D. Dingell, a Representative in
Congress from the State of Michigan
Mr. Chairman, I commend you for scheduling today's hearing into
whether our current accounting standards are protecting investors.
Enron's demise has focused public attention on accountants and
auditors and the rules that they apply. A growing body of evidence
suggests that Enron represents an egregious case of bad if not corrupt
corporate management, misleading accounting and financial disclosure,
shoddy auditing, and outright fraud. But the weaknesses illuminated by
this debacle have long been familiar from previous scandals involving
appalling audit failures. These include Cendant, Sunbeam, Waste
Management, Microstrategy, and, most recently, Global Crossing. It is
urgent that we respond soon with the right reforms.
I have been and remain a strong supporter of the Financial
Accounting Standards Board (FASB) and the important work that it does.
FASB has always produced high-quality standards, often against great
odds. One criticism that we will hear today is that FASB's standard-
setting process is too cumbersome and FASB is too slow in addressing a
number of controversial and cutting-edge issues. FASB has been too
slow, but not without help. I recall a rash of appropriations riders,
as well as nasty letters, from key Members of Congress on some of these
same issues in the past, telling FASB to go back and study for a year
or more, re-propose the standard for public comment, or hold more
hearings. You can't have it both ways.
Another criticism is that FASB's standards are too complex. So too
are the financial transactions and structures to which they apply. A
lot of the complexity is the result of comment letters to FASB asking
for specific interpretations and clarifications. It seems that we may
be damning FASB for the act of being responsive to its constituents. If
FASB did simpler rules, I suspect we would be hearing complaints that
FASB wasn't giving appropriate guidance.
I believe that we should aim for improvements that make sense. We
should be mindful of the trade-offs and the unintended consequences. We
should not compromise the public interest.
That brings me to the proposal to scrap ``rule-based'' standards
and instead go to ``principle-based'' accounting standards. Mr.
Herdman's testimony warns us that: ``A move to principle-based
standards will require greater discipline by the corporate community,
the accounting profession, private-sector standard-setting bodies, and
SEC staff . . . [A]ll constituencies must make concerted efforts to
report transactions consistent with the objectives of the standards.''
I have no such faith in human nature. I don't believe for an instant
that the good folks at Enron and Arthur Andersen would have felt more
constrained by general principles than they were by explicit rules.
Enron happened because these bad actors stood the rulebook on its head
in order to achieve illegal objectives. Crooked management and abetting
accountants will have more room to maneuver under general principles
with no rules.
Nonetheless, Mr. Chairman, I have an open mind about these things,
and I look forward to being educated by our witnesses. I welcome them
and look forward to hearing what they have to say. I am especially
interested in hearing more about how FASB intends to improve accounting
for special purpose entities and the determination of fair values.
Mr. Stearns. We will move to our first panel.
I want to welcome Mr. Robert Herdman, Chief Accountant for
the U.S. Securities and Exchange Commission; Mr. Edmund
Jenkins, the Chairman of the Financial Accounting Standards
Board, and Mr. James C. Castellano, Chairman of the American
Institute of Certified Public Accountants. We welcome all three
of you on this early morning, and we look forward to your
opening statement, and we will start with you, Mr. Herdman.
STATEMENTS OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT, U.S.
SECURITIES AND EXCHANGE COMMISSION; EDMUND L. JENKINS,
CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD; AND JAMES G.
CASTELLANO, CHAIRMAN OF THE BOARD, AMERICAN INSTITUTE OF
CERTIFIED PUBLIC ACCOUNTANTS
Mr. Herdman. Chairman Stearns, Ranking Member Towns, and
members of the subcommittee, I am pleased to appear before you
on behalf of the Securities and Exchange Commission to testify
on the importance of responsive and transparent financial
reporting to investors and our capital markets. My written
testimony addresses these issues in more detail, and I ask that
it be included in the record.
Our financial reporting system has long been considered the
best in the world and is one of the underpinnings of our
capital markets, which are the deepest and most liquid in the
world. However, certain aspects of the system can and should be
improved so changes to accounting standards can be implemented
more quickly, be more responsive to market changes, and provide
more transparent information to investors.
Concerns about our financial reporting system precede the
bankruptcy of Enron Corporation and my testimony reflects that.
The Commission is investigating events associated with Enron's
collapse; and, consistent with the Commission's rules and
practice, I am unable to discuss the specifics of that ongoing
investigation. The Commission requests that the subcommittee
respect the confidential nature of the Commission's
investigation and our reluctance to address specific issues
related to Enron's compliance with Federal securities laws in
this public forum.
The SEC relies on an independent, private sector standards-
setting process that is thorough, open and deliberate. While
the Commission has the statutory authority to set accounting
principles, for over 60 years it has looked to the private
sector for leadership in establishing and improving accounting
standards. The quality of our accounting standards and our
capital markets can be attributed in large part to the private
sector standards-setting process, as overseen by the SEC.
The primary private sector standards-setter is the
Financial Accounting Standards Board. The FASB's standards are
designated as the primary level of generally accepted
accounting principles, which is the framework for accounting.
The interpretative body of the FASB is the Emerging Issues
Task Force. The secondary standard-setter is the Accounting
Standards Executive Committee of the AICPA. The principal
purpose of AcSEC is to develop standards for specialized
industries under the oversight of the FASB.
Even before Enron's collapse, we called upon the FASB to
work with us to address concerns about timeliness,
transparency, and complexity. Specifically, we asked the FASB
to address criticisms that: The current standard-setting
process is too cumbersome and slow, much of the recent FASB
guidance is rule-based and focuses on a check-the-box mentality
that inhibits transparency, and much of the recent FASB
guidance is too complex.
Recently, some people have suggested that the FASB should
be Federalized instead of remaining in the private sector.
There is no assurance that simply placing the structure within
the Federal Government would result in better accounting
standards. For example, many question whether the FASB's
proposal to expense stock compensation, before the Congress
intervened, would have been better for investors.
I believe that with the Commission's leadership, the FASB
can be effective, and confidence in the process can be
restored. Private-sector standard-setting can work in our
current business environment, even as financial transactions
become more complex. Our financial reporting system can
continue to be the best in the world.
When done properly, standard-setting in the private-sector
has greater flexibility to complete rules more quickly than
accounting standards set by the government. Furthermore, the
FASB, the EITF and AcSEC are comprised almost entirely of
people with accounting expertise, and the FASB has greater
ability to attract and retain qualified personnel.
To understand the criticisms, it is important to understand
how the current system of standard setting evolved. In the late
1970's and early 1980's, the FASB undertook a series of
projects to drastically change how financial information is
reported to investors and other financial users. As you might
expect, such sweeping change has been very controversial and
sapped the resources of the FASB.
As a result, issues such as revenue recognition, which is a
factor in approximately one-half of all restatements and SEC
enforcement cases, and consolidation of SPEs have not been
adequately addressed by the Board. The EITF and the SEC staff
have attempted to address some of the issues, but without an
underlying principle the result has been disappointing.
Another criticism that has arisen over time is the trend to
complex, rule-based accounting standards, particularly for
financial instruments such as derivatives. This can be
attributed to a number of factors including (1) changes in how
companies do business; (2) granting exceptions to new
controversial standards; (3) internal conflicts in the
accounting literature as the conceptual underpinnings change;
and (4) demands for a single answer to every question.
As I mentioned in my introduction, over the last few years
many of the standards have become rule-based as opposed to
principle-based, and we believe that that trend needs to be
reversed and that more principle-based standards need to be
enacted. The rule-based approach makes it difficult for
preparers and auditors to step back and evaluate whether the
overall impact is consistent with the objectives of the
standards, and rule-based standards invite financial
engineering, which is one of the reasons why yesterday I sent a
letter to the AICPA's Auditing Standards Board asking it to
prohibit opinions on accounting interpretations that accompany
investment bankers' products that are designed to achieve a
particular financial statement result by taking a path around
the detailed rules.
And so while FASB addresses issues of timeliness,
transparency and complexity, it must remain nimble to deal with
changes in the market. It must accelerate its efforts to
achieve short-term convergence with the International
Accounting Standards Board and coordinate with the SEC's
financial reporting and disclosure reform initiatives so our
capital markets can continue to be the deepest and most liquid
in the world.
In summary, let me reiterate that we have the deepest and
most liquid capital markets in the world now largely because of
the high quality of our financial reporting system. While it is
imperative that the issues of standard-setting timeliness,
transparency, and simplification of accounting standards be
addressed, we should not abandon the system that has allowed us
to achieve what we have to date. Instead let us take the
opportunity to make fundamental changes to standard setting and
SEC oversight. Thank you.
[The prepared statement of Robert K. Herdman follows:]
Prepared Statement of Robert K. Herdman, Chief Accountant, U.S.
Securities and Exchange Commission
Chairman Stearns, Ranking Member Towns, and members of the
Subcommittee: I am pleased to appear before you on behalf of the
Securities and Exchange Commission (``SEC'' or ``Commission'') to
testify on the importance of responsive and transparent financial
reporting to investors and our capital markets. The specific question
this panel was asked to address is ``Are current financial accounting
standards protecting investors?''
Our financial reporting system has long been considered the best in
the world and is one of the underpinnings of our capital markets, which
are the deepest and most liquid in the world. However, certain aspects
of the system can and should be improved so changes to accounting
standards can be implemented more quickly, be more responsive to market
changes, and provide more transparent information to investors. Our
current system's weaknesses are more visible as a result of Enron's
failure.1 However, these weaknesses did not arise overnight,
rather they evolved over many years. Investors expect our system to be
the finest in the world. We intend to see that it remains the finest.
Today I will discuss what should be done.
---------------------------------------------------------------------------
\1\ In a Form 8-K dated November 8, 2001, Enron Corporation stated
that it would restate its financial statements for the years ended
December 31, 1997 through 2000 and quarters ended March 31 and June 30
2001 because it did not follow GAAP. On December 2, 2001 Enron filed
for bankruptcy.
---------------------------------------------------------------------------
Concerns about our financial reporting system precede the
bankruptcy of Enron Corporation and my testimony reflects that. The
Commission is investigating events associated with Enron's collapse;
and, consistent with the Commission's rules and practice, I am unable
to discuss the specifics of that ongoing investigation. The Commission
requests that the Subcommittee respect the confidential nature of the
Commission's investigation and our reluctance to address specific
issues related to Enron's compliance with federal securities laws in
this public forum.
overview of us standard-setting process
The SEC relies on an independent, private sector standards-setting
process that is thorough, open, and deliberate. While the Commission
has the statutory authority to set accounting principles,2
for over 60 years it has looked to the private sector for leadership in
establishing and improving accounting standards.3 The
quality of our accounting standards and our capital markets can be
attributed in large part to the private sector standards-setting
process, as overseen by the SEC.
---------------------------------------------------------------------------
\2\ See, e.g., section 19(a) of the Securities Act of 1933, 15USC
77s(a), and section 13(b)(1) of the Securities Exchange Act of 1934, 15
USC 78m(b)(1).
\3\ Accounting Series Release (ASR) No. 4 (April 1938) and ASR No.
150 (December 1972).
---------------------------------------------------------------------------
The primary private sector standards-setter is the Financial
Accounting Standards Board (the ``FASB''), which was established in
1972. An oversight body appoints the members of the FASB. This
oversight body, the Financial Accounting Foundation, is comprised of
investors, business people, and accountants. The FASB's standards are
designated as the primary level of generally accepted accounting
principles (``GAAP''), which is the framework for accounting. The
FASB's standards set forth recognition, measurement, and disclosure
principles to be used in preparing financial statements.
The secondary standard setter is the Accounting Standards Executive
Committee (AcSEC), which provides guidance in the form of Statements of
Position (SOPs), subject to the affirmative concurrence by the FASB at
every step in the process. The principal purpose of AcSEC, which is a
committee of the American Institute of Certified Public Accountants
(AICPA), is to develop standards for specialized industries.
The interpretative body of the FASB is the Emerging Issues Task
Force (EITF). It meets every other month to provide interpretative
guidance, or develop new guidance, on narrow, new or emerging issues
that arise under existing GAAP and when GAAP does not exist.
criticisms of u.s. accounting standards and standard setting
Even before Enron's collapse, we called upon the FASB to work with
us to address concerns about timeliness, transparency, and complexity.
Specifically, we asked the FASB to address criticisms that:
The current standard-setting process is too cumbersome and
slow.
Much of the recent FASB guidance is rule based and focuses on
a check-the-box mentality that inhibits transparency.
Much of the recent FASB guidance is too complex.
Recently, some people have suggested that the FASB should be
federalized instead of remaining in the private sector. Those who
suggest this apparently have lost confidence in the FASB's process.
There is no assurance that simply placing the structure within the
federal government would result in better accounting standards. For
example, many question whether the FASB's proposal to expense stock
compensation, before the Congress intervened, would have been better
for investors.
Federalization of the FASB not only would require increases to the
federal budget, but also might disenfranchise those who are best
qualified to address the highly complex business and accounting issues
that must be resolved. I believe that with the Commission's leadership
and cooperation by the FASB, the FASB can be effective, and confidence
in the process can be restored. Private-sector standard setting can
work in our current business environment, even as financial
transactions become more complex. In spite of recent events, we still
have the best financial reporting system in the world, and the
Commission is intent on making it even better.
When done properly, standard setting in the private sector is the
best alternative for our capital markets as it provides a number of
advantages over federalized standard setting. Private sector standard
setting has greater flexibility to complete rules more quickly than
accounting standards set by the government. The FASB is comprised
almost entirely of accounting experts and has a greater ability to
attract and retain qualified personnel. Similarly, AcSEC and the EITF
are composed of members with accounting expertise.
evolution of standard setting
It is important to understand how the current system of standard
setting evolved. As we contemplate reform, we need to consider how we
got here. In the late 1970s and early 1980s, the FASB undertook a
series of projects to drastically change how financial information is
reported to investors and other financial users. These projects, which
include consolidation of financial statements and accounting for
financial instruments, represent major conceptual changes in financial
reporting. As you might expect, such sweeping change has been very
controversial and sapped the resources of the FASB.
As a result, issues such as revenue recognition (which is a factor
in approximately one-half of all restatements and financial reporting
enforcement cases) and consolidation of SPEs have not been adequately
addressed by the FASB. The EITF and the SEC staff have attempted to
address some of the issues, but without an underlying principle the
result has been disappointing.
In other cases, the FASB has delegated broad issues such as
accounting for partnerships; property, plant and equipment; and the
accounting for environmental liabilities to AcSEC. AcSEC is comprised
of part-time volunteers from the preparer, auditor, and user
communities and is subject to affirmative review by the FASB each step
of the way. As a result, AcSEC is ill equipped to deal with broad
issues in a timely manner. While AcSEC's guidance has been of high
quality, it often takes years to issue because of its infrastructure
constraints.
Another criticism that has arisen over time is the trend to
complex, rule-based accounting standards. This trend can be attributed
to a number of factors including (1) changes in how companies do
business; (2) granting exceptions to new controversial standards; (3)
internal conflicts in the accounting literature as the conceptual
underpinnings change; and (4) demands for a single answer to every
question. FASB Statement No. 133 on accounting for derivatives and
hedging and Statement No. 140 on transfers of financial assets and
extinguishments of financial liabilities are two prominent standards
that have been subject to such criticism.
improving timeliness
Now I would like to review with the Subcommittee actions that
should be taken to continue to ensure that our financial reporting
system remains the premier system in the world. Let's begin with the
FASB. The FASB must change the scope of many of its technical projects
and the manner in which it carries out its activities.
The FASB uses a building-block approach when developing standards.
That is, the Board addresses a handful of issues at any given meeting
instead of all of the issues that comprise a single proposal. This
approach tends to expand the time it takes to resolve reporting issues.
In contrast, the SEC staff generally will present an entire proposal to
the Commission for consideration. The FASB needs to reconsider its
approach.
The Board's major projects tend to be very broad. For example, the
FASB currently has on its agenda a liabilities and equity project that
raises six or seven important issues. I believe this project has too
broad a scope. It attempts to weave too many issues into a conceptual
framework everyone can agree on. Most people agree that more guidance
is needed on equity derivatives and redeemable preferred stock. Why not
separate out these issues and provide timely guidance on them? The
remaining issues, where many believe no additional guidance is
necessary, can be addressed at later dates. Narrowing the scope to its
critical elements allows the process to move forward in a timely
manner.
Some are calling for a limitation on the time a project can be on
the FASB's agenda. I share their concerns about timeliness. It is clear
that the FASB must work more quickly and be more responsive to market
needs. For example, how it deals with the issue of when to consolidate
SPEs is important. This project must be finished so it can be both
effective for, and implemented by, the end of this year. If the FASB is
not able to make progress on such important issues as they arise, the
SEC should take action. We must improve our oversight of the standard-
setting agenda.
principle-based accounting standards
As I mentioned in my introduction, over the last few years many of
the FASB standards have been rule based, as opposed to principle based.
Rule-based accounting standards provide extremely detailed rules that
attempt to contemplate virtually every application of the standard.
This encourages a check-the-box mentality to financial reporting that
eliminates judgments from the application of the reporting. Examples of
rule-based accounting guidance include the accounting for derivatives,
employee stock options, and leasing. And, of course, questions keep
coming. Rule-based standards make it more difficult for preparers and
auditors to step back and evaluate whether the overall impact is
consistent with the objectives of the standard.
An ideal accounting standard is one that is principle-based and
requires financial reporting to reflect the economic substance, not the
form, of the transaction. FASB Statement Nos. 141, Business
Combinations, and 142, Goodwill and Other Intangible Assets, which were
issued in 2001, appear to be steps in the right direction. These
standards will serve as a test of the level of specificity needed to
strike a balance between rules and principles. Principle-based
standards will yield a less complex financial reporting paradigm that
is more responsive to emerging issues.
Furthermore, a byproduct of rule-based accounting standards has
been an increase in the number of ``SAS 50'' letters issued to
investment banks providing opinions as to whether hypothetical
transactions follow accounting standards. SAS 50 letters may be used as
the basis to structure complex transactions that technically comply
with accounting standards, but do not accurately reflect the objectives
of the standards. I believe it is in the public interest that the
Auditing Standards Board ban those types of letters, and yesterday I
sent a letter to the Auditing Standards Board urging that it do so.
A move to principle-based standards will require greater discipline
by the corporate community, the accounting profession, private-sector
standard-setting bodies, and the SEC staff. A move away from a check-
the-box approach to financial reporting means that all constituencies
must make concerted efforts to report transactions consistent with the
objectives of the standards. While this may mean that not all
transactions are recorded in exactly the same manner, it is my belief
that similar transactions in this system of principle-based standards
will not be reported in materially different ways, preserving
comparability.
While the FASB addresses issues of timeliness, transparency and
complexity it must remain nimble to deal with changes in the market.
Looking ahead, it must accelerate its efforts to achieve short-term
convergence with the International Accounting Standards Board and
coordinate with the SEC's financial reporting and disclosure reform
initiatives so our capital markets can continue to be the deepest and
most liquid in the world.
resource management
Now I would like to discuss how better resource management should
improve timeliness of standard setting. This is where the leadership of
the SEC is important. As I stated at the outset, the FASB is subject to
the oversight of the SEC.
Allow me to describe how I believe that oversight should work. In
light of its enforcement and review activities, the SEC is in a unique
position to provide input into the FASB's agenda. We have a
responsibility to do that, and the FASB has a responsibility to address
the issues we refer to them in the time frame that we request, even if
it is 180 days. I believe that we can and should stay out of their way
once we ask them to take on a project. However, we should meet with the
FASB frequently to monitor the status of their projects. If projects
are languishing, we must determine why.
Generally, there are two reasons that topics remain on FASB's
agenda for extended periods. First, there may not be a problem with
existing guidance, as many believe is the case with the basic
consolidations model. Using resources to revisit this model slows the
process and detracts from the Board's ability to address the more
important issues such as SPEs.
Second, a topic may remain on the agenda for an extended period
because it is too broad. This is a principal reason why the Board has
had to spend much time on its liability and equity project. Instead of
focusing solely on the pressing issues of accounting for redeemable
preferred stock and equity derivatives, the FASB has decided to use the
project to make conceptual changes to minority interest and require
separate accounting for elements of certain debt instruments, delaying
project completion.
The changes I have discussed in my testimony should allow the FASB
time to address important issues as they arise, and eliminate the need
to refer broad issues to AcSEC and the EITF, so they can focus on
developing industry and interpretative guidance, respectively, as they
were designed to do.
conclusions
In summary, let me reiterate that we have the deepest and most
liquid capital markets in the world largely because of the high quality
of our financial reporting system. While it is imperative that the
issues of standard-setting timeliness, transparency, and simplification
of accounting standards be addressed, we should not abandon the system
that has allowed us to achieve what we have to date. Instead let us
take the opportunity to make fundamental changes to standard setting
and SEC oversight.
Mr. Stearns. I thank the gentleman.
Mr. Jenkins.
STATEMENT OF EDMUND L. JENKINS
Mr. Jenkins. Good morning, Chairman Stearns, Ranking Member
Towns, and the members of the subcommittee. I appreciate the
opportunity to speak to you this morning again.
I appear here on behalf of the Financial Accounting
Standards Board. I have brief prepared remarks, and I would
respectfully request that the full text of my testimony and all
supporting materials be entered into the public record.
Mr. Stearns. By unanimous consent, so ordered.
Mr. Jenkins. As you know, the FASB is an independent
private-sector organization. We are not part of the Federal
Government and we receive no Federal funding.
We are an independent group, and our independence comes
from the fact that our seven-member Board serves full-time and
we are required to sever all financial ties with our former
employers. We are funded primarily through the sale of our
publications and to a lesser extent through private donations
solicited by the Trustees of a not-for-profit foundation, the
Financial Accounting Foundation. Board members and members of
the FASB staff are prohibited from being associated with
fundraising activities.
Our mission is to establish and improve standards of
financial accounting and reporting for both public and private
enterprises. Those standards are essential to the efficient
functioning of the capital markets because investors,
creditors, and other consumers of financial reports rely
heavily on credible, transparent, and comparable financial
information.
