United States General Accounting Office
GAO
January 2003
GAO FORUM ON GOVERNANCE AND ACCOUNTABILITY
Challenges to Restore Public Confidence in
U.S. Corporate Governance and Accountability Systems
a
GAO-03-419SP
Governance and Accountability
Forum Discussion
There was general agreement among the participants that the root
causes of the accountability breakdowns are systemic in nature,
complex, and will require leadership and alterations to the current
models in each of the four interrelated areas to transition to an
overall system that is more focused on protecting the public
interest and, in that regard, accountability. They also agreed that
considerable actions have been taken and/or proposed towards
achieving those objectives, but that having the "right people" and
"stakeholders" involved was critical to successfully achieve and
effectively maintain the necessary reforms. Several other key
observations follow:
•
Many boards of directors are reassessing their roles and
responsibilities and currently it is difficult to determine what is
working and what is not working.
•
Participants agreed there is no "silver bullet" to
enhancing the effectiveness of boards of directors in their role of
overseeing management and protecting the public interest. However,
for a board to effectively perform its responsibilities, it must
have the "right people" who possess an "independent spirit" and are
"knowledgeable" of the company/industry and the company's
constituencies.
•
Little progress has been made moving toward a more
comprehensive financial reporting model that would include such
information as operating and performance measures and
forward-looking information about opportunities, risks, and
management's plans.
•
The impetus for changing the financial reporting model
needs more involvement of investors and other users of financial
information as the current model is too driven by those who have
historically focused more on the technical aspects of financial
reporting, such as accountants, regulators, corporate management,
and boards of directors.
•
An "artful blend" of principle-based and rule-based
accounting standards, as well as a financial reporting model with
different tiers of reporting that provides full disclosure, are
fundamental changes needed to improve the financial reporting
model.
•
An "expectation gap" of what an audit is and what users
expect continues to exist, especially with the auditor's
responsibility for fraud detection.
•
Supplementing the traditional financial statement audit
with a "forensic audit" as well as with a more informative
auditor's report could help to narrow the "expectation
gap."
•
A strong, viable Securities and Exchange Commission is
needed to maintain investor confidence. Concern was raised that the
Commission is not fully at that status and that funding issues need
to be resolved.
•
The new Public Company Accounting Oversight Board needs
to officially get up and running with immediate priorities focusing
on establishing policies and procedures for performing its
disciplinary, inspection, and standardsetting functions.
Contents
Comptroller General Aof the United States
United States General Accounting Office Washington, D.C.
20548
January 24, 2003
The last 2 years witnessed major accountability breakdowns at
Enron and WorldCom leading to significant restatements of financial
statements and bankruptcy adversely affecting thousands of
shareholders and employees. Unfortunately, such failures were not
isolated instances as other accountability breakdowns in recent
years included Qwest, Tyco, Adelphia, Global Crossing, Waste
Management, Micro Strategy, Superior Federal Savings Banks, and
Xerox. Although stakeholders of these companies were directly
affected by the accountability breakdowns, these failures have
cumulatively contributed to the general shaking of investor
confidence in
U.S. capital markets.
Last year, on February 25, 2002, GAO held a forum to discuss
systemic issues related to these accountability failures, such as
corporate governance, accounting and reporting, and auditing.1
Since that time, major reform legislation has been enacted-the
Sarbanes-Oxley Act of 2002-and regulators have proposed and/or
finalized a number of new requirements to address issues related to
the failures. However, much of the regulatory reform action is in
process and experience will be needed to evaluate the effectiveness
of the changes. Moreover, the changes to date do not address all
the issues raised by the accountability breakdowns.
On December 9, 2002, GAO convened a governance and
accountability forum for the purpose of identifying past, pending,
and proposed actions designed to protect the public interest by
•
identifying challenges to improving public confidence in
U.S. corporate governance and accountability systems to assist
regulators, the accounting profession, and boards of directors and
management of public companies to effectively implement the
Sarbanes-Oxley Act of 2002 and other related regulatory actions
and
•
placing special interest on steps designed to enhance
independence of the corporate governance system and enhancing the
accounting/auditing and attest/assurance models for the 21st
century.
1U.S. General Accounting Office, Highlights of GAO's Corporate
Governance, Transparency and Accountability Forum,
GAO-02-494SP(Washington, D.C.: March 2002).
Page 1 GAO-03-419SP Governance and Accountability Forum
Specifically, the forum focused on four interrelated
areas-corporate governance, the financial reporting model, the
accounting profession, and regulation and enforcement.
The invited participants were from public, private, and
not-for-profit entities having extensive experience and subject
matter expertise in the accounting profession, corporate governance
issues, financial reporting and disclosure models, auditing,
accounting, and related regulatory issues. GAO also extended
invitations to chairs and ranking minority members of relevant
Congressional committees. Over 40 invites attended. As agreed with
the participants, the purpose of the discussion was not to reach a
consensus, but rather to engage in an open, no attribution-based
dialogue. Therefore, this report summarizes the collective
discussion and does not necessarily represent the views of any
individual participant or GAO.
The participants acknowledged that recent legislative and
regulatory
Corporate Governance
reforms in response to issues raised by significant restatements
of financial statements and corporate failures were placing greater
emphasis on the roles and responsibilities of boards of directors.
