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Former SEC Chairmen Urge Reforms in Senate Testimony

In recent Senate testimony, five former SEC chairmen recommended substantial and innovative reform of the corporate governance process, accounting industry oversight, and the setting of rules for the preparation and auditing of corporate financial statements. Former chairmen Arthur Levitt, Richard Breeden, David Ruder, Roderick Hills and Harold Williams testified before the Senate Banking Committee, whose chairman, Sen. Paul Sarbanes, emphasized that the failure of Enron raises numerous important issues ranging from the integrity of certified financial audits and the appropriate accounting principles and auditing standards to be employed, to indeed the effectiveness of the entire accounting regulatory oversight system. Mr. Levitt set a broad theme for the discussion by noting that the market system itself will be "fundamentally weakened" unless reforms are instituted to preserve and enhance the independence of the gatekeepers who safeguard the interests of investors.

Audit Committees

The former chairmen strongly believe in the particular importance of the audit committee of the board of directors. Mr. Ruder emphasized that the audit committee should understand the company's business, ask management hard questions about its strategies, accounting policies, and disclosures, and seek to ensure that disclosures are accurate and complete.

Mr. Hills called on the SEC to make it "absolutely clear" that the failure to have a competent independent audit committee by itself constitutes a material weakness in the internal controls of a reporting company. A simple statement in any speech by an SEC Chairman will do the job, said Mr. Hills, who added that this unequivocal statement will force the auditors to look into the question of both the independence and the competence of the audit committee.

Mr. Hills also urged the Commission to make it clear to audit committees that they have the responsibility of protecting the independence of the auditors. Noting that appointment to an audit committee is not a "passive assignment," the former chairman emphasized that the audit committee must:

• understand the fee negotiations;

• lead any effort to select a new firm;

• initiate interviews for a new audit partner in charge;

• insist that all disagreements between management and the auditor be exposed to them; and

• insist that they be made to understand any alternative presentations of the company's financial position that would lessen earnings or debt.

In short, he emphasized, the audit committee's most important task is to make the independent attesting auditor believe that its retention depends solely on the decision of the audit committee. In addition, audit committees must have latent independent authority to hire their own consultants. They must insist that all allegations of financial misconduct be conveyed to them immediately. In Mr. Hills' view, the complaint by Ms. Watkins to Enron's CEO should have been given directly to the audit committee, which should have hired its own counsel to investigate her complaint.

Rotation of Auditors

The former chairmen examined the question of whether auditors should be rotated as an antidote to the Enron-type problems found in the auditing process. Mr. Levitt proposed that companies be required to change their audit firm, not just the partners, every five to seven years to ensure that "fresh and skeptical eyes are always looking at the numbers." Mr. Williams suggested a fixed retention and rotation policy. He urged the SEC to consider requiring that a company retain its auditor for a fixed term with no right to terminate. After that fixed term, the company would have to change auditors.

As a consequence, he reasoned, the auditor would be assured of the assignment and, therefore, would not be threatened with the loss of the client and could exercise truly independent judgment. Under this system, the client would lose its ability to threaten to change auditors if in its judgment the assigned audit team was inadequate. It would also reduce the client's ability to negotiate on fees, continued Mr. Williams. There would be costs, he admitted, as the required rotation of auditors would involve the inefficiency of the learning curve for the new auditor. But Mr. Williams emphasized that the costs are acceptable if the policy reinforces the auditor's independence and makes the work more comprehensive. Finally, he said that the client could be given a right to appeal to a reconstituted independent oversight organization if it believes that it is not well-served by its auditor and needs some relief.

Mr. Breeden agreed that one way of insulating audit firms from the pressure of keeping the audit engagement would be to provide for mandatory limits on engagements to a specified period of time, such as five years. But also noting that mandatory rotation would cause considerable costs, Mr. Breeden offered the less drastic alternative of requiring the audit committee to conduct a formal reproposal process at least every four to five years, but leaving the decision up to management and the board.