Because the actions of the FASB affect so many
organizations and are so important to the efficient functioning
of the capital markets, our decisionmaking process must be open
and thorough. Many times Congress has asked us to assure them
that that process is working, and we believe it is. An open and
thorough process is essential for ensuring both the credibility
and quality of the resulting standards. The standards in the
U.S. are generally recognized as the highest quality standards
in the world.
It is important to understand that the FASB has no
authority for to enforce its standards. Responsibility for
ensuring that financial statements comply with accounting
requirements rests with the officers and directors of the
reporting entity's financial statements, and for public
companies, the SEC. It is also important to understand that the
FASB has no authority or responsibility with respect to
auditing, independence, or scope of services matters. Rather,
our responsibility relates solely to establishing financial
accounting and reporting standards.
Now, the FASB does not know many of the facts relating to
Enron's financial accounting and reporting. However, it is
clear that Enron publicly acknowledged in its filings with the
SEC that its financial statements did not comply with existing
accounting requirements in at least two areas. Those failures
resulted in financial statements that materially inflated
assets and net income and materially understated liabilities in
years beginning in 1997 through 2000. In addition, the February
1, 2002 Report of Investigation by the Special Investigative
Committee of the Board of Directors of Enron further suggests
that Enron's financial statements included other violations of
existing accounting requirements. One such reference in the
report states: ``Enron's original accounting treatment of the
Chewco and LJM1 transactions that led to Enron's November 2001
restatement was clearly wrong, apparently the result of
mistakes either in structuring the transactions or in basic
accounting. In other cases, the accounting treatment was likely
wrong, notwithstanding creative efforts to circumvent
accounting principles through the complex structuring of
transactions that lacked fundamental substance.''
I want to assure you, Mr. Chairman and members of this
Committee, that consistent with the FASB's mission and due
process, the Board is prepared and committed to work with the
subcommittee, with the SEC, and all other constituents to
proceed expeditiously to resolve any and all financial
accounting and reporting issues that may arise as a result of
the Enron bankruptcy.
Attachment 4 to the full text of my testimony provides a
detailed listing of the FASB's extensive existing guidance
relating to accounting and disclosures of related party
transactions, special purpose entities, and off-balance-sheet
financial arrangements and guarantees.
The Board has active projects underway in over a half-dozen
areas that will propose significant improvements to existing
requirements, including a project to improve the accounting for
consolidations, and a project to improve the guidance for
determining the fair values of financial instruments. With
respect to the project on consolidations, which we have
struggled with for far too long, the Board plans to issue a
proposal on an expedited basis in the second quarter of this
year that will resolve some of the more common issues
encountered by some entities in present practice, including
issues relating to consolidation of SPEs.
Yesterday at our public Board meeting, the Board concluded
to go forward with a proposal developed by our staff that will
address these issues. We are going to bring the full proposal
to our Board in a meeting in 2 weeks on the 27th, and debate
that proposal with the intent of issuing it for public comment
as quickly as we can thereafter.
I discuss mark-to-market accounting in my testimony. I need
to point out to you that we cannot alone sustain the
transparency necessary to maintain the vibrancy of our capital
markets. Other parties must also carry out their
responsibilities in the public interest. They include reporting
entities, auditors and regulators. We can no longer tolerate
reporting entities that seek loopholes to existing standards
and don't apply them with the intent with which they were
written. We no longer can tolerate reporting entities and
auditors that look to see ``where does it say that I can't do
that.''
Just one more comment in summary, Mr. Chairman, please. If
anything positive results from the Enron bankruptcy, it may be
that this highly publicized investor and employee tragedy
serves as an indelible reminder to all of us, as you, Mr.
Chairman, stated in your opening comments, that transparent
financial accounting and reporting do matter and that the lack
of transparency imposes significant costs on all who
participate in our capital markets. Thank you very much.
[The prepared statement of Edmund L. Jenkins follows:]
Prepared Statement of Edmund L. Jenkins, Chairman, Financial Accounting
Standards Board
Chairman Stearns, Ranking Member Towns, and Members of the
Subcommittee: I am pleased to appear before you today on behalf of the
Financial Accounting Standards Board (``FASB'' or ``Board''). My
testimony includes an overview of the FASB, its structure, and due
process. My testimony also includes an overview of the existing
accounting requirements for special-purpose entities (``SPEs''),
related party transactions, and mark-to-market accounting, and Enron
Corp.'s (``Enron'') restatement of its financial statements to comply
with the existing accounting requirements. Finally, my testimony
includes the actions the FASB has undertaken to improve our process for
setting standards, to address issues relating to the complexity of our
standards, and to address other financial accounting and reporting
issues that are necessary to further improve the transparency of
financial reports. I want to thank you for the opportunity to again
appear before your Subcommittee. I understand and appreciate your
important oversight role.
what is the fasb, what does it do, and what has it done lately?
The FASB is an independent private-sector organization. We are not
part of the federal government and receive no federal funding.
Our mission is to establish and improve standards of financial
accounting and reporting for both public and private enterprises. Those
standards are essential to the efficient functioning of the economy
because investors, creditors, and other consumers of financial reports
rely heavily on credible, transparent, and comparable financial
information.
The FASB's authority with respect to public enterprises comes from
the US Securities and Exchange Commission (``SEC''). The SEC has the
statutory authority to establish financial accounting and reporting
standards for publicly held enterprises. For more than 60 years, the
SEC has looked to the private sector for leadership in establishing and
improving those standards.
The FASB has no power to enforce its standards. Responsibility for
ensuring that financial statements comply with financial accounting and
reporting standards rests with the auditors of those statements and,
for public companies, ultimately with the SEC. It is also important to
understand that the FASB has no authority or responsibility with
respect to auditing, independence or scope of services matters. Rather,
our responsibility relates solely to establishing financial accounting
and reporting standards.
The focus of the FASB is on consumers--users of financial
information, such as investors, creditors, and others. We attempt to
ensure that corporate financial reports give consumers an informative
picture of an enterprise's financial condition and activities and do
not color the image to influence behavior in any particular direction.
The US capital markets continue to be the deepest, most liquid, and
most efficient markets in the world. The unparalleled success and
competitive advantage of the US capital markets are due, in no small
part, to the high-quality and continually improving US financial
accounting and reporting standards. As Federal Reserve System Chairman
Alan Greenspan stated:
Transparent accounting plays an important role in maintaining
the vibrancy of our financial markets . . . An integral part of
this process involves the Financial Accounting Standards Board
(FASB) working directly with its constituents to develop
appropriate accounting standards that reflect the needs of the
marketplace. 1
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\1\ Letter from Federal Reserve System Chairman Alan Greenspan to
SEC Chairman Arthur Levitt (June 4, 1998).
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Some of the FASB's significant activities during 2001 included the
following:
Issuance of a standard that improved the transparency of
business combinations.2
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\2\ See FASB Statement No. 141, Business Combinations (June 2001).
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Issuance of a standard that improved the transparency of
purchased goodwill and intangible assets.3
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\3\ See FASB Statement No. 142, Goodwill and Intangible Assets
(June 2001).
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Issuance of a standard that improved the transparency of asset
retirement obligations.4
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\4\ See FASB Statement No. 143, Accounting for Asset Retirement
Obligations (June 2001).
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Issuance of a standard that improved the transparency of
impairment or disposal of long-lived assets.5
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\5\ See FASB Statement No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets (August 2001).
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Issuance of a video to assist the public in understanding the
importance of financial reporting to the US capital markets and
to individual investment decisions.6
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\6\ See FASB Presents Financially Correct with Ben Stein (2001).
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Issuance of a report that encourages companies to continue
improving their business reporting and to experiment with the
types of information disclosed and the manner by which it is
disclosed.7
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\7\ See Business Reporting Research Project, Steering Committee
Report, Improving Business Reporting: Insights into Enhancing Voluntary
Disclosures (2001).
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what is the financial accounting foundation (``faf''), and what is the
faf's relationship to the fasb?
The FASB is an operating unit of the Financial Accounting
Foundation (``FAF''). The FAF is a not-for-profit foundation that was
incorporated in 1973 to operate exclusively for charitable,
educational, scientific, and literary purposes within the meaning of
Section 501(c)(3) of the Internal Revenue Code.
The Foundation is separate from all other organizations. Its 16-
member Board of Trustees is made up of 11 nominees from sponsoring
organizations whose members have special knowledge of, and interest in,
financial reporting.8 There also are 5 Trustees-at-large who
are not nominated by those organizations but are chosen by the sitting
Trustees.
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\8\ See Attachment 1 for a list of the sponsoring organizations.
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The FAF Trustees are prominent individuals with a broad range of
backgrounds. Each of them shares a common understanding of the
importance of independent private-sector accounting standard setting to
the efficiency of the US capital markets.9
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\9\ See Attachment 1 for a list of the current FAF Trustees.
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The FAF Trustees have several important responsibilities with
respect to the FASB.
Those responsibilities include:
1. Oversight of the FASB's process to ensure that the FASB is
fulfilling its stated mission (see below the discussion, ``What
Process Does the FASB Follow in Developing Accounting
Standards?'')
2. Selecting the FASB Board members, and
3. Arranging for the financing of the FASB.
FAF Trustees select the FASB Board members based on their technical
expertise in financial accounting and reporting. Board members,
however, have diverse backgrounds. Of the seven current members of the
Board, three are from the accounting profession, two from corporations,
one from the analyst community, and one from the academic community. A
public vote of five Board members is required to issue a proposal or
standard.
Each of the Board members is a full-time employee of the FAF and is
required to be independent of all other business and professional
organizations. Thus, upon joining the FASB, Board members are required
to sever all financial ties with former employers. Board members can
serve no more than two full five-year terms.
Approximately two-thirds ($14 million in 2000) of the FASB's
financing results from the public sale and licensing of the FASB's
publications. The remaining one-third ($6 million in 2000) results from
the fundraising efforts of the FAF Trustees who solicit donations from
a broad range of consumers, preparers, and auditors of financial
reports.
To ensure the independence and objectivity of the FASB, the Board
members are prohibited from participating in the FAF Trustee's
fundraising efforts, and the FAF Trustees are prohibited from
participating in the Board's technical decisions on establishing and
improving accounting standards.
what process does the fasb follow in developing accounting standards?
Because the actions of the FASB affect so many organizations and
are so important to the efficient functioning of the capital markets,
its decision-making process must be open and thorough. An open and
thorough process is essential to ensuring the credibility and quality
of the resulting standards. An open and thorough process also reduces
the possibility that standards will create unintended consequences
inconsistent with transparent financial reporting.
Our Rules of Procedure require an extensive and public due process
that is broader and more open in several ways than the Federal
Administrative Procedure Act, on which it was modeled. The FASB process
involves public meetings, public hearings, field tests, and exposure of
our proposed standards to external scrutiny and public comment. The
Board makes final decisions only after carefully considering and
understanding the views of all parties, including consumers, preparers,
and auditors of financial information.
The FASB and the FAF, in consultation with the Board's
constituents, periodically review the FASB's due process to ensure that
the process is working efficiently and effectively. In response to
constituent requests, including requests from our Financial Accounting
Standards Advisory Council, 10 the FASB has recently
initiated several administrative projects and activities to improve
upon the Board's due process procedures, including the timeliness of
the Board's standard setting.
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\10\ See Attachment 2 for information about the Financial
Accounting Standards Advisory Council.
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Those projects and activities include the following:
Making it easier for constituents to find all of the
appropriate accounting requirements for a particular topic by
including references to all applicable US accounting literature
in the FASB's future standards and in the FASB's Current Text,
a compilation of all FASB accounting standards categorized by
subject. In addition, the FASB is seeking to partner with
others in developing an online database that will include all
of the US accounting literature.
Working with the Emerging Issues Task Force (EITF),
11 the American Institute of Certified Public
Accountants, and the SEC to more clearly define and coordinate
their accounting-standard-setting roles with those of the FASB
with an eye toward streamlining certain activities.
---------------------------------------------------------------------------
\11\ See Attachment 1 for information about the EITF.
---------------------------------------------------------------------------
Reducing the complexity of accounting literature by (1)
seeking to determine if the FASB can issue standards that are
less detailed and have few, if any, exceptions or alternatives
and (2) more actively engaging FASB constituents in discussions
about the cost-benefit relationship of proposed standards.
Working with the SEC in its initiative to modernize financial
reporting and disclosure.
Implementing an improved approach to determining what major
new topics should be added to the FASB's technical agenda. That
approach involves issuing a proposal for public comment before
the Board decides whether to add a particular project to its
agenda. The proposal discusses the problem to be addressed
(that is, the reason for the project), its proposed scope,
relationship to the conceptual framework and relevant research,
the main issues and alternatives the Board expects to consider,
and how practice might be affected. It also explicitly reviews
the Board's agenda decision criteria.12 The Board
believes this improved approach provides additional discipline
to the Board's project management capabilities, particularly in
the area of defining and refining the scope of a new agenda
project. Scope expansion during the life of a project has
sometimes been a significant impediment to the timeliness of
the Board's standard setting.
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\12\ See Attachment 1 for information about the Board's agenda
criteria.
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Implementing a more rigorous project planning and management
process, which requires the establishment of clear project
milestones and plans for meeting them, resource budgets, and
status reporting in terms of previously established milestones.
what is an spe, and what are the accounting requirements for spes?
``Special-purpose entity'' or ``SPE'' are terms frequently used to
refer to an entity that is created solely to carry out an activity or
series of transactions directly related to a specific purpose. An SPE
may take on any legal form including a corporation, a partnership, a
limited liability company, or a trust.
SPEs are commonly used as financing vehicles to which an entity
(the sponsor) sells assets (such as a pool of mortgage loans) in
exchange for cash or other assets. The funding for the SPE's purchase
comes primarily from the SPE issuing debt or equity (or both) to third-
party lenders or investors. An SPE also may be established to acquire,
construct, or manufacture assets that are used by another entity (its
sponsor) under leases, management contracts, or other
arrangements.13 When properly structured, an SPE often
reduces the credit risk or other risks for lenders or investors and,
thus, lowers financing costs. SPEs also may create certain tax
advantages for the participating parties.
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\13\ See Attachment 3 for a simple example of one such SPE
structure that illustrates some of the potential business purposes that
accompany the decision to form and transact with an SPE.
---------------------------------------------------------------------------
SPEs raise a number of complex financial accounting and reporting
issues. One issue is which party, if any, should be responsible for
reporting or consolidating the assets and liabilities of the SPE into
its financial statements.
The existing accounting requirements generally provide that the
sponsor of the SPE (for example, Enron) is required to report all of
the assets and liabilities of the SPE in its financial statements
unless all of the following criteria are met:
1. A third-party owner (or owners) independent of the sponsor has a
sufficient equity investment in the SPE;
2. The independent third-party owner (or owners) investment is
substantive (generally meaning at least 3 percent of the SPE's
total debt and equity or total assets);
3. The independent third-party owner (or owners) has a controlling
financial interest in the SPE (generally meaning that the owner
holds more than 50 percent of the voting interest of the SPE--
thus, if the SPE's total equity is only 3 percent of total
assets, all of its equity must be held by one or more
independent third parties); and
4. The independent third-party owner (or owners) possesses the
substantive risks and rewards of its investment in the SPE
(generally meaning the owner's investment and potential return
are ``at risk'' and not guaranteed by another
party).14
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\14\ See EITF Issue No. 90-15, ``Impact of Nonsubstantive Lessors,
Residual Value Guarantees, and Other Provisions in Leasing
Transactions''; EITF Issue No. 96-21, ``Implementation Issues in
Accounting for Leasing Transactions involving Special-Purpose
Entities''; and EITF Topic No. D-14, ``Transactions involving Special-
Purpose Entities.''
---------------------------------------------------------------------------
Although a sponsor of an SPE that meets all of the above conditions
is not required to consolidate the assets and liabilities of the SPE in
its financial statements, the sponsor is required either to recognize
in its financial statements or to disclose in the footnotes to its
financial statements the obligations, including conditional or
contingent obligations or guarantees, that may arise from its
transactions and relationships with the SPE. Whether the obligations
must be recognized in the financial statements or disclosed in the
footnotes generally depends on their nature and the extent to which
payments are probable. The following is a brief summary of some of the
more significant accounting requirements that might apply to the
sponsor's (reporting entity's) financial statements:
A reporting entity that sells financial assets is required to
report information about what was sold. It is also required to
report liabilities, including guarantees and recourse
obligations, incurred in the sale, on the face of its financial
statements at their fair value on the date of
sale.15
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\15\ See FASB Statement No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities
(September 2000).
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A reporting entity that enters into certain derivatives or
energy trading contracts is required to recognize those
contracts in its financial statements at fair value, including
the fair value of any obligation that arises from those
contracts.16
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\16\ See FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities (June 1998); and EITF Issue No. 98-
10, ``Accounting for Contracts Involved in Energy Trading and Risk
Management Activities.''
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A reporting entity is required to disclose in the footnotes to
its financial statements the fair value of its financial
instruments, including the fair value of any commitments,
letters of credit, financial guarantees, or debt.17
---------------------------------------------------------------------------
\17\ See FASB Statement No. 107, Disclosures about Fair Value of
Financial Instruments (December 1991).
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A reporting entity is required to disclose certain unrecorded
long-term obligations in its financial statements.18
---------------------------------------------------------------------------
\18\ See FASB Statement No. 47, Disclosure of Long-Term Obligations
(March 1981).
---------------------------------------------------------------------------
A reporting entity is required to disclose indirect guarantees
of indebtedness of others in its financial
statements.19
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\19\ See FASB Interpretation No. 34, Disclosure of Indirect
Guarantees of Indebtedness of Others (March 1981).
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A reporting entity is required to recognize certain loss
contingencies in its financial statements, including guarantees
of indebtedness of others, and to disclose the nature and
amount of loss contingencies in its financial statements even
though the possibility of loss may be remote.20
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\20\ See FASB Statement No. 5, Accounting for Contingencies (March
1975).
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In recent testimony before Congress, SEC Chief Accountant Robert K.
Herdman commented on the existing accounting requirements for
SPEs.21 He stated, ``On balance I think that the special
purpose entity accounting is working as well as could be expected right
now, but it does cry out for the FASB to finish their project here and
conclude whether . . . a different set of rules should be enacted.''
22 The FASB project that Chief Accountant Herdman was
referring to in his testimony is one of a group of the Board's related
projects on consolidations and related matters.
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\21\ See Transcript of hearing before the Capital Markets,
Insurance, and Government Sponsored Enterprises Subcommittee and
Oversight and Investigations Subcommittee of the Committee on Financial
Services, United States House of Representatives, page 28 (December 12,
2001).
\22\ Transcript of hearing, page 28. The SEC recently issued a
Commission statement setting forth certain of its views regarding
disclosure that should be considered by public companies while
preparing annual reports for the year ended December 31, 2001. Those
views included a reminder of existing disclosure requirements relating
to liquidity and capital resources, including off-balance-sheet
arrangements, certain trading activities that include non-exchange-
traded contracts accounted for at fair value, and effects of
transactions with related and certain other parties. See Release Nos.
33-8056; 34-45321; FR-61 (January 22, 2002).
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In 1982, the Board added a group of projects on consolidations and
related matters to its agenda. The projects were intended to cover all
aspects of accounting for affiliations between entities along with
several other matters that raise similar or potentially related issues
about financial statements. Specific areas to be addressed by the
projects included:
Consolidations policy and procedures
The equity method of accounting
Disaggregated disclosures or segment reporting
Investments in unconsolidated entities and joint ventures
New basis or ``push down'' accounting in the financial
statements of subsidiaries.
Since adding the group of projects to its agenda, the Board has
issued two major standards. The Board has also issued, through other
projects, extensive guidance in the form of Statements and
Interpretations that address the accounting for SPEs or other off-
balance-sheet financing arrangements.23 The EITF also has
issued guidance in the form of consensuses that address those
areas.24
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\23\ See Attachment 4 for a detailed listing of guidance provided
by FASB Statements and Interpretations related to related party
transactions, special purpose entities, and off-balance sheet financial
arrangements.
\24\ See Attachment 5 for a detailed listing of significant EITF
issues related to special purpose entities and off-balance-sheet
financial arrangements.
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The first major standard, issued in 1987, requires consolidation of
the assets and liabilities of all majority-owned and controlled
subsidiaries in the financial statements of the parent
entity.25 That standard eliminates what was arguably the
major vehicle for off-balance-sheet financing at the time in terms of
the amounts involved. Before that standard, many entities established a
financing subsidiary that borrowed capital and utilized that capital to
finance customer purchases of the products of its parent and other
affiliates or finance other parts of the operations of the consolidated
group. Such subsidiary assets and liabilities often were not
consolidated, even if the parent entity owned all of the subsidiary's
equity.
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\25\ See FASB Statement No. 94, Consolidation of All Majority-Owned
Subsidiaries (October 1987).
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The second major standard, issued in 1997, requires improved
reporting of information about an entity's various operating
segments.26
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\26\ See FASB Statement No. 131, Disclosures about Segments of an
Enterprise and Related Information (June 1997).
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In addition, the Board issued two Exposure Drafts addressing
consolidation policy--the first in 1995 and the second in
1999.27 Establishing criteria or policy for determining
which entities should be included in a set of consolidated financial
statements involves many difficult considerations extending beyond
SPEs, and both of those proposals were extremely controversial. For
example, the most controversial issue in the project on consolidations
policy has been whether to require consolidation of entities that a
parent entity effectively controls by means other than majority
ownership, such as a large minority holding if ownership of the
majority is widely dispersed. That issue extends beyond what are
usually thought of as SPEs, and both Board members and constituents
have been sharply divided on it.
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\27\ See FASB Exposure Draft, Consolidated Financial Statements:
Policy and Procedures (October 16, 1995); and FASB Revised Exposure
Draft, Consolidated Financial Statements: Purpose and Policy (February
23, 1999).