They noted that many boards are reassessing their roles and
responsibilities and, at this time, it is difficult to determine
what is working and what is not working. Information on best
practices of boards would be useful to help improve board
operations, for example in areas of improving communications with
management and using external advisors. However, participants
generally agreed that there is no "silver bullet" for enhancing the
effectiveness of boards of directors in their role of oversight of
management and protecting shareholders.
In discussing the role and responsibilities of boards of
directors, participants stated that it starts with having the right
people on the board who are independent, knowledgeable, and ethical
and whose integrity is unquestionable. The basic roles and
responsibilities of the board were defined as enhancing shareholder
value, assessing and monitoring risk, and ensuring management
accountability. It was noted that boards need to do a better job of
identifying their constituencies and understanding and addressing
their concerns. In addition, board members have a responsibility to
educate themselves about the company's operations and plans and to
seek advice of external experts, when and as appropriate.
Participants also focused on the roles of the nominating,
compensation, and audit committees noting that (1) nominating
committees need to independently identify candidates for board
membership rather than "rubber stamp" management's candidates, (2)
compensation committees need to focus more on achievements related
to the company's long-term strategic objectives and less on
short-term accomplishments, such as meeting earnings projections,
and (3) audit committees need to work more effectively with the
independent auditor as defined by the Sarbanes-Oxley Act of 2002,
and not get "tied up" in procedural matters concerned with their
legal liabilities as committee members.
Participants stressed that having the "right people" on the
board was just as important if not more so than having the right
rules. In that respect, it was noted that board members should
possess an "independent spirit" to ask the tough and probing
questions of management. Participants stated that the existing
system for identifying board members might not always be attracting
the "right people." For example, it was stated that some board
members are serving on too many boards to be effective, and that
some board members are serving for personal incentives that could
adversely affect their independence. Some participants believed
that in today's environment, potential legal liabilities were
adversely affecting finding qualified board members. Other
participants believed that there is no shortage of qualified board
members willing to serve and that the board needed to look beyond
the "list of usual suspects."
The traditional financial statements, in terms of form and
content, have not
Financial Reporting
changed much over the years. The financial reporting model uses
a mixture of historical costs and fair value to present a company's
transactions. This model has value but fails to meet the broader
range of information needs of investors who want more
forward-looking information and data that reflect a company's
overall performance, risk profile, and expectations for future
performance.
Little progress has been made in moving toward a more
comprehensive reporting model that would include both financial
information (financial statements and related disclosures) and
nonfinancial information (such as high-level operating and
performance measures used by management and forward-looking
information about opportunities, risks, and management's plans).
Participants stated that the current model is too driven by
accountants, regulators, corporate management, and boards of
directors who have historically focused on the technical aspects of
financial reporting and are more likely to move slowly and
cautiously in making
The Accounting Profession
changes. As a result, the current model has failed to get
adequate "traction" to move toward a more comprehensive reporting
model.
Going forward, participants believed that the impetus for change
to the financial reporting model would have to come more from the
investors and other users of financial information who need timely,
accurate, and useful information to make value and risk judgments
about publicly traded companies. Also, a safe harbor for preparers
and auditors of more forwardlooking information may be necessary to
progress. Other suggestions by participants included moving toward
more principle-based accounting rules to provide more substance
versus form in reporting. There was general agreement that (1) a
combination of principle-based and rule-based standards would be
needed and (2) principle-based accounting rules were not a panacea
to solve financial reporting problems. In that respect, some
participants suggested that standard setters first needed to get
the basics right with the current financial reporting model, for
example in areas such as accounting for pensions, post-employment
benefits, and pro-forma financial statements, to help restore
investor confidence. It was also suggested that the financial
reporting model have different layers of reporting, while still
having full disclosure, coupled with different levels of assurances
depending on users' needs. Such layering would allow a user to
"drill down" to the level of detail needed.
An expectation gap between what an audit is and is not continues
to exist, especially with regard to the auditor's responsibility
for detecting fraud. Some participants believed a periodic forensic
audit may be needed to supplement the traditional financial
statement audit to assist in detecting fraud. However, it was
recognized that an audit cannot create precision or certainty where
such factors do not exist, as financial statements are not as
precise as users may believe. In addition, management and audit
committees have important roles and responsibilities for internal
control to prevent and detect fraud. The Sarbanes-Oxley Act of 2002
will help to close the expectation gap concerning the effectiveness
of internal control over financial reporting by requiring
management and auditor reporting on these controls. Nonetheless, an
expectation gap may still exist as users may be expecting that an
audit addresses internal control over the company's overall
operations and performance. Educating users on the terminology of
internal control reporting, such as reportable conditions, was also
urged so that the users and capital markets do not over react in
interpreting the internal control reports.
Regulation and Enforcement
Participants suggested the need for a new reporting model for
auditing, a renewed focus on the quality of auditing, and building
more effective working relationships with the audit committee. It
was recognized that the standard auditor's report could be made
more useful to users who are seeking greater information about what
the auditor did and found, as well as expanded assurances. Tiered
reporting that would provide expanded optional assurances was
suggested. Participants stated that the quality of audits can be
adversely affected by "time and fee pressures" that lead to less
substantive auditing. Caution was also urged that rotation of audit
partners required by the Sarbanes-Oxley Act of 2002 does not have
the unintended consequence of adversely affecting the quality of
audits through loss of experience with a particular company's
operations and financial reporting. It was recognized that
confidence in audits needs to be restored not only for investors,
but also to attract and retain the best people for the accounting
profession over time.
