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Committee for Economic Development Recommends Improvements in Corporate Governance

The Committee for Economic Development yesterday released a set of recommendations aimed at restoring public trust in U.S. corporations. SEC Chairman Christopher Cox spoke at the luncheon forum at which the CED's policy statement was released and said he looked forward to reading the report. The CED report addresses corporate governance issues, Cox said, which are of vital importance to the SEC's mission of investor protection. CED is an independent research organization that is nonprofit, nonpartisan and nonpolitical. Its subcommittee on corporate governance is led by former SEC Chairman Roderick Hills. The CED report includes recommendations in five broad areas relating to audit committees, financial statements, the Sarbanes-Oxley Act, executive compensation and the selection of directors.

Audit committees have become more effective since the adoption of the Sarbanes-Oxley Act, according to the CED report. The CED said the definition of who is a financial expert is less important than the relationship between the board's audit committee and the external and internal auditors. In CED's view, the audit committee should exercise the same control over the internal auditor as it does over the external auditor, including the power to hire, fire and set compensation. The internal auditor should have a level of operational independence that would allow the PCAOB and the external auditor to accept its work if they are satisfied with its independence and competence.

Financial statements must provide a fair and clear picture of a company, CED noted, but markets must be prepared to accept that financial information is largely based on judgments. CED believes that the quest for too much comparability sacrifices both detail and accuracy. Integrity, ethics and the competence of management, along with the rigorous oversight of the financial reporting process, are as important as rules and guidelines, according to CED. CED added that an autonomous and vigorous audit committee will produce a better result than any particular set of rules, and called for fewer rules and greater reliance on judgment and integrity in their application.

CED said that the sometimes excessive delegation of responsibility for financial reporting to management is inconsistent with the responsibilities of audit committees to provide a fair and clear presentation of the company's financial condition. The Sarbanes-Oxley Act requires auditors to provide audit committees with alternative treatments of financial information. Audit committees must then determine whether management has fairly chosen from those alternatives.

CED emphasized that stock analysts, investors and regulators must recognize the inherently judgmental nature of accounting statements and financial information. Financial statements should be supplemented with non-financial indicators of value to make the company's situation understandable.

Auditors should not be required or assumed to attest to specific numbers, CED added. Their attestations should be viewed as opinions on whether the financial statements, taken as a whole, are fairly stated, not whether each number is precisely correct. Financial disclosure should be written in plain English so that it is both clear and concise.

The CED report also addresses the issue of litigation. CED believes that litigation has negatively affected the economy and society in many respects. The reasonable exercise of judgment in preparing financial statements should not be subject to excessive litigation as long as the judgment is made in a transparent manner that is free of fraud, according to CED. CED suggested that the PCAOB could assign inspectors to annually review the audits of firms whose client companies are on a watch list due to risks in their audit processes. CED advised that external auditors maintain watch lists and share them with the PCAOB.

Any misconduct could be dealt with by the PCAOB, the SEC or the Department of Justice, depending on the severity of the offense, CED explained. The SEC could provide a safe harbor to prevent third-party litigation from challenging good-faith judgments made by auditors once the PCAOB has demonstrated its ability to examine the high risk audits.

As an alternative to the safe harbor approach, CED suggested the creation of a special federal court for adjudicating such disputes. If no action is taken, the cycle of litigation will continue, as will so-called defensive accounting, CED said.

CED believes that Sarbanes-Oxley Act section 404 has had a positive impact on the U.S. corporate governance system and does not recommend a broad exemption for small-capitalization companies. The process could be revisited, however, to find ways to lower the costs for smaller companies, such as three-year cycles of certification, more risk-based auditing measures or reviews of company-level control functions, as others have recommended.