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The Board continues to actively pursue further improvements in
connection with its longstanding project on consolidations policy and
procedures.28 In November 2001, the Board decided to
concentrate its efforts on developing guidance on an expedited basis
fordealing with consolidation policy issues that have been identified
by constituents in the following four areas:
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\28\ See Attachments 6 and 7 for a summary of the Board's project
on consolidations policy and procedures and a detailed timeline of the
Board's activities in connection with the project, respectively.
1. So-called strawman situations (for example, situations in which
control of an entity is indirect and perhaps disguised through
holdings of an entity's agents, management, or other related
parties)
2. Entities that lack sufficient independent economic substance
3. Convertible instruments and other contractual arrangements that
involve latent control
4. The distinction between participating rights and protective rights
of various shareholders, partners, and other investors in an
entity.
The Board believes that effective guidance for the above situations
would resolve many of the issues encountered by some entities in
present practice, including issues relating to consolidation of SPEs.
The Board's immediate plans are to issue proposed guidance dealing with
the first two of those situations in the second quarter of this year
and the following two situations soon thereafter.
what are related parties, and what are the accounting requirements for
related party transactions?
For accounting purposes, related parties are defined quite broadly
to include:
Affiliates of the enterprise
Entities in which the enterprise has investments that it
accounts for using the equity method
Management of the enterprise (including members of the board
of directors, the chief executive officer, chief operating
officer, vice presidents in charge of principal business
functions, and other persons who perform similar policy-making
functions)
Other parties with which the enterprise may deal if one party
controls or can significantly influence the management and
operating policies of the other to the extent that one of the
transacting parties might be prevented from fully pursuing its
own separate interests
Another party also is a related party if it can significantly
influence the management or operating policies of the
transacting parties or if it has an ownership interest in one
of the transacting parties and can significantly influence the
other to an extent that one or more of the transacting parties
might be prevented from fully pursuing its separate
interests.29
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\29\ FASB Statement No. 57, Related Party Disclosures, paragraph
24(f) (March 1982).
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Transactions with related parties generally are accounted for in
the same way as if they were transactions with unrelated parties. More
specifically, related party transactions generally are required to be
accounted for in accordance with their terms; it usually would not be
feasible to account for a transaction based on what the terms might
have been had the transaction been between unrelated
parties.30 Reporting entities, however, are required to
disclose detailed information in their financial statements about their
related party transactions. Those requirements include, but are not
limited to, disclosure of:
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\30\ One exception involves the accounting for leases. In cases
where ``it is clear that the terms of the transaction have been
significantly affected by the fact that the lessee and lessor are
related . . . the classification and/or accounting shall be modified as
necessary to recognize economic substance rather than legal form''
(FASB Statement No. 13, Accounting for Leases, paragraph 29 [November
1976]).
1. The nature of the relationship(s) involved
2. A description of the transactions, including transactions to which
no amounts or nominal amounts were ascribed, for each of the
periods for which income statements are presented, and such
other information deemed necessary to an understanding of the
effects of the transactions on the financial statements
3. The dollar amounts of transactions for each of the periods for which
income statements are presented and the effects of any change
in the method of establishing the terms from that used in the
preceding period
4. Amounts due from or to related parties as of the date of each
balance sheet presented and, if not otherwise apparent, the
terms and manner of settlement.31
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\31\ Statement 57, paragraph 2.
---------------------------------------------------------------------------
In describing the basis for the Board's conclusions regarding those
requirements the Board stated:
The Board believes that an enterprise's financial statements
may not be complete without additional explanations of and
information about related party transactions and thus may not
be reliable. Completeness implies that ``. . . nothing material
is left out of the information that may be necessary to insure
that it validly represents the underlying events and
conditions.''
The Board also believes that relevant information is omitted
if disclosures about significant related party transactions
required by this Statement are not made. ``Completeness of
information also affects its relevance. Relevance of
information is adversely affected if a relevant piece of
information is omitted, even if the omission does not falsify
what is shown.'' [Footnote references omitted.] 32
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\32\ Statement 57, paragraphs 16 and 17.
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what is mark-to-market (``mtm'') accounting, and what are the
requirements for mtm accounting?
``Mark-to-market'' or ``MTM'' accounting describes an accounting
method whereby certain contracts (largely financial contracts but also
some nonfinancial contracts) and the changes in the value of those
contracts are reported at their fair value on the face of an entity's
financial statements. MTM accounting has long been used by broker-
dealers and traders of financial contracts, for both internal and
external reporting purposes, to provide transparent and relevant
information to management and investors about the economic results--
favorable and unfavorable--of the entity's trading activities. Those
entities utilize MTM accounting not only because it provides the most
relevant information, but also because other cost-based accounting
methods present difficulties that can result in opaque and potentially
misleading information about those activities.
Beginning nearly a decade ago, in an effort to further improve the
transparency of financial reports in the face of similar difficulties,
accounting standards gradually expanded MTM accounting beyond broker-
dealers and traders of financial contracts to entities that buy or sell
certain financial instruments and other contracts. Thus, MTM accounting
became required for certain debt and equity securities in
1994,33 energy trading contracts in 1999,34 and
certain derivative instruments in 2000.35
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\33\ See FASB Statement No. 115, Accounting for Certain Investments
in Debt and Equity Securities (May 1993).
\34\ See EITF Issue 98-10.
\35\ See Statement 133.
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MTM accounting is especially important in providing relevant and
transparent information about energy trading contracts and many
derivative instruments because the alternative often would be not to
account for the contracts at all during the period they are
outstanding. Because energy trading contracts and many derivative
instruments often are entered into at no net upfront cost (because they
create rights and obligations that are initially equal but opposite),
those contracts escape accounting recognition in a cost-based
accounting model until the contracts are transferred or closed.
One element of MTM accounting is computing a contract's fair value
and changes in fair value. The accounting requirements for determining
those amounts include the following:
Fair value of a financial instrument is the amount at which
the instrument could be exchanged in a current transaction
between willing parties, other than in a forced or liquidation
sale. If a quoted market price is available for an instrument,
the fair value to be disclosed for that instrument is . . .
that market price.36
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\36\ Statement 107, paragraph 5.
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Quoted market prices, if available, are the best evidence of
the fair value of financial instruments. If quoted market
prices are not available, management's best estimate of fair
value may be based on the quoted market price of a financial
instrument with similar characteristics or on valuation
techniques (for example, the present value of estimated future
cash flows using a discount rate commensurate with the risks
involved, options pricing models, or matrix pricing
models).37
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\37\ Statement 107, paragraph 11. The Board has an active agenda
project to determine whether the requirements in Statement 107 should
be improved. The Board plans to issue a proposal to replace Statement
107 in the first quarter of 2003. In addition, the EITF is in the
process of codifying additional interpretative guidance about the
accounting for energy trading contracts, including guidance for
measuring the fair value of those contracts and providing disclosures
about the presentation of the gains and losses on those contracts. See
EITF Issue No. 02-3, ``Accounting for Contracts Involved in Energy
Trading and Risk Management Activities.''
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Chief Accountant Herdman in his recent testimony before Congress
stated:
I don't believe that there's any evidence to indicate that
Mark-to-Market accounting has led to misleading information to
investors. The broker/dealers in this country have used Mark-
to-Market accounting . . . to account for their activities for
many, many, many years. And they have sophisticated financial
instruments that aren't quoted on exchanges that need to be
accounted for at market value. And so estimates need to be made
of value in order to accomplish the mark-to-market
process.38
---------------------------------------------------------------------------
\38\ Transcript of hearing, page 22.
---------------------------------------------------------------------------
He also added, ``We haven't seen any indication that Mark-to-Market
accounting has caused problems . . . for any . . . companies within the
energy industry.'' 39
---------------------------------------------------------------------------
\39\ Transcript of hearing, page 22.
---------------------------------------------------------------------------
Finally, in commenting on the existing MTM accounting requirements,
Chief Accountant Herdman stated, ``I think the principles of Mark-to-
Market accounting are quite clear in the accounting literature that
exists today, and the circumstances under which it should be done.''
40
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\40\ Transcript of hearing, page 22.
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did enron's financial statements comply with existing accounting
requirements?
Enron publicly acknowledged in its November 8, 2001, Form 8-K and
November 19, 2001, Form 10-Q filings with the SEC that it had failed to
comply with existing accounting requirements in at least two areas.
First, Enron indicated that with respect to four SPEs that it created
during the year 2000, it issued Enron common stock to the SPEs in
exchange for notes receivable from the SPEs. At the time, Enron
reported an increase in assets and shareholder's equity to reflect
those transactions. Longstanding accounting requirements, however,
provide that notes receivable arising from transactions involving an
entity's own capital stock are generally required to be reported as
deductions from stockholders' equity and not as assets.41
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\41\ See EITF Issue No. 85-1, ``Classifying Notes Received for
Capital,'' and SEC Staff Accounting Bulletin No. 40, Topic 4-E,
``Receivables from Sale of Stock.''
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As a result of this error, Enron indicated that it had overstated
both total assets and shareholders' equity in its financial statements
for the second and third quarters of 2000, and its annual financial
statements for 2000, by $172 million. It also indicated that it had
overstated both total assets and shareholders' equity in its financial
statements for the first and second quarters of 2001 by $1.0 billion.
Second, Enron indicated that the assets, liabilities, gains, and
losses of three previously unconsolidated SPEs should have been
included in Enron's financial statements under existing accounting
requirements (see above discussion, ``What Is an SPE, and What Are the
Accounting Requirements for SPEs?''). As a result of that error, Enron
indicated that it had overstated reported net income by approximately
$96 million in 1997, $113 million in 1998, $250 million in 1999, and
$132 million in 2000. It also indicated that it had understated net
income by $17 million and $5 million in the first and second quarters
of 2001, respectively, and overstated net income by $17 million in the
third quarter of 2001. Finally, Enron indicated that as a result of
this error, it also had understated debt (or liabilities) by
approximately $711 million in 1997, $561 million in 1998, $685 million
in 1999, and $628 million in 2000.
In commenting on Enron's restatements in recent testimony before
Congress, former SEC Chief Accountant Lynn Turner stated:
New accounting rules were not needed to prevent the
restatements of Enron's financial statements or improve the
quality of some of its disclosures. Compliance with and
enforcement of the accounting rules that have been on the books
for years would have given investors a timely and more
transparent picture of the trouble the company was
in.42
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\42\ Written statement by Lynn Turner in testimony before the
Committee on Governmental Affairs, United States Senate, page 3
(January 24, 2002).
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More recently, a committee of three outside members of Enron's
board of directors filed a public report (``Powers Report'') that
stated that its investigation ``identified significant problems beyond
those Enron has already disclosed.'' 43
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\43\ William C. Powers, Jr., Chair, Raymond S. Troubh, and Herbert
S. Winokur, Jr., Report of Investigation by the Special Investigative
Committee of the Board of Directors of Enron Corp., page 3 (February 1,
2002).
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Those further problems included entering into transactions that
Enron
could not, or would not, do with unrelated commercial entities.
Many of the more significant transactions apparently were
designed to accomplish favorable financial statement results,
not to achieve bona fide economic objectives or to transfer
risk. Some transactions were designed so that, had they
followed applicable accounting rules, Enron could have kept
assets and liabilities (especially debt) off its balance sheet;
but the transactions did not follow those rules.44
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\44\ Powers Report, page 4.
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The Powers Report suggests that ``other transactions'' resulted in
``Enron reporting earnings from the third quarter of 2000 through the
third quarter of 2001 that were almost $1 billion higher than should
have been reported.'' 45
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\45\ Powers Report, page 4.
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The Powers Report also states that Enron's disclosures about its
transactions with the partnerships were ``obtuse, did not convey the
essence of the transactions completely or clearly, and failed to convey
the substance of what was going on between Enron and the
parternships.'' 46
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\46\ Powers Report, page 17.
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conclusion
The FASB is responsible for establishing and improving financial
accounting and reporting standards that ensure that financial reports
provide transparent information to investors and other consumers.
I want to assure you, Mr. Chairman, Ranking Member Towns, and all
the Members of the Subcommittee, and all investors and other consumers
that participate in the US capital markets, that consistent with the
FASB's mission and due process, the Board is prepared and committed to
proceed expeditiously to resolve any and all financial accounting and
reporting issues that may arise as a result of Enron's bankruptcy.
The Board already has active projects under way in over a half-
dozen areas that will propose significant improvements to existing
requirements in the areas of:
Accounting for consolidations, including consolidations of
SPEs
Determining the fair values of financial instruments
Disclosing fair values and changes in fair values of financial
instruments, and
Distinguishing liability instruments from equity instruments
and accounting for complex instruments with both debt and
equity components.
The Board also is cognizant that some, including SEC Chairman
Harvey L. Pitt, have raised concerns about the speed of our standard-
setting activities. As described above, we have begun pursuing a number
of projects and activities to improve our efficiency and effectiveness
without jeopardizing the openness and thoroughness of our due process
that are essential to maintaining high-quality accounting standards.
The FASB and the accounting standards we issue, however, cannot
alone sustain the transparency necessary to maintain the vibrancy of
our capital markets. Other market participants also must carry out
their responsibilities in the public interest. Those participants
include officers and directors of reporting entities, auditors, and
regulators.
Officers and directors of reporting entities that seek to access
the capital markets to finance their needs are responsible for
preparing their financial statements and presenting those statements to
investors and other consumers. They must apply the accounting standards
in a way that is faithful not only to the language of the requirements,
but to the requirements' clear intent. Seeking loopholes to find ways
around the language or intent of the standards obfuscates reporting and
harms investors and other consumers by creating information that is not
transparent and that is not a true reflection of the economics of the
underlying transactions.
Auditors are required to examine a reporting entity's application
of accounting standards to determine that the requirements have been
fairly applied. They too must ensure that not only the language, but
the stated intent, of the standards are followed, and not accept facile
arguments by a reporting entity's management that the financial
statements are acceptable just because the language of the standards
does not explicitly prohibit an inventive reporting technique or
methodology that is intended to hide information from unsuspecting
consumers. Auditors' primary responsibility is to the investing public
who do not have the benefits of the same level of access as auditors do
to the underlying facts about an entity's operations and transactions.
Finally, regulators, principally the SEC, also have an important
role to play. The SEC's responsibility is investor protection. Through
its oversight and enforcement activities it must also seek to ensure
that reporting entities provide information consistent with the
language and intent of the relevant standards. The SEC must also ensure
that auditors, in accordance with accepted auditing standards, have
properly and thoroughly examined and certified the reporting entity's
information.
If anything positive results from the Enron bankruptcy, it may be
that this highly publicized investor and employee tragedy serves as an
indelible reminder to all of us, including reporting entities,
auditors, and regulators, that transparent financial accounting and
reporting do matter and that the lack of transparency imposes
significant costs on all who participate in the US capital markets.
Conversely, providing transparent financial information the markets
need to operate efficiently benefits not only those who use the
information but also the entities who provide it. The Royal Swedish
Academy of Sciences recognized the importance of adequate transparent
information to markets in awarding the 2001 Nobel Prize for Economics
to three Americans for their pioneering contributions to the theory of
how markets work when buyers and sellers have differing amounts of
information.47
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\47\ The Royal Swedish Academy of Sciences, ``The Prize in Economic
Sciences 2001,'' press release (October 10, 2001).
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The work describes why market participants may overdiscount for the
effects of uncertainty if they do not trust the information available
to them. The result is that items traded in that market, whether it is
the market for stock in entities or the market for used cars, are not
efficiently priced. In essence, providing transparent, credible
information lowers the risk premium charged by market participants.
Thank you, Mr. Chairman. I very much appreciate this opportunity
and would be pleased to respond to any questions.
Mr. Stearns. I thank the gentleman.
Mr. Castellano.
STATEMENT OF JAMES G. CASTELLANO
Mr. Castellano. Thank you, Chairman Stearns, Ranking Member
Towns and other distinguished members of the subcommittee, for
inviting me to testify before you today. I am Jim Castellano,
elected Chairman of the Board of The American Institute of
Certified Public Accountants, the AICPA. I live in St. Louis,
Missouri. I am the managing partner of a local CPA firm in St.
Louis--Ruben, Brown, Gorenstein and Company. I welcome this
opportunity to appear before you today on behalf of the AICPA's
340,000 members in public practice, in industry and academia,
and government. I, too, have submitted written testimony that I
ask be included in the record of today's hearing.
Events of the past few months are deeply disturbing to the
accounting profession. What happened at Enron is a tragedy on
many levels, and this is a difficult time for us and all those
involved with the financial reporting process.
We are proud of our profession. We take seriously our
public responsibility, and we are committed to doing our part
to restore confidence in the financial reporting system.
No one has all the facts about the Enron failure, and
jumping to conclusions prematurely disserves everyone,
including investors. But the accounting profession wants to
make one thing perfectly clear, and that is that our profession
has zero tolerance for those who break the rules.
The accounting profession is actively engaged on a number
of fronts. Some are new initiatives, and many more are an
acceleration of initiatives that have been underway.
Since the Enron collapse, we have come forward to embrace
some reform proposals that we previously opposed, such as some
scope of service restrictions for auditors of public companies,
and we are supporting the SEC's initiative to move from self-
regulation to public regulation, from public oversight to
public participation, a move that is unprecedented in the 100-
year history of our profession.
The United States General Accounting Office, in its 1996
study of the profession, concluded that the actions taken by
the profession in response to the major issues raised from the
many studies from 1972 through 1995 show that the profession
has been responsive in making changes to improve financial
reporting and auditing of public companies, but we cannot rest
on the past.
There are a number of additional reforms that need to be
enacted. These include revising current accounting rules for
special purpose entities such as those used by Enron to deter
accounting abuses; requiring additional disclosures in company
filings with the SEC including management's discussion and
analysis, MD&A; requiring reporting on a company's internal
control system to evaluate its effectiveness in making that
report available to investors; requiring auditors to take
additional steps to search for fraud; requiring nonfinancial
information to supplement the historical financial statement;
increasing the frequency of financial reporting, and making it
illegal for anyone in the company to lie to an auditor or
withhold material information.
We also stand ready to provide additional assurances over
management's discussion and analysis. In June 2001, we
introduced a new audit level service to examine management's
discussion and analysis, so we hope that more audit committees
and board members will avail themselves of this added
assurance.
The focus of auditing must change as well. Auditors will be
reporting on information systems. They will be focusing heavily
on preventive controls and providing assurance that information
systems are operating effectively and sufficiently to produce
reliable information.
This transition is going to require that the accounting
profession attracts the most talented professionals to serve
the public interest. But there will still be pitfalls even in
this scenario. There is the threat of management overriding the
systems and preparing fraudulent and untruthful disclosures.
That is why our profession, even before these recent Enron
events, has been working on improving auditing standards and
guidance to auditors to help them better detect fraud.
An exposure draft of a new board standard intended to
elicit public comments will be issued by this month's end, with
the final standard issued later this year. In addition to these
changes, we are also reviewing the adequacy of all auditing
standards regarding all issues emanating from Enron.
Now to the reporting model. No reporting model will protect
investors from greed and bad judgment. However, an improved
reporting model will provide every investor with better quality
information and increase the likelihood of better investment
decisions. We need more information, timely disclosures and
plain English.
Reporting models should also address off-balance-sheet
activity, liquidity issues, other risks and uncertainties,
forward-looking information, nonfinancial performance
indicators, unreported intangibles, and other information.
To modernize the model, we must focus on three things.
First, a broader bandwidth of information; second, different
distribution channels, namely, the Internet; and, third,
increased reporting frequency, ultimately, we can see in the
future leading to on-line, real-time reporting. The profession
has been working actively on additional reforms, and they are
outlined in my written testimony. We, too, look forward to
working with Congress, the SEC, and the FASB to develop
meaningful reforms in these areas, and we are open to other
areas of inquiry. This is a debate that is long overdue and one
that we welcome.
In conclusion, Congress and others should carefully
consider these reforms. They are essential to restoring
investor confidence in the financial reporting system, and I
can assure you that the CPA profession wants, as I know you do,
to assure that this future comes about to the benefit of
shareholders, consumers and, indeed, all American citizens.
Again, I thank you for the opportunity to address this
important issue with you today.
[The prepared statement of James G. Castellano follows:]
Prepared Statement of James G. Castellano, Chair, American Institute of
Certified Public Accountants
Thank you, Chairman Stearns, Ranking Minority Member Towns and
other distinguished members of the committee for permitting me to
testify today on the adequacy of current accounting standards. I am Jim
Castellano, Chairman of the Board of the American Institute of
Certified Public Accountants. Corporate accountability is of great
importance to the continued strength of the American economy and
confidence in our capital markets. In order for our capital markets to
function effectively and for our economy to allocate resources
efficiently, it is essential that business enterprises report
accurately and fairly to investors and that investors perceive that
they do so. Our economy needs both the fact and appearance of credible
financial reporting.
The business collapse of Enron last year has shaken the faith of
America, and of the world, in our financial markets. The personal
tragedy to Enron's employees, retirees, and investors goes far beyond
the dollars and jobs they have lost. And this tragedy occurred despite
the fact that we have the freest, most open, transparent, and dynamic
financial market in the world. The accounting profession has also been
deeply disturbed by what has occurred. We are proud of our history of
serving the public interest by providing assurance to the investors
that the financial statements of public companies fairly present, in
all material respects, the financial position of these companies'.
The Enron business failure has added additional pressures on our
economy and raised questions concerning confidence in our capital
markets. Legitimate questions are being asked about corporate ethics
and governance, including the role of a company's board of directors
and its audit and finance committees, internal controls, compliance
with accounting and audit standards and other SEC reporting
requirements, financial reporting transparency, the adequacy of the
current financial reporting model, the auditor disciplinary and quality
review process, how analysts use available financial information in
making buy/sell recommendations to investors, and other issues.
While no one has all the facts and relevant information about the
failure, it appears to be the result of many contributing factors, all
of which need to be addressed to restore investor confidence in the
system. Our profession has zero tolerance for those who do not adhere
to the rules. The AICPA and its members are committed to the goal of
assuring that investors and creditors have the highest quality of
financial information. We will take the necessary steps to restore
public confidence in the accounting profession and capital market
system, and will work with Congress to develop meaningful public policy
reform.