A strong, viable Securities and Exchange Commission (SEC) is
needed to maintain investor confidence in the markets. Participants
recognized that the SEC's resources had not kept up with its
increased workload over the years. This situation has adversely
affected the SEC's ability to adequately enforce the securities
laws and also its ability to invest in technology to more
efficiently manage its workload. Some participants suggested that
the SEC may wish to consider pursuing the status to operate
independently in setting its own funding levels, as the Federal
Reserve does. It was also suggested that the SEC needed to explore
how it is using its enforcement powers, as civil penalties may
ultimately be hurting shareholders more than those who have
violated the securities laws. In that respect, the SEC should
reexamine the amount and targeting of its civil sanctions, its use
of criminal statutes, and working effectively with the Department
of Justice to put violators behind bars when appropriate.
The new Public Company Accounting Oversight Board (PCAOB) needs
to officially get up and running. Suggested priorities for the
PCAOB included establishing policies and procedures for
disciplinary actions and conducting inspections of registered
public accounting firms. Also, decisions need to be made on the
setting of standards for auditing, quality control, ethics, and
independence. It was also suggested that the PCAOB should evaluate
the recent events that have affected the public's confidence in
auditors to consider what further actions may be needed beyond
those mandated by the Sarbanes-Oxley Act of 2002 and recent
regulatory changes and proposals. In addition, the PCAOB needs to
work cooperatively with the SEC and state boards of accountancy.
The fragmentation of the regulatory system for the public
accounting profession was not completely dealt with by the
Sarbanes-Oxley Act of 2002. At a minimum, the PCAOB will need to
effectively work with the other public regulators on
enforcement/disciplinary matters. Participants generally believed
that the provisions of the Sarbanes-Oxley Act of 2002 should be
implemented and assessed before the Congress should consider adding
any new legislative requirements; however, participants agreed that
much can and should be done by other responsible parties, such as
by regulatory and self-regulatory bodies, within their existing
authority.
Restoring public trust and confidence in a manner that can be
sustained
GAO Observations
over the long-term will require concerted actions by a variety
of parties, including accounting and auditing standard setters,
regulators, management and boards of directors of public companies.
The Sarbanes-Oxley Act of 2002 provides a strong framework for more
effective corporate governance and regulation of the accounting
profession. The SEC and the stock exchanges, along with the
Financial Accounting Standards Board, have also been actively
making progress to address a range of issues raised by the
accountability breakdowns. However, the fundamental principles of
providing the right incentives, providing adequate transparency,
and ensuring appropriate accountability are even more important and
relevant as the new structure and reforms are being
established.
It is important to recognize that rules alone will not
effectively resolve the problems that resulted in massive
restatements of financial statements and ultimately bankruptcy of
certain public companies. The Congress cannot legislate nor can
regulators establish by rule human behavior or integrity to always
do the right thing in protecting the public's interest. Public
company management needs to set the appropriate "tone at the top"
and that culture needs to be carried throughout the company and
exhibited by the board of directors in its oversight of management
and in its protection of shareholder interests.
The accounting profession needs to vigorously work to rebuild
its greatest asset-public trust-in order to restore faith in the
integrity and objectivity of the profession. Accounting and
auditing standards need to be reexamined to provide enhanced value
to users of financial statements, related disclosures, and more
comprehensive business reporting. Users of these products will need
to step forward to help ensure the value of an enhanced financial
reporting model and related auditor assurances for the effective
functioning of U.S. capital markets. Accountants and regulators who
have historically driven changes to the financial reporting model
do not have the same set of needs as users of financial statements.
In that respect, a broader performance and accountability reporting
model is needed and should include not just financial statements
but also performance and other information necessary to better
assess institutional value and risk.
GAO will continue to play a professional, objective, nonpartisan
and constructive role in assisting the Congress, regulators, and
the accounting profession as initiatives are proposed, agreed upon,
and become operational. In that respect, the views of the
participants in this forum represent considerable experience in the
matters discussed and represent one way in which an independent
party, such as GAO, can assist those who define and/or implement
policy.
The results of the forum are organized by the major areas of
discussion and reflect subsequent comments we received from the
participants on a draft of this report. Appendix I provides a list
of the participants.
For additional information on our work concerning corporate
governance, the accounting profession, financial reporting, and
related regulatory matters, please contact Jeffrey C. Steinhoff,
Managing Director, Financial Management and Assurance, on (202)
512-2600 or at
[email protected].
I wish to thank each of the participants for taking the time to
share their knowledge and to provide their insights and
perspectives on the important matters discussed during the forum. I
look forward to working with them on these important issues of
mutual interest and concern in the future.
