House Enron Reform Bill Would Mean Broad Change for Auditing and Corporate Disclosure

CCH Analysis by James Hamilton, J.D. LL.M.

A sweeping measure approved by the House Financial Services Committee would establish a self-regulatory organization for the accounting profession, provide real time and transparent corporate disclosure in a number of areas, enhance auditor independence, allow the SEC to bar officers and directors, and mandate disclosure of off-balance sheet transactions. The bill seeks to effect important changes in the accounting profession, in the way public companies report their financial results, and the manner in which investors access that information. The bill also calls for a number of studies on such topics as audit committees, analyst conflicts of interest, and the role of investment banks, that could eventually lead to further changes in the future.

Professional Regulatory Organization

The legislation would create an entirely new oversight regime for public accountants, requiring them to be rigorously reviewed to ensure that they meet the highest standards of competence, independence, and ethical conduct. This new professional regulatory organization (PRO) would be subject to strong SEC oversight. The PRO would be made up of a majority of public members not associated with the accounting industry. The SEC, by rule, will establish the criteria under which the PRO may be recognized. The Commission will have the power to disapprove any member of the PRO if it finds the elected member unfit to serve.

The PRO's board will be comprised of both accountants and public members who are not accountants, but the public members must comprise at least two-thirds of the board. Each board member must satisfy financial literacy standards to be set by the SEC. The structure and power of the oversight board seems to be generally modeled on the Exchange Act provisions under which the NASD was formed. (See testimony of Marc Lackritz, Securities Industry Association, before the Financial Services Committee, Mar. 13, 2002).

If the SEC fails to recognize a PRO within one year, the SEC must perform the duties of such organization with respect to any certified financial statement for any fiscal year that ends before one year after any such board is recognized by the Commission.

The PRO would have to certify any accountant wishing to audit the financial statements required from public companies. Additionally, companies would be responsible for ensuring that their accounting firms were in good standing. An accountant disqualified by the PRO could be prohibited from certifying financial statements. The PRO would have the statutory authority to punish accountants who violate securities laws or standards of ethics, competency, or independence, subject to SEC review.

The Commission will mandate the PRO's recordkeeping duties. In addition, the PRO will have to submit an annual report and a proposed budget to the SEC for review and approval. In turn, the SEC must submit the annual report to Congress along with the agency's own views on the functioning of the PRO.

According to former SEC Chairman Roderick Hills, the PRO that H.R. 3763 would create appears to have the authority to investigate and assess the quality of an accounting firm before damage is done. Also, the PRO appears to be able to discipline accountants and accounting firms without compromising the primacy of the SEC. In the view of former SEC Chief Accountant Lynn Turner, the PRO will enhance audit quality through effective independent inspections.

Section 2 of the bill would restrict the ability of auditors to provide non-audit services to clients. The SEC is directed to revise its auditor independence rules to require that accountants will not be considered independent with respect to an audit client if they provide the client with services for financial information system design or implementation, or internal audit services. The SEC must make the requisite revisions within 270 days of enactment. In addition, the bill authorizes the SEC to review the impact of the provision of non-audit services on auditor independence and, after conducting the review, the Commission may add to the list of prohibited non-audit services.

While calling the proscription against providing financial information system design "constructive," former Chairman Hills said that the absolute prohibition on providing any internal audit service was "both unwise and impractical," adding that there is no "bright line" between the internal and external audit tasks.

Insider Reporting

CARTA would dramatically increase the timetable for disclosing insider transactions. Currently, insiders can have up to 40 days to report transactions on Form 4.

The bill would require that Section 16 insiders, such as officers and directors, would have to make transaction information available electronically to the SEC and to their company before the end of the next business day after the day on which the transaction occurs.

In turn, the SEC must make the disclosed information publicly available electronically by the end of the next business day after the day on which the disclosure is received. Furthermore, if the company has a corporate website, the information must be made available on that website before the end of the next business day after the day on which the disclosure is received by the SEC.