My goal today will be to touch on some of the reforms we have
supported and will continue to support for the accounting and auditing
system, and to suggest additional reforms which we as CPAs believe will
strengthen the financial reporting system.
Capital should be deployed where it can be most productive. At the
root of productive capital investment is the availability of timely,
reliable and meaningful information. The success of our capital markets
depends upon informative, reliable financial reporting--often referred
to as ``transparency.'' Three critical conditions must exist for
investor information reporting to be meaningful. There must be:
1. Adequate reporting standards that provide full transparency of all
meaningful and relevant information to investors;
2. Compliance with those reporting standards, including appropriate
auditing;
3. Timely access to, and sufficient user understanding of, the
information available.
adequacy of current accounting standards and reporting system
The current accounting model has historically performed well. But
to work for today's economy, it must be modernized. Economic change has
moved much more swiftly than accounting for such changes has adapted.
Intellectual capital has become the greatest engine for corporate
growth. Yet, accounting is still based on hard assets--physical plant
and related items for producing goods. Many companies, like those in
advertising, produce revenues based almost exclusively from knowledge
work. Knowledge work has become the key to all companies'
effectiveness. Even companies producing tangible goods have become
highly dependent on intangible sources of revenues and competitive
advantage.
Changes in business prospects have made quarterly reports outdated.
Timely information has always been prized, but the pace of change in
corporate dynamics and earnings capabilities has made it much more
important. Corporate diversification, alliances of all sorts, the rate
and depth of economic change, and transnational relationships have
enormously changed the risks facing modern corporations. The relative
absence of up-to-date information with which to assess corporate
earning capacity coupled with the pace of change, helps explain the
volatility of today's share prices. Meanwhile, the use of the Internet
for economic communications has been exploding. Real-time disclosure of
selected financial information--that is, information that can be useful
to investors without creating competitive disadvantage to companies--on
the Internet is clearly foreseeable. Investors need more frequent
corporate financial and non-financial disclosures (i.e. on-line, real-
time) to make informed investment decisions.
The accounting profession was first among those convinced the
accounting model needed to be modernized. From 1991-1994, a special
committee of the American Institute of Certified Public Accountants
(AICPA) studied the state of business reporting.1 The
committee's greatest achievement was its research on the needs of
investors and creditors. The research showed that investors have many
unmet information needs. This evidence was new because investors and
creditors do not actively make their information needs known to the
accounting community.
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\1\ AICPA Special Committee on Financial Reporting, Improving
Business Reporting--A Customer Focus, 1994.
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The findings on information needs should have been a loud wake-up
call to those who depend on the disclosure system or have
responsibility for it. Investors and creditors are, figuratively
speaking, the customers of financial reporting. More precisely, because
corporations seek capital from investors and creditors, investors and
creditors are customers of the corporation's sale of securities.
Monetary exchanges do not take place without information, and the
better the information about a prospective purchase, the better the
purchaser's chance to make a satisfactory pricing assessment. Putting
the same point in terms of investors' purchases of securities, the
better the information they have the lower the risk of poor investment
or credit decisions.
The report concluded that investors' needs were not being fully
met. It described needs that go far beyond what is required by the
current financial reporting model. In fact, to capture the idea of
reporting non-financial information, the report adopted the broader
term ``business reporting.'' The report contained an illustrated,
comprehensive model of business reporting designed by the Special
Committee, as well.
Business reporting is wider than financial statements. It should
include non-financial information and presentations outside the
financial statements. The Special Committee's business reporting model
was not limited to financial statements, although it at all times
includes them, in recognition of their importance to investors and
creditors. The ``accounting model'' has in the past referred only to
financial statements, but in the future it will refer as well to
business reporting to investors and creditors.
It is very disappointing that the report was produced seven years
ago and so little has been done in response. If investors' needs were
not being met seven years ago, they are likely being met even less
today. Calls for reform have come from many different sources,
including nonaccountants. They include former SEC Commissioner Steven
M. H. Wallman, economist Robert E. Litan, and Yale School of Management
dean and former Under Secretary of Commerce for International Trade
Jeffrey E. Garten. Wallman has written on his own and with Margaret
Blair as part of a Brookings Institution project on intangibles. Litan
joined Peter Wallison in a project for the AEI-Brookings Joint Center
for Regulatory Studies.
Garten recommended that companies be given incentives to provide
more information on intangible assets and performance metrics, in a
report by a group commissioned by the SEC. Economists recognize the
importance of intellectual capital as a source of economic growth,
which means a source of revenue. For example, Brad DeLong wrote,
``Economic development has become less and less about accumulating more
and more physical capital and more and more about the creation and
deployment of intellectual capital.'' 2 A 1996 United States
General Accounting Office report said: ``[T]he current reporting model
does not provide information about important business assets. As a
result, historical cost-based financial statements are not fully
meeting users' needs.'' 3
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\2\A Framework for Understanding Our New Economy, part of a joint
project with Stephen Cohen and John Zysman, http://
econ161.berkeley.edu/OpEd/virtual/technet--outline.html.
\3\ GAO, The Accounting Profession: Major Issues: Progress and
Concerns, GAO/AIMD-96-98, September 1996,p.16.
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In the broadest sense, if we are going to modernize the accounting
model, we must focus on these things:
First, a broader ``bandwidth'' of information, such as was
endorsed by the AICPA's Special Committee;
Second, different distribution channels, namely, the Internet;
And third, increased reporting frequency, ultimately, on-line,
real-time reporting.
The root problem is the mismatch between widespread agreement that
users' information needs are not being met and the lack of consensus on
how best to meet those needs. Efforts to modernize business reporting
must be accelerated, but where should they start?
Reform should address unreported intangibles, off balance sheet
activity, non-financial performance indicators, forward-looking
information, enterprise opportunity and risk, and more timely
reporting. These could become time-consuming projects. However, we
support the following list of near term reforms.
near term reforms:
The FASB should issue standards-level guidance on the location,
form, and content of non-financial information that would supplement
the historical financial statements. In particular, the FASB should
address non-financial performance indicators, unrecorded intangible
assets, and forward-looking information. The FASB should determine
whether such supplementary reporting should be required, based on
experience with voluntary reporting or any other relevant factors it
chooses to bring to bear.
As part of the its standards-level guidance, the FASB should make
explicit that for purposes of its mandate, disclosures that supplement
the financial statements can be desirable to meet users' needs, even if
the disclosures go beyond what some believe is necessary to understand
the financial statements. The broader criterion of information useful
for making investment and credit decisions should apply. In addition,
in the same guidance, the Board should make more explicit the tension
between the desirability of comparability and of relevance in business
reporting, making clear that users' needs can at times be satisfied
best by relevant information that is not comparable across a population
of companies.4
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\4\ Statement of Financial Reporting Concepts No. 2, Qualitative
Characteristics of Accounting Information (FASB 1980), states:
``Improving comparability may destroy or weaken relevance or
reliability if, to secure comparability between two measures, one of
them has to be obtained by a method yielding less relevant or less
reliable information'' (par. 116).
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The FASB, working with the SEC, should begin a project to consider
revising the frequency of reporting based upon the needs of users
utilizing the capabilities of modern accounting software and
telecommunications.
The accounting profession stands ready to sponsor projects to help
the FASB and the SEC complete the projects recommended above in the
shortest reasonable timeframe.
These recommendations to the FASB are compatible with its adoption
of its project on intangibles.5 The project would establish
standards for disclosures about intangible assets not recognized as
assets in the financial statements. The proposed project follows the
publication of a study by the FASB staff which identified four possible
intangibles projects.6 We strongly support the FASB's
adoption of the proposed agenda item. Although the project will entail
some difficult subjects, it should be put on a fast track.
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\5\ Available at the FASB's website: http://www.fasb.org.
\6\ Wayne Upton, Business and Financial Reporting, Challenges from
the New Economy (April 2001). Available at the FASB's website:
www.fasb.org. Upton's potential projects were as follows: ``Address''
the format and content of non-financial metrics, in notes or elsewhere
(5 issues are set out, including whether standard setters should
develop a standard format); the format and content of disclosure about
recognized and unrecognized intangible assets; recognition of
intangible assets created as the result of a ``project'' effort (e.g.,
R&D); and recognition and measurement of embedded intangibles and
service obligations (e.g., a bank's core-deposit intangible and an
insurer's claim-handling obligation). The list is in Appendix A,
pp.111-113, of the website version.
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other reforms
Support for reform should not be limited to standard setters,
regulators, and those whose oversight can take on formal qualities. All
interested parties--including but not limited to the accounting
profession, the investment community, registrants, creditors, and the
financial industry--should be actively and constructively engaged. They
should be united by the common goal of improving the national welfare
by empowering investors with better information and thereby spurring
growth-creating capital allocation.
For example, we recommend reforms in the following areas:
off balance sheet disclosures:
We encourage FASB to reprioritize its project agenda and move
quickly on its consolidation project to address off-balance sheet
disclosure transparency issues. Existing accounting rules for special
purpose entities should be reviewed for possible accounting abuses and
new types of financing vehicles.
reports on effectiveness of internal controls:
In the near term, company management should be required to make an
analysis and assertion as to the effectiveness of the company's
internal control apparatus. The auditor should be required to attest to
and report separately on the effectiveness of the management assertion.
Management and auditor's reports on internal controls could make a
positive and cost effective contribution to the assurance system and
will improve investor confidence in the integrity and reliability of
financial statements issued by those who access the capital market. In
the wake of the savings and loan collapse, congress placed similar
requirements on depository institutions and their auditors.
disclosures by company management:
Stock Options: The FASB working with the SEC should require
expanded disclosure of stock options received by the company
management.
Insider Trading: Currently, company insiders do not have to
disclose stock sales on the open market until the month after the
transaction at the earliest. We believe it would make more sense to
require disclosure of the intent to sell shares PRIOR to the
transaction. In addition to the SEC, all other interested parties such
as employees, shareholders, retirees, and pension fund managers should
be notified.
Other Disclosures: We encourage the SEC to initiate additional
rulemaking action to enhance disclosures in public company filings
related to other management disclosure issues. The AICPA recently
endorsed a petition to the SEC calling for more disclosure in a
company's proxy statement about a company's liquidity, off-balance
sheet entities, related party transactions and hedging contracts.
We are encouraged by the SEC's desire to make rapid progress on
business-reporting reform and its desire to achieve timely and more
informative filings that can help better inform investors without harm
to the SEC's investor-protection mission. It should consider carefully
the relevant recommendations of the ABA Committee on Federal Regulation
of Securities 7 and revisit the proposals made in 1996 by
the SEC's own Advisory Committee on the Capital Formation and
Regulatory Processes. The Congress should support these efforts.
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\7\ A letter with relevant proposals, in the context of reforming
the regulatory regime under the 1993 Securities Act, was sent to the
SEC Division of Corporation Finance on August 22, 2001. See
www.abanet.org/buslaw/fedsec/comments.html.
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management discussion and analysis of operations:
As auditors, we also stand ready to provide additional assurances
over management's discussion and analysis (``MD&A''). Our
responsibility, under a traditional audit, is to read the MD&A and
consider whether such information is materially inconsistent with the
financial information presented in the audited financial statements. We
are not required to render a report on our findings; rather we are only
required to inform management of our findings if we believe the
information is materially inconsistent. Because as a profession we
believed that audit committees and boards of directors may want
additional assurances relative to MD&A, we introduced, in June 2001, a
new audit level service to examine the MD&A. This service, which is
separate from our traditional audit, examines MD&A for the purpose of
expressing an opinion as to whether:
a) The presentation includes, in all material respects, the required
elements of the rules and regulations adopted by the SEC.
b) The historical financial amounts have been accurately derived, in
all material respects, from the entity's financial statements.
c) The underlying information, determinations, estimates, and
assumptions of the entity provide a reasonable basis for the
disclosures contained therein.
While the demand for this additional voluntary examination has been
slow to develop, we hope that more audit committees and board members
will avail themselves of this added assurance.
auditor responsiblity:
We also need new audit strategies and technologies. In an ideal
world, companies would be producing the new disclosures with the
desired frequency over the Internet; auditors would be providing
contemporaneous assurance that the information was reliable; investors
would benefit from better decision making information; productive
corporations would benefit from a lower cost of capital; and the
economy would be growing with more stability and promise, even than
now.
To accomplish this result, not only must the reporting model change
but also the focus of auditing must change. Steps toward this new
direction have already begun. Auditors in this new world would be
reporting on information systems. They would be focusing heavily on
preventive controls and providing assurance that information systems
were operating effectively and sufficiently to produce reliable
information. The transition is also going to demand personnel of the
highest caliber. But there will still be pitfalls even in this
scenario. While new disclosures could be produced, and the auditors
could provide assurance over the systems producing the disclosures,
there is still the threat of management overriding the systems and
preparing fraudulent and untruthful disclosures. That is why our
profession, even before these recent Enron events, has been working on
improving auditing standards and guidance to help auditors better
detect fraud. Two of the more noted proposed changes, among others, are
explicit procedures addressing the risk of management override of
controls and required procedures to evaluate the business rationale for
significant unusual transactions. A draft of this new standard,
intended to elicit public comments, will be issued by month's end with
the expectation of issuing a final standard by the end of the year.
In addition to these changes, we are also looking at the following
reforms:
We are reviewing the adequacy of professional auditing standards
regarding all issues emanating from Enron, including audit procedures
from related party transactions, special purpose entities, hedging
contracts, internal controls established by the finance or audit
committees, and working paper and record retention, and others. We will
work with the SEC, FASB and Members of Congress on these
recommendations.
We believe it should be illegal to lie to your auditor in the same
way for example, that it is a illegal to lie to a prosecutor. We would
support legislation or regulations that would accomplish that.
Public Participation:
The AICPA, is committed to working diligently with Congress and the
SEC to develop a new regulatory model that improves and goes beyond the
current self-regulatory processes. While the current self-regulatory
model provides for significant public oversight over the existing peer
review process, there is no public oversight over discipline. This new
model would affect all firms doing SEC audits. We will diligently work
to improve the profession's peer review and disciplinary process as it
relates to auditors of SEC registrants. We strongly support moving from
public oversight to public participation and increasing the
transparency, effectiveness, and timeliness of the process. We will
work with the Congress and the SEC to strengthen regulation of the
profession as they implement a system that incorporates active public
participation to enhance discipline and quality monitoring.
Non-Audit Services
We will not oppose prohibitions on auditors of public companies
from providing financial systems design and implementation and internal
audit outsourcing. We believe such prohibitions will help to restore
the public's confidence in the financial reporting system.
Preparing For the Future Now:
But there is another way of viewing this scenario. The disclosures
could be produced, and auditors could find themselves inadequately
prepared to provide assurance to investors about the information's
reliability. The transition to new reporting and auditing models is
going to demand not only new audit approaches but personnel of the
highest caliber. With this in mind, the profession has been working
actively in the following areas:
Continuous Auditing. Continuous auditing or continuous assurance
involves reporting on short time frames and can pertain to either
reporting on the effectiveness of a system producing data or more
frequent reporting on the data itself. An AICPA task force has
concluded that the enabling technologies, if not the tools, required to
provide continuous assurance services, are, for the most part,
currently available. Their actual implementation will evolve with
progressive adoption of the concept and the emergence of appropriate
specialized software tools. Work is needed, however, to better
understand the market potential for continuous assurance. A clearer
insight is needed into both users' needs as well as decision-makers'
perceptions of the value of this service. A marketing study of user
needs would help assess the types of key performance indicators, system
reliability issues, and financial and non-financial information that
would benefit users. Depending on corporate platforms and established
monitoring processes used for other purposes the costs of providing
continuous auditing or assurance will vary. Therefore, further research
is also needed to better understand how the potential purchasers of
these services, such as management, boards and institutional investors,
perceive the value of continuous assurance relative to the current
model of periodic assurance.
XBRL. XBRL (or Extensible Business Reporting Language) is a freely
available internet-based language for business reporting. It is a
framework that provides the business community a standards based method
to prepare, publish, reliably extract and automatically exchange
business reports of companies and the information they contain.
Whatever new reporting standards are considered appropriate, it is
likely to be richer in disclosure than what we have today and will need
XBRL to facilitate.
SysTrust. SysTrust is an assurance level service that independently
verifies the reliability of a particular system (including a financial
reporting system) against a framework of standards that address
security, availability and integrity. Providing a freely available
benchmark for what makes a system reliable, SysTrust is designed to
provide assurance to boards of directors, corporate management, and
investors that the systems that support a business or a particular
activity are reliable.
Performance Measures and Value Measurement. The Value Measurement
and Reporting Collaborative (VMRC) is the culmination of years of
discussion about the need to change the reporting model. Numerous
reports, white papers and books have cited the need for better
information to be disclosed by publicly traded companies, not merely
more information. Over the past year, the AICPA has been approached by
a number of organizations that claim to have the solution to the need
for better disclosure. While some companies are already taking steps to
report information that investors want, currently these efforts are
isolated and may not be comparable between companies. Rather than work
with one organization, the AICPA and the Canadian Institute of
Chartered Accountants are establishing the VMRC as a means to allow the
various stakeholders to work together to determine the best methodology
for reporting. Current suggestions include, but are not limited to,
reporting of non-financial measures, intangible assets or a combined
discounted cash flow and risk analyses. Specifically, the collaborative
will:
Understand the needs of the user community/stakeholder groups;
Determine what is currently taking place in the field;
Undertake an in-depth review of 7 or 8 alternative approaches
to value measurement and reporting;
Further, this new framework, which will work in conjunction with
the current model, will move the current reporting forward not in an
incremental step, but in the revolutionary change that is needed today.
Student Recruitment. The AICPA has embarked on a new student
marketing and recruitment plan, designed to attract more students--and
the best students--to the accounting profession. This five-year, $25
million initiative is targeted toward late high school and college
students, and is interactive in its approach, using web-based business
simulations and games, college TV networks and other technology-based
techniques to reach this important generation of young people. The
campaign will help students understand the important role that CPAs
play in all facets of the business world, and the important
responsibilities CPAs have in helping businesses and individuals
succeed.
In conclusion, I maintain that Congress and others should carefully
consider these reforms as they are essential to restore investor
confidence in the financial reporting system. I can assure you that the
CPA profession wants, as I know you do, to assure that this future
comes about for the benefit of shareholders, consumers, and indeed, all
American citizens.
Thank you for this opportunity to express our views.
Mr. Stearns. I thank the witnesses of the first panel. I
will start with questions. The accounting profession has been
looked at as something that is arcane and difficult to
understand, but I think Mr. Bass, from New Hampshire, sort of
summarized the whole process, that ``cash is fact and
everything else is opinion,'' and we have a major corporation,
of course, that imploded with a collapse and a bankruptcy, and
we read in the paper there are other corporations that are now
questioning their accountants, they are questioning their
procedures, and even down to Krispy Kreme now. I saw in
yesterday's Washington Post there was some question about how
they are putting assets to hide the amount of debt they have.
So, whether it is Tyco or Global Crossing or Enron, you have a
host of these companies out there.
The purpose of our hearing today is to try and tell the
American people and our colleagues to come up with answers so
that investors feel confident in the market, there is
transparency.
So, the first basic question is, we talk about GAAP, which
is generally accepted accounting principles, so let me just ask
yes or no, going from left to right, Mr. Herdman, did Enron
practice GAAP?
Mr. Herdman. Chairman Stearns, they have announced that in
a couple of instances they needed to restate their financial
statements. Beyond that, because of the pendency of our
investigation, I can't comment.
Mr. Stearns. Okay.
Mr. Jenkins. As I testified, Enron and the board committee
have both acknowledged that they did not follow GAAP.
Mr. Stearns. Okay. We have Enron that said they did not
follow the generally accepted accounting principles, is that
true, Mr. Castellano? Do you agree with that?
Mr. Castellano. Chairman Stearns, they have reported that
in their filings to the SEC, that is correct.
Mr. Stearns. Okay. So, Mr. Herdman, I don't think that that
is a secret, it is public knowledge, you should acknowledge it,
too, that they didn't do it. I mean, on-line investigation is
good, but they have said it publicly, so I think we are at that
point.
So, the next question is, they didn't follow it, but there
are a lot of other corporations that say they are doing it, and
yet investors can't find the transparency and confidence. Do we
need, based upon the modern technological innovation that we
are seeing in today's market, do we need to change the
generally accepted accounting principles? Just start left to
right, yes or no?
Mr. Herdman. We need to continue to improve them.
Mr. Stearns. Do they need to be revised and modernized, or
can we just continue the way we are going with the GAAP
accounting principles?
Mr. Herdman. We need to have accounting principles that are
responsive to developments in the marketplace and have
accounting principles today to be responsive to the questions
about consolidation of SPEs. We need better accounting
principles with respect to the very important issue of revenue
recognition. I believe, Mr. Chairman, what I am describing is a
system of continuing to improve rather than just throwing out
the entire system.
Mr. Stearns. Do you think we need major change, or just on
the edges?
Mr. Herdman. We need a variety of change. Not only do we
need to continue to change the underlying principles
themselves, we need to find ways--and we at the SEC are working
very hard on projects to accomplish--ways to make financial
statements more understandable to ordinary investors. Financial
statements today are very complex because businesses are very
complex, transactions are very complex. But we need to find a
way through plain English disclosure, through some type of
condensation of disclosure, while not taking away anything that
exists today, to find methods whereby ordinary investors can
indeed read financial statements.
Mr. Stearns. So, you are saying we probably need some major
reform.
Mr. Herdman. Yes, we do.
Mr. Stearns. Mr. Jenkins?
Mr. Jenkins. As I testified, we have six initiatives
underway right now that I think are needed to improve financial
reporting and will. I would put them in the area of continuous
change and improvement. Certainly, the accounting for special
purpose entities has been an issue that has been on our agenda,
as I said, for far too long, and we need to address that and,
as I also said, we are addressing it expeditiously, and we
expect to have a completed standard in that area by the end of
the year.
Mr. Stearns. Okay. Mr. Jenkins, you are saying this morning
we do need to make major changes, and you have these along the
way.