David M. Walker Comptroller General of the United States
Corporate Governance
Defining the Roles and Responsibilities of the Board of
Directors
Recent legislative and regulatory initiatives, such as the
Sarbanes-Oxley Act of 2002, Securities and Exchange Commission
(SEC) proposals and rules, and proposed revised stock exchange
listing requirements, have addressed weaknesses in corporate
governance exposed by the major financial reporting issues raised
by restatements and corporate failures, placing greater emphasis on
the roles and responsibilities of boards of directors. Although
these reforms are not yet fully in place and not all issues have
been addressed, many corporate boards are reassessing their roles.
However, participants agreed that there is no "silver bullet" and
that it is difficult at this time to say what is working and what
is not working.
Participants believed that it is important to continue working
toward more effective boards of directors and discussed the
importance of clearly defining and, in some cases, redefining, the
roles and responsibilities of the board of directors of public
companies as a significant measure to help restore investor
confidence in the market. The board has a responsibility to enhance
shareholder value, assess and monitor risk, and ensure management
accountability. In that respect, the operations of the boards
should reflect a culture that embraces these responsibilities. In
addition to focusing on what accountants, regulators, and corporate
management and boards of directors (the "supply side") should do,
boards need to focus more on what investors and other users of
financial information (the "demand side") want from corporate
governance.
In order to fulfill its responsibility of effectively overseeing
management, the board must have a thorough understanding of the
company, its business model and related risks, corporate culture,
and the various interests the board represents. Participants
believed that the board has a responsibility to educate itself
through the use of external advisors or other means and not rely
solely on information provided by management. This will better
allow the board to raise difficult questions and probe issues to
provide input on strategy, assess and manage risk, and hold
management accountable for its actions. The time frame needs to be
very clear, as creating value is a long-term, not a short-term,
process. Investors are not looking for quick schemes that endanger
the company.
In addition to its responsibility to oversee management, the
board also has a responsibility to shareholders and other
stakeholders of the company, such as employees, creditors, and the
public. Participants believed that boards need to do a better job
of identifying their constituencies and understanding and
addressing their concerns. For example, from the shareholders'
point of view, many believe that board structures have not been
working properly to both protect shareholders' interests and grow
share value. We have become a nation of investors, and boards need
to focus attention on the fact that there has been a shift from
shareholders not only being individual investors but also
institutional investors, such as pension plans and mutual funds,
which are acting as fiduciaries for others. Institutional investors
may have concerns different from those of individual investors
regarding expectations for corporate governance and the role of the
board of directors.
Participants also felt that boards needed to reexamine how they
are structured and how they operate. Many boards were not perceived
to function properly for investor protection, which is a negative
reflection on the entire corporate governance process. To some
extent, deficiencies in the functioning of boards may have been
masked by the effect of a flourishing market and may not have been
readily apparent until market downturns began to occur. It is
incumbent upon boards to establish processes that are appropriate
and effective to restore investor confidence rather than relying on
a checklist approach to corporate governance. Participants believed
that information on best practices of boards would be useful to
help to improve board operations. Some best practices include
focusing on improving communications with management and using
external advisors. It was also suggested that boards should
effectively use the "gatekeepers" (auditors and audit committees)
for help in the board's oversight of financial management and
reporting activities of the company.
Independent committees of the board of directors, such as the
auditing, compensation, and nominating committees, play an
important role in effective corporate governance. Audit committees
should not only oversee both internal and external auditors, but
also be proactively involved in understanding issues related to the
complexity of the business, and, when appropriate, challenge
management through discussion of choices regarding complex
accounting, financial reporting, and auditing issues. In that
respect, the role of the audit committee, which in some cases has
not been very active or effective in its oversight of management or
auditors as related to financial reporting, is evolving into not
just financial management oversight, but the overall aspects of the
company's financial reporting, such as releases on earnings
expectations and quarterly financial reports. In addition, the
Sarbanes-Oxley Act of 2002 defines a number of audit committee
responsibilities for the hiring, compensation, and oversight of
auditors. However, a serious concern exists over whether audit
committee members are focusing more on procedural matters to
protect
Identifying the Right People to Serve on Boards
themselves from liability than on improving their competence and
effectiveness as a committee. Also, compensation committees need to
understand the implications of compensation to provide incentives
for management to do the right thing for the company and its
shareholders versus themselves. Compensation committees need to
focus on executive performance more related to the company's
long-term objectives rather than just short-term business results.
In addition, nominating committees need to ensure that they
identify the right mix of talent to do the job and make it clear to
candidates what is expected of them as a board member rather than
merely approving candidates identified by management. In that
respect, some participants stated that boards are often made up of
consensus builders and, in that case, a dominant member of the
board could effectively control the board's agenda.
Participants also discussed the importance of providing
reasonable transparency of key information, with regard to both
financial information of the company and board operations. Boards
need to focus on enhancing the quality and reliability of financial
reporting, identifying key elements of disclosure, and ensuring
that such information is appropriately disclosed to investors and
the public. Participants also believed that there is a need for
better transparency of board activities to help restore investor
confidence, such as reporting on the board's progress against best
practices of leading companies2 noted for the effectiveness of
their boards. If the board is not following best practices, it
should report why it is not following these practices. The point
was also made that successful companies have reinvented themselves
through two fundamental focuses-ethics/integrity and respect for
people. These behaviors have been demonstrated by longterm
successful companies.
