(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Former SEC Chief Accountants Call for Reforms in Wake of Enron

Three former SEC chief accountants have called for reform of financial accounting, ranging from the need for independent standard-setting, strengthened audit committees, auditor independence and mark to market accounting. Lynn Turner, Michael Sutton and Walter Schuetze testified before the Senate Banking Committee on what is needed to restore investor confidence in financial statements.

Mr. Turner said that a company's CEO and CFO should be required to certify to the audit committee and investors that the financial statements comply with the applicable rules and include disclosure of all material information. There should be criminal and civil penalties for intentional misrepresentations to the public or to the auditors. He also called for an SEC-supervised public accounting oversight board with the following critical elements:

• Adequate funding and independence,

• Members drawn from the public rather than the profession,

• Timely and effective disciplinary actions against those who fail to follow the rules, regardless of whether they are small or large firms,

• The authority to issue auditing and quality control standards establishing a benchmark for the performance of quality audits, and

• The ability to inspect the work of auditors on an ongoing basis to ensure they have made the investing public rather than fees their number one priority.

Mr. Turner believes that audit quality will be enhanced through effective independent inspections by the oversight board. Performance of annual on-going independent inspections of the large accounting firms, with perhaps no less than tri-annual inspections of smaller firms who tend to audit fewer public issuers, should overcome what the former SEC official called "the current system of backslapping peer reviews." He also emphasized the need for rules that will truly protect the independence and integrity of the audit, and gain the public's confidence that the auditors are working for them and not management. Specifically, he called for:

• Closing the "revolving door" between the audit firm, its partners and employees, and the company being audited.
• Requiring that in order for the auditor to be considered independent, the firm must be hired, evaluated and, if necessary, fired by the audit committee.
• An exclusionary ban approach to auditor independence that would allow auditors to provide only audit services to an audit client unless the audit committee makes a determination and discloses that the services provided by the audit firm are 1) in the best interest of the shareholders and 2) will improve the quality of the company's financial reporting.
• Prohibiting an independent auditor from assisting a company to design and structure transactions and then 1) provide their accounting or tax opinion on what the appropriate accounting is for the transaction and 2) audit the accounting for that transaction.

Audit Committees

Both Mr. Turner and former chief accountant Michael Sutton emphasized that the role of the audit committee must be enhanced. According to Mr. Turner, the audit committee should directly hire, evaluate and, if necessary, fire the auditor. This process should not involve the management team making the selection or recommendation to the audit committee, he said, since it needs to be a truly independent process. Mr. Turner also called for the elimination of the exceptions provided for in stock exchange rules permitting an audit committee member who is not independent. Similarly, the definition of an independent director must be modified to prohibit the company from engaging the director for any services other than those provided as a director, and to ban financial payments on behalf of the director, such as contributions to charitable organizations.

In addition, Mr. Turner testified that the audit committee should be required to pre-approve all non-audit services. The audit committee should also require the CEO and CFO to provide it a report clearly stating management responsibility for ensuring an effective system of internal accounting controls. Similarly, Mr. Sutton recommended the immediate rewriting of corporate governance guidelines to clearly break the bonds between management and the independent auditor and unmistakably spell out the responsibilities of audit committees to shareholders and investors. Management should be the subject of, not the manager of, the independent audit relationship, he believes. The ultimate responsibility for full disclosure to shareholders, and the direct responsibility for the independence and quality of audit relationship, must be clearly fixed with the audit committee, declared Mr. Sutton, which should be composed entirely of independent directors.

Standard-Setting

With regard to reforming standard-setting, Mr. Turner seeks the creation of an independent "no strings attached" funding mechanism for FASB, which he says could be accomplished by a fee charged to issuers and exchange members. In addition, FASB needs to develop accounting standards that reflect the reality of the actual economics of the underlying transactions. Further, FASB must implement a project management system that prioritizes the needs of investors and then establishes accountability for the timely meeting of those needs.

Mr. Sutton agreed that in order to restore confidence in the standard setters, immediate steps must be taken to secure independent funding for FASB. In addition, he recommended the establishment of an independent governance process to replace the current constituent-based foundation board. He suggested that reforms could be best developed and implemented under the auspices of an independent commission made up of "leading lights" within the corporate governance movement, heads of investment funds and retirement systems responsible for managing the nation's savings and pension assets, academic leaders grounded in business and economics and former leaders of institutions responsible for capital market regulation.

Finally, Mr. Turner believes that FASB must restructure the Emerging Issues Task Force, which establishes generally accepted accounting principles for many of the new and emerging types of accounting transactions but does not have investor protection and transparency as a key part of its mission statement. Rather, he noted, the EITF often establishes rules that "grandfather" questionable past accounting practices. According to Mr. Turner, the EITF should require public representation and should not be able to pass a new rule without FASB's explicit approval.

Mark to Market Accounting

In the view of Walter Schuetze, proposals to date for such reforms as an SRO for the accounting industry and real auditor independence will not fix the underlying problem, which be believes is a technical accounting one rooted in the financial reporting rules. Change will only come with a "deep and fundamental" reform of the financial reporting rules, he opined.

Under current financial reporting rules promulgated by FASB, management of the reporting company determines the amounts reported in the financial statements for most assets. In order to end earnings management, the former official reasoned, control of the reported numbers must be taken out of the hands of corporate management by requiring that the reported numbers for assets and liabilities be based on estimated current market prices from experts independent of the reporting company. Moreover, the names of the experts furnishing those prices should be included in annual and quarterly reports.

Mr. Scheutze's recommendations are based on his belief that a company's true economic financial condition cannot be seen when assets are reported at their historical cost amounts. In his view, the only objective way that the true financial condition of a company can be portrayed is to mark to market all of its assets and liabilities. He asked for a sense of the Congress resolution that corporate balance sheets must present the reporting company's true economic financial condition through mark to market accounting for the corporation's assets and liabilities. Implementation of this mandate would be left to the SEC, much the way it is done today by the SEC for broker, dealers and mutual funds.