Mr. Jenkins. But I put them in the area of continuous
improvement. I don't want to throw the baby out with the
bathwater. I think our basic model is sound.
Mr. Stearns. Okay. Mr. Castellano?
Mr. Castellano. I would concur that the basic model is
sound and that we do need continuous improvement, but I would
take a step further, and that is that we need to look well into
the future and envision a broader business reporting model that
would include more disclosure about nonfinancial performance
indicators, for example. I know the FASB has done research on
this. I encourage them to continue to pursue the results of
that research, and work toward additional disclosures that will
help investors make decisions about whether companies are worth
investing in for the future.
Mr. Stearns. Mr. Castellano, here there are two areas that
I am looking at--one, GAAP, but then oversight, trust to
verify. And we are at the point--are we at the point like we
were in 1934 when we established the Securities and Exchange
Commission, where we need to do something truly new to give
confidence to investors, and what should that be.
We have a corporation that has to comply with the SEC. We
have the American Institute for Certified Public Accountants,
yourself, and the arm of that, as I understand it, was the
Public Oversight Commission, and all these three in some ways
failed to find Enron. I think that is true.
And so a lot of us are trying to say, what is a better
structure? Now, the SEC has come out with the idea they think
the Public Oversight Commission should be abolished, isn't that
true, Mr. Herdman?
Mr. Herdman. Yes, it is.
Mr. Stearns. Explain to us what you want to replace that
with. You did it in your opening statement, but is this going
to be appointed by Members of Congress, appointed by you, or
the American Institute of Certified Public Accountants? Tell us
what this new structure is that you think will make sure we
don't have anymore Enrons?
Mr. Herdman. Mr. Chairman, what we have decided on is a
framework whereby the current system of self-regulation of the
accounting profession would be replaced by a system that would
no longer be under the auspices of the AICPA. It would be
composed of a board of people who would be nominated by members
representing the public rather than members representing the
profession. It would replace the current system of peer review
with a more vibrant and more frequent system of quality control
review, and it would have real disciplinary power to proceed
against accountants that have violated either ethical or
competency requirements.
As to the details of how that will all be implemented, we
are still in the process of fleshing that out. We have
announced that we are going to seek input from all
constituencies including Congress, before proceeding to a
rulemaking. We are going to be doing that partially through
some round tables that are in the process of being scheduled.
After we get our input, we are going to determine the
particulars of a rule proposal which would go out for public
comment and final implementation.
Mr. Stearns. Okay. My time is expired, and we do have a
vote, but I think we have some more time so Mr. Towns is
recognized for his questions.
Mr. Towns. Thank you, Mr. Chairman. This Committee actually
promoted pay equity for the SEC. The President recently signed
this bill into law. However, no additional funds were included
for the SEC in the President's budget. If the SEC's funding is
not enhanced, then why should we expect that a new accounting
oversight board would have the resources to properly do its
job? If we put a board in place without additional resources,
what have we really accomplished? Mr. Herdman.
Mr. Herdman. Congressman Towns, you raise two very
important points. We at the Commission very much look forward
to--we applaud Congress' passing the pay parity legislation. We
applaud the President signing it. And we certainly hope that it
gets funded promptly.
The funding for the new regulatory board would not
necessarily come from the SEC. In fact, the way we have
discussed it is coming from the public sector broadly, not just
the accounting profession definitely, but from the public
sector more broadly.
Mr. Towns. Well, I am a little concerned because I don't
want you to get involved in fundraising and not doing your job.
I mean, that is my concern.
And let me just say also, Mr. Jenkins, that is the
complaint we get about you and your agency, the fact that you
are so involved in fundraising that sometimes your other
responsibilities sort of all through the cracks.
Let Mr. Herdman respond first, and then I will come to you.
Mr. Herdman. And I think I erred in my comment, it is not
the public sector, it is the private sector more broadly.
In terms of fundraising, you are entirely correct that a
credible and consistent and reliable system of funding these
oversight activities needs to be developed just as it has been
developed with respect to the FASB, and it needs to be money
that is there year in and year out to fund the important
activities of these boards.
Mr. Towns. Now, let me say that the reason I am pushing
this issue is because it was also stated that the annual report
of all Fortune 500 companies, that you also review them. I am
just trying to see where you are going to get the resources to
do that, that is my concern.
Mr. Herdman. We have the resources to review the financial
statements of the Fortune 500 companies. That project is
beginning, and while that necessarily takes away from other
activities, we believe that it is an appropriate deployment of
our resources to review those financial statements.
Mr. Towns. I sure hope you can, but you have got to
convince me on that because you have more people than IRS in
order to do what you are saying. You would have to have as
many.
Mr. Herdman. As Chairman Pitt indicated in his testimony
last week, the Commission is undertaking a review of the
sufficiency of its resources. When it makes a determination as
to whether resources are sufficient, it will communicate that
to Congress. If it makes a determination that we need more
resources, we will certainly be up here asking you for the
money to provide those additional resources.
Mr. Towns. Mr. Jenkins?
Mr. Jenkins. Yes, thank you, Congressman Towns. The FASB
board members, the people who set the rules, we are prohibited
by our enabling legislation, by our enabling contracts, we are
prohibited from fundraising. The fundraising takes place by an
independent, largely public interest Board of Trustees that is
over the FASB itself. And that accounting foundation does three
things--it selects the board members, it raises the money, and
it makes sure that our due process is open and complete.
On the contrary, it is prohibited, again by our enabling
documents, it is prohibited--the Trustees are--from getting
involved in technical accounting standard matters.
So, we have divorced fundraising from standard-setting in
our projects. So the Board members spend no time, nor do our
staff spend any time, on fundraising.
Mr. Towns. Thank you very much. I yield back, Mr. Chairman.
Mr. Stearns. The gentleman yields back. I think we will
take a break here while we have a vote, and we will be back
shortly. A few members will be back immediately, so we will be
able to continue.
The subcommittee will stand in recess.
[Brief recess.]
Mr. Stearns. The Committee will come to order. I think in
the absence of a Republican member, Ms. DeGette, why don't you
start.
Ms. DeGette. Thank you, Mr. Chairman. Mr. Castellano, in
your testimony, you said that your organization was now willing
to consider scope of services restrictions. What exactly did
you mean by that?
Mr. Castellano. Congresswoman, what we have said is that
the accounting profession, the American Institute of CPAs, will
not oppose restrictions on auditors of public companies
performing internal audit outsourcing services or financial
systems implementation and design services for their publicly
held clients.
Ms. DeGette. And previously you had opposed such
restrictions. Why was that?
Mr. Castellano. This change in----
Ms. DeGette. Why did you oppose it previously?
Mr. Castellano. Because we don't believe even now in not
opposing those restrictions today. We don't believe that there
is an inherent conflict in auditors performing nonaudit
services for their clients, that there are safeguards that must
be followed within our code of ethics today, and if those
safeguards are followed, the auditor's judgment would not be
impaired.
Ms. DeGette. Well, in your opinion, Mr. Castellano, were
those safeguards followed in Arthur Andersen's representation
of Enron?
Mr. Castellano. I don't know the details of Arthur
Andersen's relationship with Enron.
Ms. DeGette. So, if you still think that there are
safeguards, why have you shifted your position that you are now
not opposing such restrictions? Is it a political decision?
Mr. Castellano. No, not political. Thank you for the
question.
Ms. DeGette. You are welcome.
Mr. Castellano. We recognize that public perception is a
critical element in restoring public confidence to the capital
market system and in our profession, and that because of the
debate that has gone on about this issue of those two services
going back to the prior SEC administration's rulemaking
initiative in this matter, that has raised the public's
interest, the public's sensitivity to those. We recognize that.
We know that we need to move on beyond this.
Ms. DeGette. So what you are saying is you don't think
there is a problem, but you are shifting your position because
of public perception that there is a problem, correct?
Mr. Castellano. Because it appears now that the public
believes there is a conflict in the appearance of independence
of those two services.
Ms. DeGette. But you don't think there is, right?
Mr. Castellano. We don't think, with appropriate safeguards
as required by our code of ethics today----
Ms. DeGette. You think that the safeguards are in place
now, right?
Mr. Castellano. I do believe that the safeguards are in
place now and they must be followed under our code of ethics.
Ms. DeGette. Thanks. Mr. Jenkins, I wanted to ask you a
question about FASB because a couple of weeks ago, the
Oversight and Investigations Subcommittee had a hearing on
Arthur Andersen's destruction of documents, and what we found
when we looked at Arthur Andersen's client engagement
information with Enron, which is a long document, what we found
is that while Arthur Andersen said Mr. Duncan willy nilly
destroyed documents, in fact, Arthur Andersen's own client
engagement said that the auditor is required to destroy at the
end of every engagement, all documents, all work documents
except for the final work product, and that only in the
instance where someone is served with a subpoena, either civil
or criminal summons, is document destruction to cease. Is that
consistent with FASB policy?
Mr. Jenkins. The FASB has no responsibility or authority
over that particular issue. That issue does not impact
financial reporting. That is an auditing issue. Auditing is
under the purview of the AICPA through the Auditing Standards
Board, as enforced by the SEC. We don't have anything to do in
that area.
Ms. DeGette. That is what I thought, so let me ask Mr.
Castellano, is that kind of policy allowed under your
organization's standards?
Mr. Castellano. I think to a certain extent, it is a legal
issue, but we do have standards, auditing standards, covering
documentation that, in general, require that the auditor
maintain sufficient and adequate documentation to support the
procedures that were performed and the level of review that was
conducted on the procedure.
Ms. DeGette. Okay. Let me read you this policy and see if
you think it is standard in the--let me ask you, how long have
you been involved in the industry?
Mr. Castellano. I have been a CPA for about 28 years.
Ms. DeGette. About 28 years. What Arthur Andersen's policy
says is, ``Drafts and preliminary versions of memos and
reports, superseded workpapers, backup diskettes, and other
types of information not in the central client engagement file
should be destroyed when they are no longer useful to the
engagement, and no later than when the engagement is
completed.'' Is that standard practice in the industry?
Mr. Castellano. That practice is not governed by our
auditing standards.
Ms. DeGette. Okay. Who governs that?
Mr. Castellano. I think that is really a legal issue as to
what documentation must be retained.
Ms. DeGette. Is there some organization that would govern
what papers are destroyed by auditors, if you don't do it and
Mr. Jenkins' organization doesn't do it? Mr. Herdman, does your
organization cover that?
Mr. Herdman. No.
Ms. DeGette. Who regulates that?
Mr. Castellano. As I said, there is an audit standard that
requires documentation of the matters that I mentioned. Those
matters do not include, I don't believe, the items that you
mentioned.
Ms. DeGette. I gotcha. Who is in charge of regulating what
documents auditors keep or destroy? Does anybody regulate that?
Mr. Castellano. I don't believe so.
Ms. DeGette. Thank you.
Mr. Stearns. I thank the gentlelady. The gentleman from
Nebraska is recognized for questions.
Mr. Terry. Thank you, Mr. Chairman. I have two questions.
My first, Mr. Jenkins, if you could help me. I need to tie down
the cause-and-effect to make sure that the policy that we
embrace here can actually help fix the problem and instill the
confidence back into the capital markets and investors, so help
me.
On page 23 of your testimony, you note--here is the way I
am going to frame your question--that in 1997, Enron
indicated--in 1997 it had overstated its income, net income, by
$96 million, and then every year that was compounded to some
extent, but yet it wasn't until 2001, mid to late 2001, that
anyone became aware of these problems.
So, as a layman, help me understand which of your
suggestions for changes that transparency in a variety of areas
will help shine the light as quickly as possible. Through the
changes that you suggest, would somebody have caught in 1997
that Enron had overstated its net income by $96 million? Why
did it take 5 years?
Mr. Jenkins. We don't know why Enron didn't follow
generally accepted accounting principles in 1997 and other
years, apparently. We don't know what caused them to do that.
What do know from the public record is that they didn't
follow now existing generally accepted accounting principles.
So, we wouldn't need to make any changes apparently in our
existing requirements in order to have had that result in 1997
had Enron followed our rules. What we are trying to do is to
further improve those rules for the future.
Mr. Terry. But that doesn't answer the question. What
policy--what can we adopt if there is a company like Enron or
Global Crossing who wants to manipulate the system? How do we
catch that? If this started in 1997, what policy can you
suggest to us that in that same year that this type of
shenanigans is undertaken, that it can be discovered?
Mr. Jenkins. Well, again, I am not trying to avoid your
question at all, on the contrary. But until we know why they
didn't follow the rules, it is a little hard to address how we
might correct it.
Mr. Terry. Well, let us just say they did want to and we
will make that assumption and go forward. They were
intentionally being deceptive perhaps.
Mr. Jenkins. Then it seems to me that it gets over to a
question of the responsibilities of top management, the
responsibilities of the audit committee, the responsibilities
of the auditors, and that that is accepting at face value that
Enron said they didn't follow, as they stated in 2001, they
didn't follow existing standards, I think that is where that
trail has to lead.
Mr. Terry. All right. Then, Mr. Castellano, then maybe your
suggestion that we somehow criminalize lying to your auditor as
a solution, explain how that will work, and then I want to come
back to Mr. Herdman and ask if that is appropriate, to
criminalize providing false information to your auditor. In
fact, isn't it already--aren't there already laws in place? In
essence, what you are trying to do is deceive your shareholder
and using your auditor as the conduit in which to deceive.
So, Mr. Castellano, if you would expand on why we should
criminalize and if you think it will be effective, and then,
Mr. Herdman, if you could follow up and answer the same
questions.
Mr. Castellano. Well, let me first say that as I said in my
oral testimony that I don't believe any changes in the
reporting model are going to protect investors from greed and
bad judgment. I mean, that starts with the entity itself. They
have to have the right tone at the top, and the right system of
corporate governance from the Board of Directors, the Audit
Committee, the senior investors in the company. That is where
it starts.
Auditors need protection along the lines that I described,
so that those who may be so inclined to withhold material
information from an auditor, is that a violation of securities
law? I don't know, I am not an attorney. Lying to an auditor,
is that a violation of securities law? I don't know. Perhaps we
need clarification. We are raising the issue because we think
this net of scrutiny here, that it is appropriately being cast,
needs to be cast far and wide, and all need to do a very
thorough self-review.
Mr. Herdman. Under Section 13 of the 1934 Act, lying to the
auditor is already forbidden. And I believe I have the
citation--correct me--under Section 20(c) of that Act, we
believe that through the operation of that section it would be
a criminal violation of the law.
Mr. Terry. Thank you, Mr. Chairman.
Mr. Stearns. Thank the gentleman. The gentleman from
Illinois, Mr. Rush.
Mr. Rush. Thank you, Mr. Chairman. I want to thank the
chairman, and I also want to thank the witnesses for being
present this morning.
Mr. Herdman, the SEC has the primary responsibility for
enforcing FASB's accounting standards. That is correct, is that
right?
Mr. Herdman. The SEC has the primary responsibility for
oversight of the entire disclosure system.
Mr. Rush. Well, I want to return to Mr. Towns' line of
questioning. Until the capital markets relief act is fully
funded, the SEC would find it hard to retain and attract high
quality staff as well as meet its current staggering workloads.
Now, how does the SEC intend to return investor confidence if
it is unable to provide pay parity for the very people
responsible for protecting those investors? How can SEC fulfill
its responsibility to the American public if you have a
disparity and you lack pay parity among your employees?
Mr. Herdman. Congressman, as I said earlier, we believe
that the pay parity issue is very important to the Commission's
ability to attract and retain the high caliber people necessary
to fulfill our role. However, if we don't get it, I would have
to say we will just have to continue to muddle through as we
have in the past.
Mr. Rush. What type of initiatives are you approaching in
terms of trying to get the money to pay your people a decent
wage over there?
Mr. Herdman. I am sure that our Chairman is doing
everything that he can with respect to that.
Mr. Rush. Let me ask you, can you describe what your agency
did to ensure the Enron and others were or are following the
accounting principles regarding SPEs and mark-to-market
accounting?
Mr. Herdman. I believe this Committee is aware of the fact
that we did review Enron's financial statements for its year
ended December 31, 1997, and included in that review process we
took a look at their quarterly reports that had been filed up
through March 1999.
Mr. Rush. So you haven't looked at them since 1997, is that
what you are saying?
Mr. Herdman. We haven't looked at any annual financial
statements since 1997.
Mr. Rush. What is the reason for that?
Mr. Herdman. Well, I think the Commission staff, in its
review of filings, uses what is referred to as a ``selective''
process for picking which filings will be reviewed, with the
goal of reviewing each company's filings no less frequently
than once every 3 years. As I understand it, when Enron's turn
came up for review earlier in 2001, which was prior to my
return to the Commission, Congressman, it was decided to wait
to conduct that review in 2002 because of the fact that our new
accounting rules went into place in early 2001 concerning
derivative financial instruments. It was known that Enron
engaged in a lot of derivative financial instruments, and it
was felt--and it was a very principal decision--that it would
be more productive to review Enron in 2002 when the financial
statements for the first time then would reflect these new
accounting requirements.
Mr. Rush. So your decision was based primarily on the fact
that there were new requirements that you were enforcing, and
it wasn't based on any kind of funding issues, just primarily
based on changes in terms of your procedures?
Mr. Herdman. That is my understanding, yes.
Mr. Rush. Okay. So, in other words, you have reviewed
corporate accounting work products as it relates to your
regulations for other corporations since 1997, is that correct?
Mr. Herdman. Yes, we have.
Mr. Rush. Have you found any accounting irregularities
similar to the ones at Enron pervasive throughout the economy,
or should this committee--is there a red flag that should be
waved as relates to other corporations in terms of their
accounting procedures at other corporations?
Mr. Herdman. We have, in our review process, found
instances where we disagreed with a company's interpretation of
the accounting rules or other requirements, and have required
restatement or amendment to filings with respect to that. I am
not familiar with any situations----
Mr. Rush. Does the SEC view the accounting climate in terms
of corporate America as being a situation of crises at this
point?
Mr. Herdman. I wouldn't say, Congressman, we see it as a
crisis. I don't know of any other Enron-type situations that
are out there, but we certainly are not going to just hope that
that is the case. We initiated just yesterday announcements
about new rulemaking activities that we are entering into. That
is just the start of our activities with respect to it. In the
wake of Enron, everything is on the table. There is nothing
that is off the table. We are fundamentally relooking at all of
our requirements in order to make sure that investors are
adequately protected.
Mr. Rush. Mr. Herdman, my view of the SEC--and maybe it is
correct or maybe it is not correct--but I certainly would like
the SEC be a lean, mean, fighting machine as it relates to
protecting the investors and the investors' interest in this
country, and I certainly think that we all must do all that we
can to ensure that the employees that we have to count on to
protect our investing public, that those employees are paid
adequately so that they will be able to do their job and so
that we will be able to retain those employees.
With that, Mr. Chairman, I yield back the balance of my
time.
Mr. Stearns. The gentleman yields back.
Mr. Towns. Mr. Chairman, may I ask a question?
Mr. Stearns. Sure.
Mr. Towns. Are you going to have another round?
Mr. Stearns. I think we will have another short round. The
gentleman from Illinois, Mr. Shimkus. Excuse me, Mr. Shimkus,I
am sorry. Mr. Buyer.
Mr. Buyer. Thank you, Mr. Chairman. King Solomon said long
ago that there is nothing new under the sun. And so I took a
little look at history here. To be a good listener to all of
you--and it is not just about you and how you react to this, it
is different institutions will react to something. Immediately,
you circle the wagons. You begin your introspection. You
examine yourself. Sometimes you are hard on yourself, sometimes
you are not. Sometimes you say--and I will use your quote--
``our basic model is sound,'' which means you like yourself,
but you are willing to do a self-examination. You throw out
some recommendations. But, you know, you have been here before.
So, as I was looking and reading about the Treadway
Commission, I look at this and say, well, what we are all
having to deal with is confidence in the markets, the integrity
of your systems, you are self-regulated in your profession as
CPAs. You are well respected in my hometown, and I would hate
to see anything erode that respect that the CPAs have in my
hometown.
So, when I looked at the milestone in shenanigan prevention
that the Treadway Commission did--see, all of you came together
back in 1985 to do this, and you financed it. You did it.
Government didn't do it. You said, ``If we are going to be
self-regulated out there, we are also going to lean forward,''
and there are oftentimes you get blown back on your heels, and
that is what has happened here, I think. You have been blown
back on your heels. And when I read the conclusions and
recommendations of the Treadway Commission, it almost sounds
like everything that is applicable to today.
And so when I went over here to the SEC, the SEC should
have the authority to impose fines in an administrative
proceeding, seek fines directly from court, authority to issue
cease and desist orders when securities laws are violated--it
goes on and on--criminal prosecution, fraudulent financial
reporting cases--why do fines become the exception and not the
rule? Why are you so hesitant? I don't understand.
If the academic community and all of you embraced the
Treadway Commission's findings, you get out there, you try to
teach the students, the academic curricula embraces it, and we
are trying to do the teaching, some things still failed. If we
try to set the proper tone for top management and directors,
some things failed. With regard to independent public
accounting and auditors having responsibility for the detection
of fraudulent financial reports, some things failed.
So, I almost have to pause here, gentlemen, and I want to
have a constructive dialog with you. If you lean forward to
prevent shenanigans--and King Solomon is right, you know, we
can set the rules in place, we can do everything we can, but
that is why we still have a criminal code. But I don't want to
lose sight of the ball here. The ball is making sure that that
marketplace--that there is integrity and there is confidence
out there, and that there is enforcement with teeth.
So, here is my ultimate question. Are we at a point where
instead of every entity out there saying ``circle the wagons,''
introspection, and then say, ``well, here are some
recommendations we have,'' and that Enron isn't the--don't cast
the Enron shadow on everyone, and that is sort of the fear in
the marketplace.
Are we at a time where perhaps all of you should come
together once again on Round 2 of your National Commission,
examining Treadway and--I mean, we have got to have a single
entity, you know what I am saying? Congress is out here. We are
doing all our hearings. Each of you are doing it. I don't want
government-fund a national commission that does this. Do we
need now a second sort of Treadway Commission that sort of
brings all this together, and that is what I throw on the
table. I welcome your comments.