Participants stressed the importance of independence, both in
fact and appearance, as essential for the board to be able to
fulfill its responsibilities. Participants expressed the belief
that having the right people on the board is just as important if
not more so as having the right rules under which the board
operates. Nominating committees need to identify competent
individuals who possess an "independent spirit" which allows board
members to raise difficult questions and probe issues related
2One source of information on best practices of leading
companies is the 1999 Report and Recommendations of the Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit
Committees.
Page 10 GAO-03-419SP Governance and Accountability Forum
to management's decisions to ensure that the company operates
honestly and effectively in the shareholders' interest. Even if
board members are independent, they can be ineffective as directors
if they lack expertise or knowledge relevant to the company and its
business. Therefore, board members must also be willing to educate
themselves about the company and the risks it faces rather than
relying on a checklist mentality of corporate governance
requirements issued by the stock exchanges.
Participants also noted that unfortunately, as a result of the
recent major financial reporting issues leading to restatements
and, in some cases, bankruptcy, board members have focused on the
rules and may be concerned more about their personal reputation and
financial liability rather than focusing on protecting
shareholders' interests and adding shareholder value. Participants
expressed concern that disincentives such as legal liabilities,
including financial and reputation risks, may limit a board's
ability to attract the right people to serve over time.
Participants raised the question whether the current system of
selecting directors needs to be reexamined because the existing
system from a shareholders' point of view has not been working to
get the right people on boards. For example, it was viewed that
individuals who serve on numerous boards at the same time and/or
who serve for personal incentives, over time lose the "independent
spirit" needed to be an effective board member. Participants also
stated there is some evidence that the recruiting of directors is
being adversely affected by the current environment that is placing
ever-increasing demands on board members. Examples were cited of
increased premiums for finding qualified board members and such
searches needing to identify 15 candidates for a board position
just to get one who is willing to serve. Other participants
commented that there is no shortage of qualified people to serve on
boards of directors. Many people are willing to serve higher goals
and the selection process needs to go beyond "its usual pool of
suspects." Some participants suggested that perhaps serving as a
director on a board should be a salaried position if shareholders
were willing to bear the cost. Other participants noted, however,
that having salaried board members could be problematic because
shareholders would have to be able to hire and fire the directors
that would cause great instability and salaried board members may
also lack an "independent spirit."
Participants also discussed the appropriateness of the chief
executive officer (CEO) serving as chairman of the board of
directors, which could present potential conflicts resulting from a
single individual functioning in these dual roles. Some
participants believed that separation of the CEO and chairman of
the board positions recognizes the differences in their roles and
eliminates conflicts in functions. For example, management is
responsible for the operations of the company and members of the
board in their oversight function should have the ability to
challenge the CEO in managing the company. Although the corporate
governance community in the United States may not currently be
receptive to requiring the separation of the CEO and the chairman
of the board, such a practice does exist in the United Kingdom,
where apparently there is more receptivity. Therefore, regulators
may need to look beyond the United States to consider the merit of
whether these positions should be held by different
individuals.
Other participants pointed out that not allowing the CEO to also
serve as the chairman of the board of directors does not guarantee
that problems will be avoided if the board lacks an independent
spirit to question management, citing such examples as Enron,
Global Crossing, and WorldCom, all of which had a separate CEO and
chairman. Some separations of the CEO and chairman functions are
successful and others are not. A CEO may lose authority when the
position is too diluted. United States firms have been successful
because they have had strong leaders running them, and an effective
and strong board of directors can counterbalance a strong
executive.
Financial Reporting
Little Has Changed with the Financial Reporting Model
Participants commented that traditional financial statements, in
terms of their form and content, have not really changed over the
years. The model we have today can be traced all the way back to
the early 1970s (back to the Trueblood Committee).3 Participants
attributed this lack of change to the financial reporting model
being largely driven by the supply side, that is accountants,
regulators, and corporate management and boards of directors.
Participants referred to a landmark study on financial reporting by
the Jenkins Committee4 as evidence that little has changed.
Participants acknowledged that accounting standards have changed to
capture fair value in addition to historical value, resulting in a
model that is now a mixture of the two, whereas the original
financial statement model was based solely on historical costs.
However, the majority of the Jenkins Committee's recommendations
never got any "traction" to move them forward. The Financial
Accounting Standards Board (FASB) has many of these items on its
agenda. At the same time, there are many other items on FASB's
agenda. Participants felt that if stakeholders were serious about
improving the financial reporting model, a group would be
established and funded specifically for this purpose. Participants
stated that such a group was proposed by the Jenkins Committee, but
it was never established. There needs to be a sense of urgency in
order to make the investment, commitment, and ultimately change the
model. However, one participant questioned that since almost 10
years have gone by since the Jenkins Committee made its
recommendations, is there really a demand for change?
3The Trueblood Committee (named after the chairman), a group
formed by the American Institute of Certified Public Accountants
(AICPA) to study the objectives of financial reporting, recommended
financial statements that set forth the objectives of financial
accounting and reporting and provided a conceptual framework for
deliberations about accounting matters. (See the AICPA's Objectives
of Financial Statements, Report of the Study Group on the
Objectives of Financial Statements, October 1973.)