The Role of FASB

In their testimony, the former chairmen reached a consensus that accounting principles standard-setting needs to be reformed. Mr. Williams called for a review of generally accepted accounting principles and improved and accelerating standard-setting. He believes that the functioning of the Financial Accounting Standards Board could be significantly enhanced if its independence could be protected so that it could withstand the pressures of the business community, the profession, and even the Congress. A source of financing that is dependable and not beholden to the profession or to the corporate community would increase FASB's ability to timely address critical issues, he declared. He cited the example of the pressure exerted by corporations through Congress in the mid-1990s that forced the FASB to retreat on a proposal to make companies take account of the cost of awarding employee stock options.

Echoing this theme, Mr. Ruder said that the way to relieve the financial pressures on FASB would be to provide a system of financing under which the board is financed by payments from preparers and users of financial statements. If a voluntary system cannot be established, he continued, Congress should enact legislation creating financing for FASB. For his part, Mr. Breeden recommended that the SEC be given the ability to designate priority actions and set binding deadlines for FASB action. In addition, the SEC should be able to adopt international accounting standards or standards drafted by other authorities, as well as its own staff, said Mr. Breeden, where the Commission finds that FASB standards are not in the interest of investors.

Mr. Levitt pointed out that, because FASB is funded and overseen by accounting firms and their clients, its decisions are "agonizingly slow." This "well-meaning group," he continued, must also defend itself from congressional pressure. As an antidote, he recommended that FASB's funding be secured not just through the accounting firms and corporations, but also through a number of market participants--from the stock exchanges to banks to mutual funds. Moreover, the Financial Accounting Foundation, which chooses FASB's members, should be composed entirely of the best qualified members, not merely those representing constituent interests.

Accounting Industry Oversight

Mr. Ruder also favors the creation of a new Audit Supervisory Board separate from the AICPA and composed entirely of public members with no connection to the accounting profession. The board should be subject to SEC oversight. Independent funding for the new board, an element Dean Ruder views as crucial, could be obtained by requiring payments from the companies that prepare financial statements and the institutions that use them, such as mutual funds and brokers.

According to Mr. Ruder, the new board should have appointive, administrative and budget powers and should oversee three separate functions:

• an auditing standards and ethics board composed of persons independent of the accounting profession should promulgate both auditing and ethical performance standards;

• an auditing quality control committee, composed of professional staff members reporting to the audit supervisory board, should oversee internal audit firm practices designed to improve the audit process such as rotation of audit engagements and an internal system for making controversial audit decisions. This unit should also supervise a peer review system conducted by the accounting profession; and

• an audit disciplinary committee should be empowered to inspect firm compliance with audit standards and procedures, investigate allegations of audit failures, impose disciplinary sanctions, and refer matters to the SEC for investigation and discipline.

Derivatives

There was also agreement that more work needs to be done in the accounting for and regulation of derivatives. On the subject of regulation, Mr. Ruder testified that the trading of OTC derivatives presents both systemic and individual risk. With that in mind, he asked Congress to consider whether legislation is needed in the area of off-exchange derivatives.

Mr. Breeden said that accounting standards are sometimes constructed in ways that may be "theoretically elegant" but work to the disadvantage of investors and give "too many opportunities for mischief." As an example of this he cited the "accrual" of profits that have not yet arrived in fact. There is a problem with many derivative instruments, particularly long duration contracts that are one of a kind and are without a trading market to provide a valuation.

Enron created many such instruments, Mr. Breeden observed, and it booked "enormous profits" on some contracts based on theoretical models that purported to value the cash flows that might occur pursuant to the contracts as much as ten or more years in the future. If the assumptions that the model uses are bad, he said, the answers will be also--"garbage in, garbage out. "

An auditor has a difficult job to test the realism of the assumptions used in such valuations, he emphasized, and an investor can neither evaluate those assumptions nor know how one company's models may differ from another company's. The result, explained the former official, is that management can use unrealistic assumptions to pump up earnings, "possibly enormously." In addition, earnings will not be comparable from one company to another, due to the differences in modeling that are impossible for investors to spot. Perhaps, he opined, all such "profits" should only be taken into income as the assumptions actually occur and the company realizes the cash flows. To the extent possible, he urged FASB to promote the reporting of profits that have already occurred, and to preclude reporting of profits that have not happened in fact.