Mr. Herdman. Congressman, I would say at this point that we
believe that that is the role that the SEC should be
fulfilling. We have started a number of initiatives. We have
asked the stock exchanges to once again consider the governance
provisions related to public companies, and they have set up a
committee that will start to do that. We have encouraged the
Financial Executives Institute to take a hard look at their
code of conduct and to reinforce it in the wake of recent
events. We are working with the FASB. We are working to re-
establish the regulation of the auditing profession. We last
week announced new protocols and agreements with the exchanges
and with the brokerage firms with respect to the analyst
community. We are working on a number of fronts, and believe
that we are covering all the bases and that everyone right now
is engaged, I believe, in very critical introspection with
respect to what needs to be done in the wake of these events,
and that is productive and that is appropriate.
Mr. Jenkins. The issue of the Treadway Commission which
really does, as Mr. Herdman suggested, relate to corporate
governance issues, is an important one. The tone at the top,
which I think is the basic theme of Treadway, I think is
essential and we, at the FASB, are going to try to issue
financial reporting standards that are more principle-based
rather than detailed rule-based in the hopes that we can do
away with the attitude of some in the corporate arena, and some
perhaps in the auditing arena, that apply the rules on the
basis of ``where does it say I can't do that'' rather than on
the basis of the clear intent of the rule and the clear
representation of the underlying economic events.
If we move in that direction, which we are being encouraged
strongly to do, and would like to do because I think it would
also expedite our process, then having the proper tone at the
top, to summarize in one phrase the Treadway report, will
become even more essential.
Mr. Castellano. The American Institute of CPAs is
absolutely committed to meaningful reform. The Treadway
Commission was sponsored by COSO, the Committee on Sponsoring
Organizations, which is a group that includes the American
Institute of CPAs, FEI, the American Accounting Association,
Institute of Management Accountants, and the Institute of
Internal Auditors. COSO still exists. COSO continues to work
and to meet. In fact, I understand there is a meeting February
19th where they are addressing enterprise risk management.
So, I would expect that through our participation and
support of COSO that we will continue to work toward meaningful
reform along the lines that you suggest, Congressman.
Mr. Buyer. Thank you, Mr. Chairman.
Mr. Stearns. Thank the gentleman. The gentleman from
Massachusetts, Mr. Markey.
Mr. Markey. Thank you, Mr. Chairman, very much. My brother
Johnny was a 1969 Magna Cum Laude graduate of Boston College,
majoring in finance. I said to my brother at the time, asking
wisdom from a 21-year-old, ``Why are you a finance major,
Johnny, why weren't you an accounting major?'' And he said,
``Well, Eddie, the finance majors play the game and the
accountants keep score. I want to play the game.'' Well, about
10 years later, the accountants said to themselves, ``Why don't
we play the game and keep score at the same time inside of
corporations.'' And, of course, that is the underlying
pathology here in the accounting industry, that they believe
that they could play both roles at the same time. You can't do
it. It is an inherent conflict of interest.
Now, we are having this hearing, Mr. Chairman, in the Armed
Services Committee room, and I look at this painting at the
back of the room, and I think it is symbolic of why we are here
because I see that painting characterizing investors trying to
fight their way out of a jungle of misleading documents and
fraudulent accounting statements, left to fight their own way
out without any help from the accounting industry or the
Securities and Exchange Commission in protecting their 401(k)
plans, protecting their investments for their families because
they weren't given the proper information, they were just
dropped into a jungle that was rough and tough but misled in
terms of how many protections were being given to them.
So the question now is, what are we going to do to protect
these people? Mr. Castellano, I understand that Chairman Pitt
was an attorney for the AICPA, for the accountants, and the Big
Five accounting firms prior to being appointed as the Chairman
of the Securities and Exchange Commission, now the public's
Number One protector against the accounting industry's abuses.
What were Mr. Pitt's duties for the accounting industry
when he was your attorney?
Mr. Castellano. Congressman, I wasn't involved at the time
Mr. Pitt was serving as attorney for the American Institute of
CPAs, so I can't specifically answer your question, but I will
be happy to get back to you with a response on that.
Mr. Markey. So you have no idea what he did for AICPA, is
that what you are telling us today?
Mr. Castellano. I don't know the details of what he did. I
know that he had worked at the time of the formation of the
Independent Standards Board, I believe, in some of the work in
the creation of the Independent Standards Board, but I don't
know the specifics of what his services were.
Mr. Markey. Well, how much did AICPA pay the new Chairman
of the Securities and Exchange Commission at the point at which
he was working for the accountants?
Mr. Castellano. I have no idea, Congressman, but we can get
that for you.
Mr. Markey. Did the AICPA, did the accountants recommend
Mr. Pitt to the White House when the White House was
considering who to appoint as the new head of the Securities
and Exchange Commission?
Mr. Castellano. I am not aware that the American Institute
of CPAs recommended Mr. Pitt to the White House.
Mr. Markey. So you are saying that you did not endorse his
candidacy?
Mr. Castellano. I am not aware that the AICPA recommended
the chairman----
Mr. Markey. Aha, so they did not recommend him.
Mr. Castellano. Not to my knowledge.
Mr. Markey. But you don't know that they didn't, is that
what you are saying?
Mr. Castellano. To my knowledge, we did not, but I--to my
knowledge, we did not. I believe I have answered.
Mr. Markey. So AICPA never wrote any letters to the White
House, or call anyone at the White House, or meet with anyone
at the White House to discuss Mr. Pitt's appointment?
Mr. Castellano. My advisor tells me that we did not, and we
were not consulted.
Mr. Markey. Okay. Now, how many times has the AICPA met
with Mr. Pitt since he has been at the Securities and Exchange
Commission?
Mr. Castellano. There have been a number of meetings, I
don't know how many. We have stated very clearly that we are
very interested in supporting the Commission's recommendations
to move from self-regulation to public regulation, from public
oversight to public participation in the areas of discipline in
what was formerly called ``peer'' review, but will probably
have another name under the SEC's new structure. So there have
been a number of meetings, I don't know how many, where we have
been asked to work with and support the Commission in their
proposal for moving from self-regulation to public regulation
of our profession.
Mr. Markey. Can you provide for the record each meeting
that you have had so far with the new Chairman of the
Securities and Exchange Commission?
Mr. Castellano. I believe we can, certainly.
Mr. Markey. Now, I understand that Mr. Paul Atkins and Ms.
Cynthia Glassman are also alumni of two large accounting firms,
and that they are both under consideration to become
Commissioners at the Securities and Exchange Commission, is
that correct?
Mr. Castellano. As I understand, that is correct, yes, sir.
Mr. Markey. So, if those two accountants, combined with Mr.
Pitt, are at the Securities and Exchange Commission, and there
are only five members, that would mean three out of the five
members of the Securities and Exchange Commission would then be
alumni of the accounting industry at the point at which there
is the greatest crisis in the history of the accounting
industry, would that be correct?
Mr. Castellano. Well, Mr. Pitt is not an alumni of the
accounting profession, but he has performed services, as you
said.
Mr. Markey. He was your lawyer.
Mr. Castellano. He has done work for the accounting
profession, but he has never been a practicing member of the
profession.
Mr. Markey. But he was the lawyer for your profession, for
the AICPA, was he not?
Mr. Castellano. Yes. I just want to be clear that in my
view, in my understanding, alumni means someone who is part of
the profession itself. I am not familiar with the background of
the other two Commissioners who have been recommended, although
I do understand that they do come from accounting firms in some
capacity.
Mr. Markey. Well, I guess what I am saying is, with your
former lawyer and two former accountants comprising three of
the five votes at the Securities and Exchange Commission, it
puts the accounting industry in the catbird seat.
May I continue for 1 additional minute, Mr. Chairman?
Mr. Stearns. Unanimous consent, so ordered.
Mr. Markey. Mr. Herdman, where did you work before you went
to the SEC?
Mr. Herdman. I worked at Ernst and Young.
Mr. Markey. Mr. Herdman, I have heard concerns raised that
one of the first acts taken by Chairman Pitt when he took
office was to remove the top accountant in the Corporation
Finance Division and announce to the Securities and Exchange
Commission that they would now have a ``kinder and gentler''
Securities and Exchange Commission that wouldn't force
companies to restate earnings.
I have also heard that the number of accounting slots at
the Corporation Finance Division is being slashed in the SEC's
budget request. How do you, as the Chief Accountant now at the
SEC, respond to those concerns?
Mr. Herdman. I respond that you have been misinformed. The
Chief Accountant of the Division of Corporation Finance
resigned that position. As to the question of whether the
number of accounting slots in the division has been cut, that
is not consistent with what I believe to be the case.
Mr. Markey. You are saying there is not going to be a
reduction in slots at the SEC Accounting Division?
Mr. Herdman. That is my understanding.
Mr. Markey. Will you submit that to the committee because
that is completely at-odds with what we are being told.
I think, Mr. Chairman, if I may, that there is a problem at
the Securities and Exchange Commission at this point in time.
When it comes to giving confidence to the capital formation
process in this country, that the reforms are going to be put
in place which are going to give to every ordinary family,
every investor, the real confidence that the numbers are real,
that there is some reason to trust the stock market.
Now, I know Mr. Pitt is saying that he is going to recuse
himself from any enforcement action against any particular
company or individual, but he is not going to recuse himself
from the rulemaking process in terms of putting on the books
for the next generation, the rules that are going to give every
family--and let us not kid ourselves, every single family that
was in mutual funds over the last 10 years probably had Enron
stock, or the stock of some of these other companies that had
phony numbers.
And so I think we have really got a huge question that we
have got to ask because we are not talking just about the
reality, we are also talking about the perception because
confidence is the key to investment in the stock market. And if
we don't have a public that believes that the people who have
this responsibility are independent enough from those who are
seeking to not put the toughest rules on the books to protect
the investor, then I am afraid that we might not see the
investment in the stock market in the next generation that will
create the jobs that will make our country as prosperous as it
should be.
Mr. Stearns. Thank the gentleman. The gentleman from New
Hampshire, Mr. Bass.
Mr. Bass. Thank you, Mr. Chairman. I have some reservations
about my friend from Massachusetts' very eloquent remarks.
Having accountants on the SEC certainly might be cause for
concern, but accounting is not a simple craft, and it might not
hurt to have people who understand the industry, understanding
that they have no ethical conflicts of interest, might not be a
bad way to deal with the question of where we go. After all,
President Eisenhower was the head of NATO and was an important
military officer in American history, and yet he did more to
cut and carve and make the U.S. military more efficient as
President, even though some thought he might have a conflict of
interest there.
A couple quick items. I think perhaps we should, in light
of what my friend has said prior to me, have a look at the
other picture on the wall over here. Perhaps there are some
issues that we can draw allusion to here. We have those
contrails up in the high atmosphere, the business community
moving forward, and the accounting industry not quite knowing
how to catch up with the businesses because the businesses have
so much more money than they do, and they are uncertain in this
day and age. There is a lot of interesting artwork in this room
that really does have some bearing on the hearing that we are
having this morning.
Mr. Markey. Can I say, I see that as Enron carpetbombing
the investors of their company all throughout the year 2001
without any----
Mr. Bass. Touche. Mr. Herdman, I heard you say something at
the end of I think it was Mr. Buyer's questioning, and you
said, ``There are no other Enron-type situations out there''--I
am quoting you now. Is that true?
Mr. Herdman. I believe I said, Congressman, that I am not
aware of any Enron-types of situations that are out there. I
certainly am not going to say that there are no other Enron
situations out there.
Mr. Bass. How do you define an Enron-type situation?
Mr. Herdman. Well, I would define it as a huge, huge
company that within a matter of months, a very short period of
time, goes from being a high-flier to being bankrupt.
Mr. Bass. And just one more time just to confirm it, you
are the Chief Accountant for the SEC, you are not aware of any
other Enron-type situation, as you defined it, out there?
Mr. Herdman. That is correct.
Mr. Bass. Thank you very much. What a difference a couple
of years makes. I wonder what the subject of this hearing, the
tone and tenor of this hearing might have been 2 years ago. As
I recall, the debate was quite different, how to state the real
value of dot.coms and so forth--we discussed this--but how it
has changed in the last couple of years. Third, I am surprised
at the disparity between the amount of resources that the
regulators have versus those which are available to the people
whom you regulate. I would guess, I will make this up, that the
top Fortune 500 companies probably spend about average--I will
be conservative--$10 million apiece on accounting each year. If
you add that up, it comes to about $100 million--no--$100
billion, and you guys have a budget of what, about $250 or $270
million?
Mr. Herdman. I believe it is just below $500 million.
Mr. Bass. So there is a discrepancy here. My friend, Mr.
Towns, and others on the committee need--I think we need to
examine that issue.
The last issue or open-end question I want to ask is, we
are not the only country that regulates accounting practices
and financial information. Are there any other models in any
other countries, industrialized countries around the world,
that we might look at as a guide to figure out what works
better and what doesn't work so well versus the system that we
have here in this country. Can any of the three of you address
that, do you have any knowledge?
Mr. Herdman. I think that it is safe to say that there is
no other country in the world that has anything that approaches
the SEC in terms of its oversight of the markets, oversight of
the preparer, the registrants and the auditors. It just doesn't
exist.
One thing that we are looking at is a fairly recent form of
regulation adopted in the United Kingdom with respect to
auditors, and we think that there are some valuable lessons to
be learned from that.
Mr. Bass. What are they?
Mr. Jenkins. There are a lot of different kinds of regimes
around the world. Up until quite recently, most of the regimes
that were involved with accounting and financial reporting were
directly a part of the government of those countries. But,
interestingly, the trend is significantly moving toward private
sector standard setting for the setting of accounting
standards--maybe not for the regulation of auditors or scope of
services or tax services. But for accounting standards setting,
for example, Germany has moved to a private sector standard
setter, Australia somewhat the same way, New Zealand, and other
Anglo-Saxon countries. In particular, Japan has recently
established a private sector accounting standards setter in an
effort to overcome their very significant capital market
issues.
Mr. Bass. Mr. Castellano, do you have anything to add?
Mr. Castellano. Just to say that the American Institute of
CPAs is a member of the International Federation of
Accountants, IFAC. We participate actively in that
international organization of accountancy organizations, and we
are looking at all different models to see if we can learn
something.
Mr. Bass. Mr. Chairman, my time is expired. I would like at
some point in the future if Mr. Herdman could tell us what
lessons we may have learned--the very last phrase of your
answer to the question--I would be interested in knowing that.
Mr. Stearns. Can you answer that question quickly?
Mr. Herdman. I think the predominant one concerns
regulation of the auditing profession, and that the oversight
body and the various committees that carry out the regulation
should be dominated by members representing the public interest
as opposed to those representing the profession.
Mr. Bass. Interesting. Thank you very much.
Mr. Stearns. I thank the gentleman. The gentleman from
Illinois, Mr. Shimkus, is recognized for questions.
Mr. Shimkus. Thank you, Mr. Chairman. I, too, as an Army
officer, really enjoy being in this room, although we are much
more constrained than if we had full access to our regular
committee room.
Bill Gates loses $1 billion in the tech crash--we call it--
``paper loss.'' Investors in Enron, who saw their portfolio
balloon from $15 a share to $90 over a 2-year period, and we
forget that a lot of that is what we cavalierly say is a
``paper loss.'' And I am really interested in this period of
time from January 2000 to January 2001 because we have a price
increase from approximately $37 a share to a high of $90 a
share, and then by the end of the year it is back to--well, at
the end of the year it is at $80 a share, and then because of a
lot of things it then falls off the chart.
Three things that I have been looking at--and I am not on
the Oversight Subcommittee, so I am not delving into all the
issues--but I want to know just three things, or just get some
help in educating myself.
First of all, I don't know how you could work in America
auditing major corporations and not be a member of a big
accounting firm, there are five. If you are in the business of
accounting large entities, you are a member or employed by one
of the major accounting firms, that is just a reality.
But three things--and we will just go Mr. Herdman, Mr.
Jenkins, Mr. Castellano--and maybe you can answer these, maybe
not, the problem of special purpose entities, a solution; the
problem of the employee stock option rollout issues, a possible
solution; the problem with performance statements--and you may
not think there is a problem with performance statements--a
possible solution.
Mr. Herdman. I am not sure I understood your third point,
Congressman.
Mr. Shimkus. Performance statements, you know, those
statements which some people would say is ``corporate spin'' to
explain their balance sheets and all the other hard data that
is out there. I have my MBA, but I will never say I--some
people will say it is credible, it helps. Some people say it is
spin. And it hides and deceives.
Mr. Herdman. I believe what you are referring to are
earnings press releases that present the results of operations
on an alternative basis, an alternative of GAAP sometimes known
as ``pro forma.''
Mr. Shimkus. Right.
Mr. Herdman. Fine. I will start with the SPEs. I think, as
I said earlier, we definitely need to have more comprehensive
rules about when SPEs should be consolidated with the
sponsoring entity, and we need to have those done very, very
quickly so that they are in place for year 2002 financial
reporting.
Mr. Jenkins. If you want to take each of these issues one
at a time, that is fine.
Mr. Shimkus. Yes, that would be great. Mr. Jenkins, why
don't you follow on.
Mr. Jenkins. Well, as I told this committee briefly earlier
this morning, we at the FASB have been working on providing
improved guidance with respect to special purpose entities.
Yesterday, at our public board meeting, we outlined and gained
approval from the Board of an approach that we think will
significantly improve that accounting, and our plan is to move
rapidly to meet the goal that Mr. Herdman described of existing
standards being in place by the end of this calendar year. And
to that end, we are going to develop the full--we are going to
develop a full document and have a public discussion of it on
the 27th of this month.
Mr. Shimkus. So you both agree it is a problem, and there
is movement to fix it. Mr. Castellano, on the special purpose
entities?
Mr. Castellano. Just to add to that, the AICPA in December,
I believe, asked that this issue arising from Enron be
addressed, and we are working with the FASB and absolutely
support them as a private sector standard setter to address
this issue, and we are delighted that it is being addressed. I
am sure that they will address the issue of better disclosures,
the risk and uncertainties involved in SPEs, and do so
expeditiously.
Mr. Shimkus. Mr. Chairman, since my time is up, maybe they
can--if you want me to finish the question, I can. If you want
them to submit in writing, I will be willing to do that.
Mr. Stearns. I think what we are going to do is have each
member go around and ask one quick question, just take a second
round here quickly, and see if we can get through it.
Mr. Shimkus. So, would you want them to submit the other
two answers in writing, that is my question.
Mr. Stearns. I think that would be a good idea.
Mr. Shimkus. If you would do that----
Mr. Jenkins. Could I ask just a point of clarification,
please. On the second issue, on employee----
Mr. Shimkus. I was basically referring to the employee
stock option standard--consolidation in accounting and the
standards that apply to employee stock options.
Mr. Jenkins. Employee stock options, not 401(k) plans.
Thank you.
Mr. Stearns. I think we are going to have a couple of votes
here. I think we will just each ask one quick question and
start the second panel.
The question I have for Mr. Herdman is, in your testimony
you suggested that if the FASB is not able to make progress on
important issues as they arise, the SEC should take action.
However, you also stated that FASB was better able to set
quality accounting standards than the SEC. How do you reconcile
those two statements?
Mr. Herdman. I think, Mr. Chairman, that the fact of the
matter is that FASB has more resources than we do. They are
better able to conduct research. They are better able to reach
out to various constituencies, and they have a lot more money.
But if there are situations where, because of their process,
because of delays, we find that an area desperately needs
attention and isn't receiving that attention, then we are going
to have to step up and do it.
Our solutions might often be more directed toward improved
disclosure as opposed to improved underlying accounting
principles because the SEC's expertise is much greater in the
area of disclosure and the rulemaking processes that surround
it.
Mr. Stearns. Just for the record, Mr. Herdman, how long
have you been with the SEC in your present position?
Mr. Herdman. About 4 months.
Mr. Stearns. Thank you. Mr. Towns?
Mr. Towns. Thank you, Mr. Chairman. Mr. Castellano, you
raised a question, or you made a statement that really, really
I would like for you to explain further. The statement was,
``The focus of auditors must now change.'' What do you really
mean by that? That statement bothered me.
Mr. Castellano. I am happy to clarify, Congressman. What I
was talking about is if we can look to the future, toward
financial reporting that will be more real-time, on-line
reporting, that our profession must be in position to provide
assurance to investors that the underlying systems providing
that information are reliable. That is what I am talking about,
that as financial reporting evolves from periodic reporting,
annual reports, quarterly reports, looking back at what
happened in the past, to a new model eventually that has more
forward-looking information, information about the real drivers
of future success in enterprises, our profession has to be
poised with audit approaches, audit standards to provide
assurance to investors that they can rely on that information
and that they can rely on the underlying system that is
providing it. That is what my point was.
Mr. Towns. So that would deal with documents as well?
Mr. Castellano. May deal with documents, but I foresee an
environment where auditors are expressing assurance on the
system that is providing the information. We have an assurance
service that we have invested a substantial amount of
intellectual capital to develop called ``SysTrust,'' which is
available today, that boards of directors and companies could
take advantage of to employ the accounting profession to
provide assurance that their underlying system is reliable,
available when needed, and maintainable. It is processes like
that that we as a profession are thinking about investing in,
so that when this business model evolves over time, we are
poised with a vibrant accounting profession to provide the kind
of assurance that investors will need.
Mr. Towns. Thank you. Thank you very much.
Mr. Stearns. Mr. Bass has indicated he is going to take a
pass. Ms. DeGette. What we are trying to do is just one
question before we have our vote.
Ms. DeGette. Thank you, Mr. Chairman. My question for all
three panelists is this. Last week, in our full committee
hearing, we heard a proposal which was endorsed by several of
our witnesses that outside auditors should be chosen on a
rotating basis, and one of our witnesses at least said that
they should be chosen on a rotating basis by the shareholders
of the corporation. Arthur Andersen made $52 million last year
from Enron, and slightly more from consulting and auditing, but
a lot from both.