4The Jenkins Committee (named after the chairman), a group
formed by the AICPA in 1991 to address concerns over the relevance
and usefulness of financial reporting, recommended in its 1994
report that standard setters develop a comprehensive reporting
model that includes both financial information (financial
statements and related disclosures) and nonfinancial information
(such as high-level operating data and performance measures used by
management, management's analysis of changes in financial and
nonfinancial data, and forward-looking information about
opportunities, risks, and management's plans). (See the AICPA's
Improving Business Reporting-A Customer Focus: Meeting the
Information Needs of Investors and Creditors, Comprehensive Report
of the Special Committee on Financial Reporting, 1994.)
Current Financial Reporting Model Has Limited Value in Today's
Business Environment
Some participants agreed that financial statements are an
important aspect of overall business reporting, but were concerned
that the existing model focuses too much on financial statements
rather than on the broad range of information that is needed by
investors to make good financial decisions. Other participants
commented that financial statements that exist today, while they
may be useful to some, are not used very much by investors.
Financial statement disclosures are difficult to understand, as
though written in a "foreign language." Participants stated that
the disclosures must be made more understandable.
However, there is a lot of dialogue taking place today
concerning business reporting. For example, regulators are asking
what should be disclosed, what is the purpose of financial
statements, and how useful are they? What are analysts doing with
financial statements? What do analysts use to value stock? Are they
using financial statements? If so, what information in the
financial statements are they using to value stock? What additional
information would assist them in more accurately valuing stock?
Participants noted the need to report information about the
business model, as users of financial reports first must better
understand the entity's business model in order to comprehend
financial and nonfinancial information about the entity.
Financial statements today focus on reliability much more than
on relevance. Historical information is reliable, but not
necessarily relevant. Fair value information is evolving but
improvements in reliability are needed. Participants agreed that
reliability is fundamental to useful business reporting; however,
participants felt that financial reporting would be much more
useful if it were expanded to include key performance indicators
and measures (including disclosures on how the key measures were
chosen). Participants raised questions about the gaps in reporting
of intangibles. For example, in a knowledge-based economy, one
could argue that the most important assets are people (human
capital); however, current financial reporting records investments
in people as an expense and liability. Participants agreed that it
would be useful if financial reporting recognized people as assets,
but raised the difficulty in valuing human capital. Participants
generally agreed that there is a demand for both historical and
fair value reporting. However, participants felt that FASB needed
to better differentiate between the two. In that respect, some
participants felt that FASB is marching toward a "fair value" path
and cautioned that the fair value reporting model is not always
good and needs to be used only where it really makes sense.
Considerations for Moving toward a Comprehensive Financial
Reporting Model
Participants acknowledged that financial reporting, in addition
to being largely driven by the accounting profession, also has been
driven by the legal system, resulting in an overload of information
that is too complex and not easily understood. Disclosures that run
on for pages are not understandable. Experts are needed to
interpret the disclosures and sometimes even they cannot decipher
what is being reported. However, participants understand that
accountants are taking a risk when they issue an opinion on the
financial statements. The litigious environment has also led to a
"check box" mentality where it is more important to follow the
accounting rules when preparing financial statements than actually
reporting the economic substance of the transaction.
Participants generally agreed that financial statements are not
designed to serve all business needs and that other types of
business reporting are needed to assist investors and other users
in making decisions. Participants also generally agreed that the
demand side (investors and other users of financial information),
has not been as involved as it needs to be to make financial
reporting more meaningful and understandable. More needs to be done
to convince investors and other users to demand different
reporting. Voluntary disclosures are rare and only in industries
that demand this type of information. The voluntary process has
resulted in some movement toward better reporting, but it is very
slow moving. Change is going to have to come from the demand side
and is going to require a lot of leadership from very influential
people. Input from advisory councils may also be beneficial for
developing a broader business reporting model. While it is
essential that a new model not be driven totally by the supply side
(accountants, regulators, corporate management, and boards of
directors), there cannot be a disconnect between the supply and
demand sides.
Participants also cautioned that we need to move forward
patiently toward a new comprehensive reporting model. It was viewed
that forward, realtime, qualitative information, all of which would
be helpful in predicting future cash flows, may require a safe
harbor from liability. It is also important to keep in mind the
role of the regulator in this process since the public needs to
have confidence in the regulators to enforce rules. Regulators may
not be totally supportive of a more comprehensive business model
because they are concerned that the information would be based on a
lot of judgment and, therefore, lack of precision, which could make
enforcement of reporting standards difficult.
Participants discussed the lack of investor confidence in the
current financial reporting model and the need to first improve the
reliability of financial reporting before adding any new reporting.
First, get the basics right, that is, the "blocking and tackling"
of financial reporting. Participants cited accounting for pensions,
postemployment benefits, and pro-forma financial statements as
examples of accounting treatments that need attention before
building on any new reporting requirements. Issuers of financial
statements who are inappropriately bending the current accounting
rules need to know they cannot get away with this anymore.
Participants discussed the merits of replacing accounting rules
with principle-based standards to promote more substance versus
form in reporting. However, some participants cautioned that
principle-based standards should not be viewed as a panacea to
solve the problems with financial reporting and could lead to an
undesirable situation where you would not have comparability or
agreement as to the treatment of similar transactions. Also,
stakeholders may not interpret principles consistently, and it is
important for stakeholders to have the same conceptual framework as
preparers when interpreting a principle. In addition, you would
need the right kind of implementation guidance to carry out a
principle. Participants agreed that while accounting rules are also
needed, there should not be such blind adherence to accounting
rules to result in reporting form over substance. Participants
offered that an "artful" blend of both principles and rules would
be useful. The Employee Retirement Income Security Act (ERISA) was
cited as an example of an approach that blended both a
principles-based (general fiduciary standards) and rulesbased
(prohibited transactions) approach to an important issue
(retirement security).