Enhanced Disclosure

Section 6 of the bill would require improved transparency of corporate disclosure. Off-balance sheet transactions, such those involving special-purpose entities would have to be fully disclosed. Specifically, disclosure would be required of off-balance sheet transactions to the extent they are not disclosed in the financial statements and are reasonably likely to materially affect the liquidity or the availability of capital resources, or the company's financial condition or results of operations.

In addition, there will have to be disclosure of relationships and material transactions with related persons or entities that may involve transactions on terms that differ materially from those that would likely be negotiated with third parties, including a description of the elements of the transactions that are necessary for an understanding of their business purpose and economic substance, their effects on the financial statements, and the special risks or contingencies arising from the transactions. The SEC would have to adopt rules requiring the above disclosure within 270 days of enactment.

The SEC is also ordered to conduct an analysis of whether additional disclosure may be required to improve the transparency or usefulness of financial statements and other corporate disclosures. In conducting this analysis, the Commission must consider requiring the identification of the key accounting principles that are most important to the company's financial condition and that require management's most subjective and difficult judgments.

The Commission must also consider whether to require an explanation of how different available accounting principles were applied, the judgments made in their application, and the likelihood of materially different reported results if different assumptions or conditions were to prevail.

If the analysis reveals a need for more transparency, the SEC will conduct rulemaking in these areas. In the view of former Chairman Hills, Section 6 would cause both management and auditors to exercise considerable judgment in deciding what key accounting principles are most affecting the apparent corporate financial positions.

By requiring management to explain how different accounting principles would produce materially different results, the bill would necessarily cause auditors to review such explanations. In this way, more judgment would be required of the auditors, in turn making management more concerned about the quality of the audit staff.

Real Time Disclosure

Under Section 4, companies must file with the SEC and publicly disclose, on a rapid and essentially contemporaneous basis, information concerning their financial condition or operations as determined by the Commission. In its rules, the SEC must:

• specify the events or circumstances giving rise to the disclosure obligation;

• establish requirements regarding the timeliness of the disclosure;

• identify how the disclosure will be made in a way that ensures the broad, rapid, and accurate dissemination of the information via electronic or other communications device;

• identify the content of the information to be disclosed; and

• specify any exemptions.

Corporate Bars

The bill gives the SEC the administrative authority to bar persons from serving as officers or directors of public companies, pending judicial appeal. Currently, the SEC must seek a court order to do so. This provision is designed to make it easier for the SEC to ensure that if a person's conduct demonstrates substantial unfitness to serve, that person will not serve on any corporate board. The statutory test for the bar is substantial unfitness. In determining if a person's conduct demonstrates substantial unfitness to serve as an officer or director, the SEC must consider:

• the degree of scienter;

• the economic gain from the violation; and

• the likelihood the conduct would recur absent a corporate bar.

The committee rejected an effort to allow the SEC to seek a bar on officers and directors who have been shown to be unfit to serve, which would have lowered the standard from substantial unfitness. According to Rep. John LaFalce, the committee's top Democrat, the substantial unfitness test actually raises the hurdles the SEC faces in barring officers and directors.

Studies

The bill mandates a number of important studies on issues ranging from the efficacy of audit committees to analyst conflicts of interest to the role of investment banks. For example, Section 14 orders the Commission to conduct a review of any final SRO rules involving stock analyst conflicts of interest and report to Congress on the effectiveness of the rules in addressing matters relating to the objectivity and integrity of analyst recommendations.

The committee rejected an amendment proferred by the Ranking Democrat to ban analysts from owning stocks in the companies they cover. The committee also failed to prohibit analyst compensation based on investment banking revenue. The bill does, however, command the GAO to study the role played by investment banks and financial advisors in helping companies manipulate their earnings and obfuscate their true financial condition.

In addition, the SEC is directed to review and report on whether current corporate governance practices are serving the best interest of shareholders. In particular, Congress wants to know if the rules for determining the independence of directors are adequate. Similarly, the SEC must review the adequacy of the rules for independent directors serving on audit committees. More broadly, the SEC is asked to determine if it should mandate the duties of audit committees.

The Commission must also review, analyze and report on all enforcement actions over the last five years involving violations of reporting rules and restatements of financials in order to identify reporting areas most susceptible to fraud and manipulation, specifically including revenue recognition and accounting for special purpose entities.