So, my question to all three of you is, what do you think
about the proposal to have the outside auditors rotate and,
second, how do you feel about having them chosen by the
shareholders? If you agree, why, and if you disagree, why?
Mr. Herdman. Congresswoman, those are among the issues that
we will be considering as we go forward with respect to what
modifications to the independence rules are necessary. I have
no present opinion about them.
Ms. DeGette. Thank you.
Mr. Bass. If the gentlelady would yield, I was under the
impression that shareholders do select the outside auditors. Is
that true?
Mr. Herdman. Congressman, I believe it is generally a
matter of State law as to whether the shareholders are required
to elect the auditors, or are required to ratify the
appointment of the auditors by the board of directors.
Ms. DeGette. Reclaiming my time, what normally happens, at
least as I have been told, Mr. Bass, is that the auditing team
is selected by the management of the company, and sometimes
ratified by the shareholders, and that there is no requirement
that the auditors rotate.
Mr. Jenkins. That question is outside the purview of
financial reporting standards, so I don't have an opinion, as
the Chairman of the FASB.
Ms. DeGette. Mr. Castellano?
Mr. Castellano. On the issue of mandatory rotation of
auditors, I think, is what you are asking. My concern with that
really is impact on audit quality, and I think that is what we
all want, is to make sure that the quality of audits is the
best that it can possibly be. And this concept of rotating
auditors raises a question in my mind as to whether or not the
loss of experience with the entity--these businesses are
complex, as you know, they are incredibly complex--and----
Ms. DeGette. So I guess you are saying you don't agree with
the idea of rotating auditors?
Mr. Castellano. I think we have to very seriously and
carefully consider such far-ranging proposals like that so that
we don't have unintended consequences, which could include
actually a deterioration of audit quality. That would be my
concern.
Ms. DeGette. What about having the auditors chosen by the
shareholders, the second half of my question?
Mr. Castellano. I don't have an opinion about that.
Ms. DeGette. Mr. Chairman, let me just say--I know we are
about done with this panel--what I have heard is everybody
saying they are concerned about what happens, and they are
looking at it and they are thinking about it. I don't hear
anybody saying what they want to do about it, or when they are
going to figure it out. I think we need to get some answers
from the industry, so I would hope that the gentlemen would
take this very seriously, and I would hope, Mr. Chairman, you
would consider bringing these gentlemen back in a few months so
they can tell us what, if anything, they have decided to do.
Mr. Stearns. That is a good idea. And I would point out
also that five former Chairmen of the Securities and Exchange
Commission, when talking about the collapse of Enron, all
expressed the flaws in the present accounting system and
financial reporting system, and they say, all five of them, we
need major reform to restore investor confidence.
The gentleman from Massachusetts.
Mr. Markey. Thank you, Mr. Chairman, very much. Mr.
Castellano, in the 1995 Private Securities Litigation Act which
AICPA lobbied powerfully to pass, there was a provision which
limited the liability of the accounting industry, even if the
accounting company was also providing consulting services to a
particular outside firm like Enron, so that subsequent to 1995
defrauded investors and employees of Enron public companies
would not be able to receive from Arthur Andersen the same
level of damages that they would have before 1995.
Now, in light of what happened with Enron, Mr. Castellano,
my question to you is, would you support restoring liability
for accounting companies when they also provide consulting
services to a company, so that the full joint and several
liability would be available to defrauded investors, rather
than the much limited settlement which they can receive today?
Mr. Castellano. Congressman, I think the 1995 Act has
accomplished just what Congress intended. I think it is
working.
Mr. Markey. I am just talking about this one area where the
accounting firm is a consultant--they are playing the game and
keeping score at the same time inside of a firm--they are not
just the accounting firm, they are the accounting firm and the
advisor, simultaneously.
Mr. Castellano. There is a supposition that the accounting
firm's independence is impaired in that statement, and I think
that I don't agree that the accounting firm's independence is
always impaired----
Mr. Markey. I think that is the most troubling statement I
have heard in the whole hearing, that he does not believe that
when a firm is an accountant and a consultant at the same time,
that its independence is impaired, Mr. Chairman.
Mr. Castellano. I believe, as I have testified,
Congressman, that our code of ethics very clearly states that
accountants must be independent, and there are safeguards,
checks-and-balances in our code of ethics that we, as CPAs,
must comply with to protect our--to be sure that we are
independent. And that includes not acting in the capacity of
management, not being in position to audit our own work.
Auditors can't do that.
Mr. Markey. I think what we saw in this case, though, was
that the accountants were intimately involved in the Enron
process, and that it was impossible to separate out the
auditing from the consulting services, and it has just become
one huge kind of hot-tub in which the Enron employees and the
Arthur Andersen employees were working together constructing a
strategy for Enron, and yet Arthur Andersen is not liable in a
way that they would have been before 1995 and, as a result,
there is much more of an incentive for this new accounting
profession that wants to play the game as well as keeping score
to turn a blind eye to activities which then led to serious
damage to investors.
Mr. Castellano. Congressman, as I understand the law,
Arthur Andersen, should they be found liable, will be subject
to their proportionate share of the liability.
Mr. Markey. Right, proportionate, but not joint and
several. They were a part of the corporation. That is the
problem, see. You continue to maintain this distinction when
consulting services are provided. You can't say that when a
company is paid $25 million for consulting services, that they
are not inside the corporation creating a plan. That is not
just keeping score. And anyone who is making a plan for the
company has joint and several liability, with the exception now
of the accountants who are supposed to be protecting the
public.
So, you are saying you just will oppose any changes that
ensure that that protection is built-in for the investor?
Mr. Castellano. Let me say that I don't know what Arthur
Andersen was going at Enron. I don't believe that any of us
know quite yet. But to the issue of the 1995 Act, I just will
reiterate I believe it is accomplishing what was intended. The
number of suits, as I understand, have not declined, but those
that essentially have no merit are being dismissed, and those
that do are proceeding----
Mr. Markey. This is not a question of how many suits are
brought, it is a question of who is liable when a suit is
brought, and the accountants, Arthur Andersen, is not liable in
this case. Do you understand that? I mean, that is----
Mr. Castellano. But they are liable.
Mr. Markey. Not as a player. They are players. They are as
guilty in Enron in this case as the consultant, as the company
that helped put together the plan. They are not just keeping
score.
Mr. Stearns. Let me let the gentleman finish and just make
a comment. One, in your behalf, Mr. Castellano, do you realize
that the five top accounting firms have already voluntarily
decided that they are not going to--as we understand it--in the
newspaper, they have decided they are not going to do
consulting and accounting together. Is that true?
Mr. Castellano. Yes, Congressman, and I have said earlier
in my testimony that we do not oppose restrictions on auditors
of public companies from providing----
Mr. Stearns. You don't oppose, but five top accounting
firms thought it is not good and they are not going to do it,
which is in line with Mr. Markey's question, don't you think
that this is a conflict of interest?
Mr. Castellano. As I said before, those two services,
internal audit outsourcing and financial statements system
design and implementation, it is apparent that there is a
perception that when the auditor for a public company provides
those same services, there is a perception, the appearance of
independence is impaired and, for that reason, we don't oppose
those restrictions.
Mr. Stearns. Okay.
Mr. Markey. If I may, so you are saying the five big
companies are separating now consulting from auditing, but it
is only because of this perception, in your mind, that there is
a conflict? But in your mind, there is no conflict. You
continue to maintain there is no conflict, is that correct, Mr.
Castellano?
Mr. Castellano. I maintain that as long as the safeguards
are followed, that auditors exercise their professional
judgment and follow the safeguards, that there would be--there
should be no independence impairment in fact, but there is
apparent that there is a conflict in appearance in these two
services, and for that reason we don't oppose----
Mr. Stearns. Mr. Castellano, you can make the argument that
you should have a consultant and accountant together when you
are acquiring other property. If I am going out to acquire a
property and you are doing my books, I am going to need you to
help acquire that property. Also, if the IRS is coming in to
audit me and you are my accountant, I am going to need you as a
consultant, too.
So, I think your argument could be that there are areas
where it is not a conflict and in fact it is necessary--I don't
know all those are, those are just two I can think of, but
across-the-board, over a long period of time, is that a
problem, if you keep the same accountant in the position as
auditor and consultant for 10 years, don't you think somewhere
in that range there should be maybe a stop and we say at the
end of 3 years you have got to change auditors, or at the end
of five--don't you see that that kind of relationship over 10
years gets to create ``go along to get along?'' Am I off?
Mr. Castellano. Well, it shouldn't, and that is where audit
committees should be exercising their fiduciary responsibility
to the shareholders, to make sure that that doesn't happen,
Congressman. I think there are instances where----
Mr. Stearns. You need a consultant and an auditor.
Mr. Castellano. There are certain nonaudit services that
are deeply rooted in accounting. We just have to be cautious
about dismantling an entire structure that could create
unintended consequences, and that is my caution.
Mr. Stearns. Okay. Let me just also come to your defense a
little bit, Mr. Markey, he's talking about the Securities and
Exchange Reform Bill. What it did is you are still liable for
civil and criminal penalties, but you are only liable to the
effect that your accounting affected the loss. And what happens
is, a lot of these lawsuits were frivolous in the fact they
went to the deepest pockets. So, Mr. Markey and I will disagree
on the legislation's intent, but from my standpoint, you know,
you are still, from a civil and criminal standpoint, liable,
and you can be sued. And right now, suits are going against
Arthur Andersen as we speak, and there is a lot of them
building up. So, the bill didn't stop it, it just tried to say
the liability on these accounting firms should not go because
of the deepest pockets--they might be doing a small company--
but they are there to help the small company, and if they are
sued they will pay according to their losses.
So, I think this has been a helpful exchange.
Mr. Markey. If I may, Mr. Chairman, just to follow up on
what you were saying, I think what Mr. Castellano is telling us
is that from now on none of the big firms are going to provide
auditing and consulting services to the same company, and they
are just going to do that voluntarily.
Mr. Stearns. Mr. Castellano, is that true? I mean, that is
what I read in the paper. Is that true, to your understanding?
You should know more than I.
Mr. Castellano. Well, I believe all have reported that they
are divesting themselves of their formal consulting businesses,
but I believe their statements have been that they are no
longer going to provide internal audit outsourcing services nor
financial system design and implementation services for the
public company clients that they audit.
Mr. Markey. Does that mean that they won't be consultants
any longer?
Mr. Castellano. I don't know that that means that they
won't be consultants any longer.
Mr. Markey. So they still retain the right to become
consultants and auditors for the same company, is that correct?
Mr. Castellano. In certain instances, following the
safeguards that must be followed, I believe that is right.
Mr. Markey. There you go. So, if I may, you see, I am
willing--I think we are going to wind up--let me just say
this----
Mr. Stearns. We are going to complete this because you and
I have taken----
Mr. Markey. Can I tell you, there is kind of a first
principle of politics--always try to start out in the same
place you are going to wind up because it is prettier that way.
Now, the accounting industry is going to wind up where--what
this committee, I think, is all saying--the industry should
wind up, which is separating consulting from auditing. You are
saying, no, they are going to retain the right to do
consulting. And what I am saying to you is, the longer they do
that, the more pressure is going to be applied to the
accounting industry to then accept the liability for that, the
responsibility for that, because they are still playing the
game while they keep score, and the Enron investors and
employees are going to stand in silent, though loud, testimony
that that is not right. We have got, I think, a very serious
issue here that has been raised.
Mr. Stearns. And I encourage the gentleman, we are going to
have another hearing on this. With that, I would say to the
first panel, thank you very much, and appreciate your waiting
through our voting, and also I would say that all members can
submit their statements for the record as well as ask
questions, which the panel can answer.
Our second panel today is Grace Hinchman, Senior Vice
President of Public Affairs, Financial Executives
International; Mr. Thomas J. Linsmeier, Associate Professor of
Accounting and Information Systems, Eli Broad College of
Business, Michigan State University, and we were waiting for
Sarah Teslik, Executive Director of the Council of
Institutional Investors. We have called her numerous times this
morning. She indicated to us that she accepted our invitation.
She was to be here, and for some reason, we have not been able
to get to her and for some reason she has decided not to
testify this morning, and obviously we are disappointed, but we
would like to welcome the two of you and thank you for your
patience for waiting, and at this point we would like to have
your opening statements.
STATEMENTS OF GRACE L. HINCHMAN, SENIOR VICE PRESIDENT FOR
PUBLIC AFFAIRS, FINANCIAL EXECUTIVES INTERNATIONAL; AND THOMAS
J. LINSMEIER, ASSOCIATE PROFESSOR OF ACCOUNTING AND INFORMATION
SYSTEMS, ELI BROAD COLLEGE OF BUSINESS, MICHIGAN STATE
UNIVERSITY
Ms. Hinchman. Thank you, Mr. Chairman. Good morning, Mr.
Chairman, Mr. Towns, and members of the subcommittee. My name
is Grace Hinchman. I am Senior Vice President, Public Affairs,
of the Financial Executives International, the leading
professional association representing 15,000 CFOs, treasurers
and controllers from corporations around the world.
The subcommittee has identified three areas where it
believes deficiencies in the present financial reporting model
may exist. They are consolidation rules, particularly as they
relate to special purpose entities, mark-to-market accounting
practices, and related party transactions. I would like to
comment on two of those areas.
First, let me say that more consolidation does not
automatically yield better accounting. With the FASB
consolidation project, FEI has been recommending for some time
that FASB drop the control solution portion of this project and
focus instead on the area of limited purpose entities, which
includes the now infamous SPEs.
We made this recommendation not so much because we think
the existing rules are unclear, but because consolidation
without control is quite simply an oxymoron. While FEI has long
supported re-examination and rationalization of SPE
consolidation rules, it is not because of the cases like Enron,
rather, members of FEI would like to make sure that the
information being presented is meaningful because SPE assets
could threaten to introduce irrelevant information into the
financial statements.
Another area of concern I would like to mention is related
party transactions. The GAAP disclosure rules regarding such
arrangements are clear and have been in place for more than 20
years. In addition, the SEC's proxy rules require a very
thorough analysis to be presented to shareholders.
In looking at existing arrangements, FEI is unable to
suggest any meaningful improvements that would better protect
investors beyond those already recommended by the SEC in its
Financial Reporting Release 61.
There remains a more fundamental concern of accounting
standards and the challenges that face this subcommittee. The
broad body of literature that we call ``generally accepted
accounting principles'' has evolved into a puzzle palace of
complexity. The days of the onsite audit team being capable of
fielding the majority of accounting questions that arise at
corporations have long since passed, standards are so complex
today that finance executives, out of necessity, are moving
into a brave new world of accounting specialization.
One has to question whether anything of value, especially
accounting information, should become so complex that it defies
the ability of even the most diligent investor to understand. A
cry for relief was voiced last year by the finance community
and FASB heard the plea. They have embarked on a project that
will address accounting simplification, but FASB has its work
cut out for it.
As we begin this effort, we must be careful in the
identification of the root causes and distinguish the problems
that arise from fraud and misapplication of the rules from
those problems which arise from the rules themselves.
That concludes my prepared remarks. I would like to thank
the chairman for allowing FEI the opportunity to testify.
[The prepared statement of Grace L. Hinchman follows:]
Prepared Statement of Grace L. Hinchman, Senior Vice President-Public
Affairs, Financial Executives International
My name is Grace Hinchman. I am Senior Vice President, Public
Affairs of Financial Executives International (FEI). FEI is the leading
advocate for the views of corporate financial management, representing
15,000 CFOs, treasurers and controllers from companies throughout the
United States and Canada.
The Committee has identified three key areas where they believe
deficiencies in the present model may exist: consolidation rules,
particularly as it relates to Special Purpose Entities (SPE's), mark to
market accounting practices, and related party transactions. In FEI's
view, these are only symptoms, however, of the problems confronted by a
profession that is in crisis.
consolidation rules
FASB split its consolidation project into two parts this past year:
one dealing with the control situations and another dealing with
limited purpose entities, which includes SPE's as well as other, less
well-defined entities. For its part, FEI has been recommending that the
first approach be dropped and examination be directed to the latter
area, although putting all SPE's into sponsor's financial statements
does not necessarily improve the clarity of financial reporting. We
have made this recommendation, not so much because we think the
existing rules are unclear, although they are in some respects, but
because consolidation without control is quite contrary to our
consolidation model. Even in the present framework, it would be helpful
for the FASB to referee priorities between the existing rules.
While FEI has long supported reexamination and rationalization of
SPE consolidation rules, it is not because of cases like Enron, which
we believe the existing rules address cleanly. Rather, we would like to
make sure that the information we are presenting is meaningful, and SPE
assets threaten to introduce irrelevant clutter in the financial
statements.
mark to market accounting
A second area of concern raised by the Committee concerns mark-to-
market accounting. As you are aware, Enron was applying guidance for
energy trading activities that was approved by the FASB' Emerging
Issues Task Force (EITF Issue 98-10). That issue permitted energy
trading operations to mark to market through earnings all of its
derivative contracts. Questions have been posed by analysts and
journalists about the propriety of methodologies underlying the
valuations of these energy contracts. FEI members do have experience
with fair values of non-traded instruments. We must report annually
such fair values related to finance receivables that are not traded.
FEI's experience is that, in the absence of active, liquid markets,
these valuation exercises are imprecise. Some of our members, in fact,
ensure that this fact is communicated clearly by disclosing ranges of
values in their disclosures.
For all of its proven flaws, support for mark to market accounting
among its few proponents has not abated. Unfortunately, the FASB is one
of those few proponents and has issued several fair value documents,
including a so-called Preliminary Views in 1999. Equally unfortunate,
the International Accounting Standards Committee (predecessor of the
International Accounting Standards Board) issued a similar preliminary
document for comment in 2000. Both strongly support moving to a new
accounting model under which all financial instruments are reported at
fair value and changes in fair value are reflected in earnings. As
detailed in our written statement, there are a number of conceptual and
practical issues associated with this objective.
related party transactions
A third area of concern raised by the Committee is the area of
related party transactions. The GAAP disclosure rules regarding such
arrangements are clear and have been in place for 20 years. In
addition, the SEC's proxy rules require a very thorough analysis to be
presented to share owners. In looking at existing requirements, we are
unable to suggest meaningful improvements, beyond those recommended by
the SEC in its Financial Reporting Release 61, that would better
protect investors.
other issues with accounting standards
In addition to discussing the issues raised by the Committee, I
would like to take the opportunity to raise a more fundamental point on
the present direction of accounting standards. The body of literature
we call generally accepted accounting principles has evolved into a
labyrinth of specificity and complexity. The days of the on-site audit
team being capable of fielding the majority of the accounting questions
that arise at corporations have long since passed--the standards we
have now are so complex that we are, of necessity, moving into the
brave new world of fragmentation and specialization. One has to
question whether anything of value, especially accounting information,
should become so complex that it defies the ability of even the most
diligent investor to understand. And yet in an era when ``plain
English'' disclosure has become the centerpiece of our new reporting
model, standards on securitization and derivative accounting stand as
monuments to opacity dressed up as rigorous standards. I mentioned the
800 pages of guidance on derivatives. In comparison, the guidance on
securitization is a mere 150 pages (of course that excludes the 100+
questions and answers that need to be considered). The cry for relief
was sounded late last year and the FASB has embarked on a project that
would address accounting simplification. The Board has its work cut out
for it on this one, and I am hopeful that it will ultimately yield some
tangible results.
In closing, FEI supports the interest of this Committee in
effective accounting standards. However, we urge necessary steps to
make sure we are responding appropriately to the problems that exist.
In that regard FEI offers its support and the assistance of its leaders
to help the Committee identify a way forward. However, as we embark on
this journey, let's be sure that we take the time to think carefully
about the issues, to be thorough in the identification of root causes,
and based on that analysis to distinguish problems that arise from
fraud or misapplication of the rules from those that arise from the
rules themselves.
Perhaps most important, in an environment flush with cries for
change, let's not confuse action and progress.
This completes my prepared remarks. I should like to thank the
Chairman and the members of the Subcommittee for allowing FEI the
opportunity to testify.
Mr. Stearns. Thank you.
Mr. Linsmeier, we welcome your opening statement.
STATEMENT OF THOMAS J. LINSMEIER
Mr. Linsmeier. Chairman Stearns, Ranking Member Towns, and
members of the subcommittee, I appreciate the opportunity to
testify here today.
I will address the specific question posed to the panel by
sharing with you ten lessons I have learned, or relearned,
about accounting standards as a result of Enron.
Lesson 1 is a no-brainer, accounting matters.
Lesson 2: Accounting standards were not the primary problem
with Enron. I think we have covered that well with Enron today.
Lesson 3 is that accounting standards do not reflect well
the economics of some special purpose entities, or SPEs. SPEs
commonly are created to contractually isolate the risks and
rewards relating to a specific asset or project. The typical
SPE charter explicitly specifies the operating activities of
the entity. Thus, from the beginning, the SPE is on autopilot,
existing only to carry out its contractually specific sharing
of risks and rewards. Its managers essentially have nothing to
control.
Curiously, however, the current accounting is primarily
based on the concept of control. Assets are transferred from
the books of the sponsoring company once the SPE obtains
control, however, the key accounting question should be
determining whether the sponsoring company retains any risks or
rewards from the transferred assets, and how those risks and
rewards should be reported. In part, this is a consolidation
issue. However, for the types of assets transferred by Enron,
current accounting rules provide only limited guidance on when
the SPE needs to be consolidated, and no guidance requiring
recognition of risks and rewards retained by the sponsoring
company when the SPE is not consolidated.
To properly reflect the economics of SPEs and to prevent
accounting abuses similar to Enron, comprehensive accounting
and disclosure standards must be developed to address both
these issues.