Participants also discussed the idea of exploring different
levels or layers of reporting while still having full disclosure.
Such layering will allow users to get only the information they
need. For example, the basic level of reporting would include
performance and risk data, an industry layer could include
benchmarking information, and a company specific layer could
include information management feels it is appropriate to disclose
that is not contained in other layers of reporting. Along with this
idea is the need to explore different levels of verification or
assurances by independent parties based on the users' need for such
verification or assurances. For example, what type of assurances
are needed for nonfinanical information and can auditors provide
such assurances? Overall, it is critical to get the demand side
(investors and other users of financial information) to weigh in on
what information they need and want. It is not realistic to only
expect the supply side (accountants, regulators, and corporate
management and boards of directors) to come up with the best
solutions for improving the financial reporting model.
Although time did not permit its discussion, financial literacy
was raised as an important issue that needs addressing.
Participants agreed that there clearly is a need for more education
and for investor assistance in this area.
The Accounting Profession
An Expectation Gap Exists Concerning the Role of Auditing
The participants discussed the auditor's responsibility for
detecting fraud and the meaning of the assurances provided by the
auditor's report on the financial statements. These issues have
continued to plague the accounting profession since the 1970s
despite actions taken by the profession to narrow the so-called
"expectation gap" between what the public expects or needs and what
auditors can and should reasonably be expected to accomplish.5
Users often equate a clean audit opinion with a seal of approval
that fraud does not exist and annual reports are both complete and
accurate. However, auditors do not provide absolute assurance and
the scope of the opinion is limited to certain financial-related
information. One participant explained that there are a lot of
things an audit cannot do. For example, an audit cannot create
certainty in an environment where there is no certainty. An audit
cannot guarantee precision in an environment where estimates are
made. An audit cannot ensure that stock prices will be achieved. We
cannot lose sight of the fact that in a risk-taking environment
businesses do fail. Auditing is not the "be all" and "end all" to
solve the problems in the business place. However, participants
generally agreed that while the accounting profession needs to take
additional steps to address any misunderstanding as to the limits
of an audit, there is room to improve the audit process and auditor
reporting.
5We reported on this issue in The Accounting Profession: Major
Issues: Progress and Concerns
(GAO/AIMD-96-98, Washington, D.C.: Sept. 24,
1996).
Page 18 GAO-03-419SP Governance and Accountability Forum
Participants recognized that management has the responsibility
for preventing and detecting fraud. At the same time, they agreed
that it is fair to expect auditors to provide "reasonable
assurance" of detecting any material fraud. Participants discussed
the need to mitigate the opportunity and risk for fraud by
educating boards of directors and ultimately changing the tone at
the top of the company. Some participants liked the idea of
auditors periodically performing more of a "forensic-type" audit6
in which auditors would be more skeptical of management, but
cautioned that this approach could have a negative effect on audit
quality because management and the auditor might not work as
actively together on an ongoing basis. Participants agreed that an
adversarial relationship between the auditor and management would
not be constructive in that the cooperation of management is
critical to both an effective and efficient audit. However,
participants agreed that auditors should be more skeptical and
should say no and walk away from clients more often than they
currently do. The participants applauded the deterrent put in place
by the Sarbanes-Oxley Act of 2002, which sends a signal that
persons who prepare or attest to fraudulent financial statements
can go to jail. This deterrent has raised awareness and
conscientiousness within all levels of the financial reporting and
auditing process as to the significance of their job in preparing
financial statements.
6The concept of forensic auditing was recently suggested by the
Panel on Audit Effectiveness to improve the likelihood that
auditors will detect fraudulent financial reporting (see The Panel
on Audit Effectiveness Report and Recommendations, Aug. 31, 2000).
Forensic auditing, as explained by the Panel, would require that
auditors undertake an attitudinal shift in their degree of
skepticism and presume the possibility of dishonesty at various
levels of management, including collusion, overriding of controls,
and falsification of documents.
Participants generally viewed the new internal control reporting
requirements of the Sarbanes-Oxley Act of 2002 as a good
requirement. A participant added that earlier mandatory internal
control reporting probably would have surfaced problems with
ineffective boards of directors and audit committees.7 However,
participants cautioned that reporting only on internal controls
over financial reporting could lead to more of a gap in what
investors perceive as the scope of the auditor's work. For example,
users of financial reports are interested in a company's overall
performance and outlook and, accordingly, would be interested in
the effectiveness of internal control over the process that
produces that data. In that respect, participants also discussed
the need for auditors to expand their focus on internal control to
include controls over performance data in order to better meet the
needs of investors for assurances on financial statements and for
understanding all business risks. Also, new information not only
needs to be useful, but also needs to be understood by investors.