Lesson 4: Accounting standards that are too narrow can lead
to abuse. The limited accounting guidance that does exist for
determining the consolidation status of SPEs similar to Enron's
was meant to pertain only to leasing transactions. That
guidance specifically states that it should not be applied to
other transactions. Yet, in the absence of any other guidance,
a member of the SEC staff announced that consolidation
decisions for non-leasing SPEs also could be based on the 3
percent outside ownership of assets standard used for leasing
transactions. This is not unusual. In absence of accounting
standards that are directly applicable, accountants often find
guidance by analogy to a similar standard. While there is some
economic intuition provided for the 3 percent standard in the
leasing industry, there is no economic basis for using a
similar standard in other settings. Thus, in absence of
alternative guidance, making decisions by analogy to a related
but narrow standard can lead to accounting that fails to
protect investors.
Lesson 5: Accounting standards with bright line tests fail
to protect investors. A bright line test, like the 3 percent
standard for non-consolidation of SPEs, allows companies to
structure transactions to avoid an undesired accounting result.
These transactions are engineered to lie on one side of the
line. The undesirable accounting representation that results
from being on the wrong side of the lie tends to force
transactions to be accounted for one way, causing the
accounting benchmark to define the economic depiction of the
transaction. As a result, investor protection suffers.
Lesson 6: accounting standards that are too general also
can lead to abuse. In addition to SPE transactions, Enron also
traded in a considerable number of long-term contracts to sell
energy at specified prices for periods up to 20 years. The
accounting standard in this area is general, requiring that
these contracts be marked-to-market, but not specifying how the
market price should be determined. While, in general, mark-to-
market accounting leads to better investor protection by
providing an early warning when prices move south, its
implementation in these contracts is subject to manipulation
because it requires significant judgment to estimate how
observable short-term energy price movements will extrapolate
to the long-term, potentially allowing huge swings in reported
gains and losses. While there is no evidence that Enron
manipulated its accounting numbers through these estimates, the
fact remains that general guidance such as this can provide an
opportunity for abuse.
Lesson 7: Accounting standard setting is complicated and
takes time. Lessons 4 through 6 suggest that for an accounting
standard to facilitate investor protection, it should be broad
and neither too specific nor too general. Given the complexity
of modern business transactions, developing broad standards
that both satisfy these constraints and accurately depict the
economics of the transaction is a complex task that naturally
takes time. That said, there is no good explanation for why the
FASB has not been able to set a consolidation standard for SPE
for over a decade. Efforts need to be undertaken to make the
standard setting process more efficient.
Lesson 8: The accounting standard setting process has
become too political, which slows progress to improved
standards. Standard setting profits from the political nature
of its activity. However, of late, the standard setting has
become too political. Emboldened by their success in opposing
the FASB's proposal to expense stock option compensation,
opponents of FASB's proposals have found that complaints to
Congress have been quite successful in impeding FASB's
progress, with congressional hearings becoming commonplace
before a final standard can be passed. These hearings often
produce arguments suggesting that the proposed standard will
materially alter business, as we know it, significantly
affecting the competitiveness of U.S. companies. However, I
have seen no evidence of the significant deleterious effects
claimed by businesses after the proposal has passed. Yet the
delay for lobbying activities significantly slows FASB's
progress, hindering its ability to develop timely standards
that may serve to reduce accounting abuses, such as those found
at Enron.
Lesson 9: For the reasons discussed in my written
testimony, accounting standard setting should remain in the
private sector. However, I have one suggestion I believe should
be given consideration. Currently, FASB funding is provided, in
part, by companies and audit firms that at times are strong
opponents to its proposals. Consideration should be given as to
whether a different funding structure for the FASB could
improve the efficiency and effectiveness of the standard
setting process.
Lesson 10, and the most important: Accounting standards
cannot protect investors, proper implementation of standards by
accounting professionals leads to investor protection. Enron's
collapse has called into question the functioning of auditors,
audit committees and accounting standards. In the end, however,
I must conclude that the accounting problems surfaced by Enron
had little to do with the quality of accounting standards but
arose primarily due to failures in their application. This
fundamental problem arises because auditors and audit
committees are hired not by the investors they are obligated to
serve, but by the companies they must scrutinize. For me, the
ultimate public policy issue is to find a way to mitigate this
conflict of interest, thereby serving better the ultimate
objectives of investor protection and continuing efficiency of
U.S. markets.
Thank you for your attention. I will be pleased to answer
any of your questions.
[The prepared statement of Thomas J. Linsmeier follows:]
Prepared Statement of Thomas J. Linsmeier
Chairman Stearns, Ranking Member Towns, and members of the
Subcommittee, I appreciate the opportunity to testify here today. I
will address the specific question posed to the panel, ``Are current
financial accounting standards protecting investors?'', by sharing with
you ten lessons I have learned or relearned about accounting standards
as a result of Enron.
lesson 1: accounting matters
Rarely has a corporate bankruptcy had such wide repercussions on
the accounting profession. Capital markets, and indeed capitalism
itself, can function efficiently only if the highest standards of
accounting, disclosure, and transparency are observed. The collapse of
Enron is raising significant questions about the institutions governing
public capital markets, and especially the role of the accounting
profession. Issues are being raised about the regulation of auditors,
the functioning of audit committees, conflicts of interest in
accounting firms, and the quality of U.S. accounting standards. Clearly
accounting matters. The purpose of the hearings today is to address one
of these issues: the quality of accounting standards. I commend the
Committee for addressing this important issue.
lesson 2: accounting standards were not the primary problem with enron
Enron has admitted in its November 2001 filings with the SEC and
through its February 2002 report by a committee of its board of
directors that it failed to comply with U.S. accounting standards for
most of the transactions at issue. Proper application of existing
accounting and disclosure standards for Enron's off-balance-sheet
partnerships (sometimes called special purpose entities) would have
increased the reported amounts of debt and decreased the reported
amounts of net income in Enron's 1997-2001 financial statements, making
transparent to capital markets its declining financial fortunes.
lesson 3: accounting standards do not reflect well the economics of
some special purpose entities (or spe's)
SPEs commonly are created to contractually isolate the risks and
rewards relating to a specific asset or project. The typical SPE
charter explicitly specifies the operating activities of the entity.
Thus, from its beginning, the SPE is on autopilot, existing only to
carry out its contractually specified sharing of risks and rewards; its
managers have essentially nothing to control.
Curiously, however, the current accounting by sponsoring companies
is primarily based on the concept of control. Assets are transferred
from the books of the sponsoring company once the SPE obtains control.
However, the key accounting question should be determining whether the
sponsoring company retains any risks or rewards in the transferred
asset and how those risks and rewards should be reported. In part, this
is a consolidation issue. However, for the types of assets transferred
by Enron, current accounting rules provide only limited guidance on
when the SPE needs to be consolidated and no guidance requiring
recognition of risks and rewards retained by the sponsoring company
when the SPE is not consolidated.
To properly reflect the economics of SPEs and to prevent accounting
abuses similar to Enron, comprehensive accounting and disclosure
standards must be developed to address both these issues. I understand
the SEC has charged the FASB with achieving this outcome by June of
this year. Given that the FASB has struggled with this issue for over a
decade, I am not optimistic about its ability to succeed in such a
short time frame. However, to protect investors, it must succeed.
lesson 4: accounting standards that are too narrow can lead to abuse
The limited accounting guidance that does exist for determining the
consolidation status of SPEs similar to Enron's was meant to pertain
only to leasing transactions. That guidance specifically states that it
should not be applied to other transactions. Yet, in the absence of any
other guidance, a member of the SEC staff announced that consolidation
decisions for non-leasing SPEs also could be based on the 3% outside
ownership of assets standard for SPE leasing transactions. This is not
unusual; in absence of accounting standards that are directly
applicable, accountants often find guidance by analogy to a similar
standard. While there is some economic intuition provided for the 3%
standard in the leasing industry, there is no economic basis for using
a similar standard in other settings. Thus, in absence of alternative
guidance, making decisions by analogy to a related but narrow standard
can lead to accounting that fails to protect investors.
lesson 5: accounting standards with bright line tests fail to protect
investors
A bright line test, like the 3% standard for non-consolidation of
SPEs, allows companies to structure transactions to avoid an undesired
accounting result. These transactions are engineered to lie on one side
of the line. The undesirable accounting representation that results
from being on the wrong side of the line tends to force all
transactions in this fuzzy area to be accounted for one way, causing
the accounting benchmark to define the economic depiction of the
transaction and constraining auditors' ability to require an
alternative accounting representation when it better reflects economic
reality. As a result, investor protection suffers.
lesson 6: accounting standards that are too general also can lead to
abuse
In addition to SPE transactions, Enron also traded in a
considerable number of long-term contracts to sell electricity or buy
natural gas at specified prices for periods up to 20 years. The
accounting standard in this area is general, requiring that these
contracts be ``marked-to-market'' but not specifying how the market
price should be determined. While in general ``mark-to-market''
accounting leads to better investor protection by providing an early
warning when energy prices move south, its implementation in these
contracts is subject to manipulation because it requires significant
judgment on the part of management to estimate how observable short-
term energy price movements will extrapolate to the long-term,
potentially allowing huge swings in reported gains and losses. The FASB
currently is working on a project to make ``mark-to market'' accounting
guidance more specific. While there is no evidence that Enron
manipulated its accounting numbers through these estimates, the fact
remains that general guidance such as this can provide an opportunity
for abuse.
lesson 7: accounting standard setting is complicated and takes time
Lessons four through six suggest that for an accounting standard to
facilitate investor protection it must (1) be broad enough to
contemplate all related transactions to which it may be analogized and
(2) be specific enough to mitigate opportunities for manipulation
without providing bright line cutoffs. In other words, effective
standards should be neither too specific nor too general. Given the
complexity of modern business transactions, developing broad standards
that both satisfy these constraints and accurately depict the economics
of the transaction is a complex task that naturally takes time. That
said, there is no good explanation for why the FASB would need more
than a decade to set a consolidation standard for SPEs. Efforts need to
be undertaken to make the standard setting process more efficient.
lesson 8: the accounting standard setting process has become too
political, which slows progress to improved standards
Standard setting profits from the political nature of its activity
by surfacing valuable questions and potential implementation issues
that when addressed can materially improve the final standard. In
addition, by following an open due process, the resulting accounting
standards gain better acceptance from various accounting
constituencies. However, of late, standard setting has become too
political. Emboldened by their success in opposing the FASB's proposal
to expense stock option compensation, opponents of FASB' proposals have
found that complaints to Congress have been quite successful in
impeding FASB's progress, with Congressional hearings becoming
commonplace before a final standard can be passed. These hearings often
produce arguments suggesting that the proposed standard will materially
alter business, as we know it, significantly affecting the
competitiveness of U.S. companies. However, I have seen no evidence of
the significant deleterious effects claimed by businesses after the
proposal has passed. Yet the delay for lobbying activities
significantly slows FASB's progress, hindering its ability to develop
timely standards that may serve to reduce accounting abuses, such as
those found at Enron.
lesson 9: accounting standard setting should remain in the private
sector
To make standard setting most efficient and to ensure that the
constructive political attributes of the process are focused
exclusively on pertinent economic issues, standard setting should
reside in an organization that is not influenced by other important but
unrelated issues of the day. Private sector standard setting has
performed this function well and with improvements in its efficiency
and reductions in the amount of political intervention, I fail to see a
better alternative. In this regard, I have one suggestion that I
believe should be given consideration. Currently FASB funding is
provided, in part, by companies and audit firms that at times are
strong opponents to its proposals. Consideration should be given as to
whether a different funding structure for the FASB could improve the
efficiency and effectiveness of the standard setting process.
lesson 10: accounting standards cannot protect investors; proper
implementation of standards by accounting professionals leads to
investor protection
In the United States, well-policed stock markets, fearsome
regulators at the Securities and Exchange Commission, rigorous
accounting standards, and confidence in audit skills of CPA's and audit
committees, have long been seen as crucial to the biggest, most liquid
and admired capital markets in the world. Enron's collapse has called
into question the functioning of auditors, audit committees and
accounting standards. In the end, however, I must conclude that the
accounting problems surfaced by Enron had little to do with the quality
of accounting standards but arose primarily due to failures in their
application. The fundamental problem arises because auditors and audit
committees are hired not by the investors they are obligated to serve
but by the companies that they must scrutinize. For me the ultimate
public policy issue is to find a way to mitigate this conflict of
interest, thereby serving better the ultimate objectives of investor
protection and continuing efficiency of U.S. capital markets.
Thank you for your attention. I will be pleased to answer the
Committee's questions.
Mr. Stearns. I thank both of you. I will start out the
questions. Mr. Linsmeier, do you think that are more Enrons out
there?
Mr. Linsmeier. Well, let us consider what Enron--what
happened with Enron. To the best of my knowledge----
Mr. Stearns. Because you are saying here FASB has taken 10
years to come up with consolidated standards. You are pointing
out some of the slowness of the process, and you are pointing
out some of the conflicts of interest, and you are pointing out
these things which would lead me to believe that Enron is not
alone, that there are other Enrons. And so is that----
Mr. Linsmeier. Perhaps there are companies out there that
are not following GAAP and that is not being detected by their
auditors, to the extent that we will not find out about those
problems for a period of time. Perhaps that is true.
Mr. Stearns. You know, some of the technical aspects in
these SPEs, these special purpose entities, when I first saw
that they used a 3 percent outside ownership test for
nonleasing of SPEs, I thought that seemed pretty doggone small.
Mr. Linsmeier. So did I.
Mr. Stearns. Do you think Congress, or FASB, or the
American Institute of Accounting, or SEC should stipulate it
should be 20 percent, or 10 percent, and is that problematic,
or would that actually--if that practice is instituted, would
we actually see a better understanding of these sheltering of
debt?
Mr. Linsmeier. Well, first of all, the reaction to the 3
percent, let me give you a little background. The reason why 3
percent might make some economic sense for leasing transactions
is the margin is that industry is so slow and so small and the
competition is so high that giving away 3 percent of the
return----
Mr. Stearns. Is their profit.
Mr. Linsmeier. [continuing] is their profit. And it
materially changes the economics of that SPE. But, now--and
then let us think about the 3 percent standard. You asked about
a 3 percent standard versus a 10 percent standard. Part of my
testimony is any bright line test will create incentives for
someone to be just on the other side. What Enron tried to do is
be just on the other side, but failed. They didn't do it right.
And that is why we can say that existing accounting standards
were not the problem with Enron.
If they had structured their transactions sufficiently to
be on the other side and not transferred some of the risk in
that process, they could have potentially been following GAAP.
Mr. Stearns. Ms. Hinchman, Mr. Bass wanted to introduce
you. I guess he worked with you.
Ms. Hinchman. Yes, he did, in another lifetime.
Mr. Stearns. And so I'm sorry Mr. Bass----
Mr. Bass. Congratulations, Grace, you have come a long way
in the last 25 years.
Ms. Hinchman. Thank you, Mr. Congressman, so have you.
Mr. Bass. Where are those tough questions you had, I want
to ask a couple of those.
Ms. Hinchman. Don't you have to go to a vote or something
on the floor?
Mr. Stearns. Ms. Hinchman, you stated that valuation of
nontraded instruments is imprecise and that ``some of your
members ensure that this fact is communicated clearly by
disclosing ranges of values in their disclosures.'' Do you
think the disclosure of a range of values should be mandated?
Ms. Hinchman. Well, you are talking about the valuation
aspect in the mark-to-market.
Mr. Stearns. Nontraded instruments.
Ms. Hinchman. Correct. And that is something that we are
currently working with FASB in one of our technical committees
right now, and we are not yet at a position to make a statement
on that, but I will certainly get back to you and the
subcommittee with our findings.
Mr. Stearns. Is it possible that Beerstown Ladies who did
the investment out there in the Midwest in mutual funds, and
they did so well they beat all the people on Wall Street, and
they used to study all these financial accounting reports.
Ms. Hinchman. It was an investment club, or something like
that.
Mr. Stearns. Yes, investment club, the Beerstown Ladies, I
remember. Can we have effective financial accounting standards
without this labyrinth of complexity? I mean, is it possible--
are we as Members of Congress being Don Quixote, thinking that
we can make it so that the average person out there can
understand something he is investing in, or does he have to go
to a stockbroker, stock analyst, or somebody that he has got to
rely on? Is there any way that we would somehow have a
financial accounting standard that people, the common man or
woman, could understand?
Ms. Hinchman. Well, that is certainly what we, our
membership of FEI, would like to see have happen, and that is
why we did go to the FASB pleading with them to try and make
more simple the current panoply of standards that they have to
abide by because it has become virtually impossible.
One example that has often held out, which is in my more
complete comments, is the FAS 133 on derivatives. It is, I am
told, unusable. It is 800 pages of uninterpretable, unusable
standards for guidance. And it has been a huge problem for our
members in order to apply that to their businesses. And that is
why we have begun to work with FASB in terms of making more
simple a board range of principles for these standards instead
of having the actual rules in terms of abiding by the
standards. And we hope to work with them, but it is a tough
challenge, but it is something that we have to do because today
the investors cannot use the standards for the purposes that
they are intended.
Mr. Linsmeier. Could I comment on that just briefly?
Mr. Stearns. Yes.
Mr. Linsmeier. I think there is something that is useful to
understand. There is a difference between complexity of
standards and complexities of financial statements that
investors read. And there is the possibility that standards
should be complex to control the activities or to monitor or
help focus the activities of people within corporations, and
auditors and their aspects, and yet not have the financial
statements be complex. I think there is a distinction. We want
those financial statements, those reports, to communicate
fairly the economics of a company and hopefully have some
people understand that. The business is complex.
Mr. Stearns. But you heard the expression I said earlier,
which is ``cash is fact and everything else is opinion.'' Let
me have the distinguished ranking member ask, and then we will
finish up.
Mr. Towns. Thank you very much, Mr. Chairman. Let me ask,
why didn't the analysts in companies such as J.P. Morgan and,
of course, CitiBank, loan officers see this coming? Did they,
in fact, use the same accounting standards to make their loans?
I mean, why wouldn't the analysts be able to figure this out? I
mean, there is talk, I think, J.P. Morgan and Chase appears to
have lost approximately $1.3 billion, and CitiBank maybe
$800,000, almost a million. Wouldn't analysts sort of--I am
trying to see why wouldn't they see this.
Mr. Linsmeier. Well, remember, for Enron, the accounting
was incorrect. They have admitted that in their filings. So, we
trust those reports to indicate that what is being said is
correct, that then their analysts have a difficult time to be
able to ferret that out, if, as what has been publicly stated,
they didn't follow GAAP.
In addition, though, I think we had a circumstance for a
company that is doing extremely well, and a lot of people want
to believe that it was doing that well and didn't scrutinize it
as carefully because reading the financial statements of Enron
is a very difficult task, and they did work very hard at not
saying things in their reports.
Ms. Hinchman. Congressman, I think from FEI's perspective,
this has been a huge wake-up call for our members. And I think
because of the investigations that are going on, which will
yield the answer to your question, we don't know specifically,
but it certainly has caused our membership to wake up and be
more scrutinizing and be more demanding on the part of its
auditors, on the part of its investment analysts all up and
down the line, so we can avoid anything like this happening
again.
Mr. Towns. Well, let me ask this question. What should the
Congress do to try to prevent this kind of stuff from happening
ever again?
Ms. Hinchman. Well, not to take the other side of my co-
witness here, but FEI just recently submitted a letter to the
Wall Street Journal, New York Times and Washington Post in
support of the oversight of Congress in the role of accounting
policy, legislation, standards, et cetera. And we certainly
endorse that and think it is appropriate. A proactive oversight
role on the part of Congress on these issues I think is timely,
warranted, and potentially very productive, but we would like
to see the actual standards developed in an organization like a
FASB, a private sector organization, because that is where the
independence of the private sector from the business community
and the accounting community can come into play and develop the
best standards.
I think you would probably agree with me that you all do
not want to be legislating accounting standards, and FEI would
not want you to do that either, quite honestly, but I think a
consistent oversight role, I think, is a healthy, warranted and
helpful role that you all can be playing.
Mr. Towns. Because I look at the J.P. Morgan situation, of
course. and according to testimony in another committee, it
said that some people saw it and a red flag went up, and of
course others didn't, and that bothered me. I mean, a person is
an analyst, and one person is able to see it and another one
doesn't see it. You are talking about a lot of money here, $1.3
billion.
Ms. Hinchman. And a lot of lives, too, have been ruined.
Mr. Towns. Yes, a lot of people are hurt by this, so I was
just wondering, from that standpoint--because some were able to
see it, others were not able to see it, and of course now we
have this mess. So, I was just wondering in terms of what could
we do to try to further prevent this kind of situation, and you
answered that part, and I thank you for it.
Did you want to add anything, Mr. Linsmeier?
Mr. Linsmeier. I don't think we are in disagreement. I
mean, my comments about congressional involvement was not ones
looking at the overall oversight or structure of the
profession. I mean, what I mention in the testimony is that, in
part, we have problems in the standard setting area in that it
is not very timely. And if there is a structural issue to try
to induce more timely standard setting by, in part, not being
involved with the individual standards but the overall
structure of the process, that is important.
But I think, more importantly, there are some conflicts
that arise where money flows here, and the two issues that I
brought up were the FASB is funded by public accounting firms
and by companies that tend to lobby them. That is one, but that
is not as significant.
To me, the big significant issue, if there was an
application of standards problem here, is why didn't the
auditors and the audit committee perform their oversight here?
And what I raised to you is--and I don't know that there is a
natural automatic response--but what I raised to you is the
auditors are paid by the company. The audit committee, even
though they represent the shareholders, receive much of their
resources from the company. We have a natural conflict of
interest that has gone on from the time of the Treadway
Commission to this time period, that money comes from the
people that the auditors and the audit committees are trying to
scrutinize, think that is a natural conflict of interest.
Mr. Towns. I yield back.
Mr. Stearns. Are you saying the auditor of the board of
directors has failed?
Mr. Linsmeier. I am saying the audit committee----
Mr. Stearns. Audit committee of the board of directors.
Mr. Linsmeier. It seems yes.
Mr. Stearns. We have a vote, we have about 3 minutes left,
so I am going to thank you and adjourn the subcommittee. And
thanks again for your patience in waiting through the first
panel.
[Whereupon, at 12:10 p.m., the subcommittee was adjourned.]
[Additional material submitted for the record follows:]
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