For example, investors do not understand terminology such as
"reportable conditions,"8 which could result in investors over- or
under-reacting to problems. Participants also suggested that the
one-page audit opinion should be replaced with "tiered" reporting
of audit results, where firms can obtain the level of assurance
they desired. For example, in today's environment, audit committees
would most likely ask for the deepest "tier" of audit reporting to
better carry out their responsibilities.
Participants generally agreed that the profession needs a new
reporting model for audits to eliminate the misunderstanding as to
what an audit of financial statements is and what its limits are.
The participants acknowledged that the financial audit process is
largely driven by the accounting profession and suggested that the
profession needs to spend more time understanding what the demand
side (investors and other users of financial information) needs and
wants from auditors. However, the participants recognized that one
of the big obstacles for innovation in
7This comment was based on the standards and guidance contained
in Internal Control-Integrated Framework, published by the
Committee of Sponsoring Organizations (COSO) of the Treadway
Commission, for reporting on the effectiveness of internal control,
which addresses a company's control environment including boards of
directors and audit committees.
8The AICPA's Generally Accepted Auditing Standards defines a
reportable condition as a significant deficiency in the design or
operation of internal control that could adversely affect the
entity's ability to record, process, summarize, and report
financial data consistent with management's assertions in the
financial statements.
More Attention Is Needed on the Quality of Audits
reforming the audit process and auditor reporting is the
auditor's fear of legal liability. One participant added that the
current regulatory structure has dampened the profession's spirit
for innovation.
Participants commented that there are good solid audits being
performed; however, some participants expressed concern that
overall, time and fee pressures both from company management and
from within the auditing firms have resulted in less and less
auditing, particularly less substantive testing of transactions. In
that respect, the financial audit is considered the "loss leader"
in many audit organizations with a focus on cutting hours and costs
and as a means to obtain consulting engagements. Some participants
also pointed out that most of the auditing is currently being
performed by inexperienced auditors. Further, several participants
cautioned that the auditor rotation rules currently being developed
by the regulators could further reduce audit quality by resulting
in a loss of continuity, experience, and technical knowledge on an
audit.
Participants felt that the profession needs to elevate and
restore the importance and the quality of the financial statement
audit. Participants stated that the accounting profession needs to
candidly discuss what it is doing to improve the audit process to
restore public trust. Further, a growing concern for the profession
is its ability to attract and retain the best people over time. It
was stated that auditors frequently leave the profession early in
their careers to join clients, and that over half of CPAs are not
practicing public accounting. One participant added that the
interest in the profession over the past 10 years has dropped by
half, although the recent publicity stemming from Enron and
WorldCom, albeit negative, has actually sparked increased interest
in the profession. Participants generally agreed that the
profession needs to aggressively address the issue of attracting
the best people to the profession.
Auditors Need to Strengthen Their Relationship with Others in
the Corporate Governance Process
Participants generally agreed that improvements in corporate
governance will bring about improvements in auditing. It was viewed
that one of the more positive outcomes of the Sarbanes-Oxley Act of
2002 is the relationship the act establishes between the auditor
and audit committee by making the audit committee in essence the
client, versus company management. Historically, participants felt
that auditor communication with audit committees has been variable.
Participants generally agreed that auditors should be able to speak
more freely, openly, and honestly with audit committees on risks
facing the company and on the appropriateness of the company's
accounting policies. Audit committees should be demanding more
information from auditors and asking auditors if they have
sufficient resources, both in number and expertise, to adequately
perform the audit. Audit committees and auditors together can
become good safeguards for investors. A point was also made that
the role of the internal auditors, specifically their cooperation
and coordination with the external auditors and the board of
directors, should be improved, which ultimately could improve the
quality of financial reporting and the external audit. In addition,
disclosures, such as those required to be reported to the SEC on
Form 8-K,9 should be improved to be more transparent and helpful to
regulators in determining the reasons and circumstances surrounding
auditor changes.
9An SEC registrant must file a Form 8-K when its external
auditor resigns, declines to stand for reelection, or is
dismissed.
Page 22 GAO-03-419SP Governance and Accountability Forum
Regulation and Enforcement
Providing the SEC with Sufficient Resources to Restore Investor
Confidence
Participants uniformly agreed that the nation needs a strong,
viable SEC to instill investor confidence in our markets. The SEC
plays an important role through its responsibilities to regulate
activities of public companies and their auditors and to conduct
related enforcement actions, as well as to establish and sustain
the new Public Company Accounting Oversight Board (PCAOB)
established by the Sarbanes-Oxley Act of 2002 until the PCAOB is
certified by the SEC as ready to operate. However, participants
noted the SEC may not have been provided with sufficient resources
to achieve such results. For example, participants stated that the
SEC has recently been operating on a budget of about $450
million.10 It was noted that although the Senate authorized about
$750 million for the SEC for fiscal year 2003, an amount that the
Senate believed would be sufficient to implement provisions of the
Sarbanes-Oxley legislation to restore investor confidence, the
Office of Management and Budget only proposed a funding level of
about $500 million.
Participants believed that a lack of sufficient funding provides
constraints in two areas that are vital to the SEC-staffing and
technology. To carry out its important function of restoring
investor confidence, the SEC may not always be able to attract the
right people and retain them under the existing structure. In
addition, to effectively conduct its reviews of public companies,
the SEC will require a large technology investment and related
training of SEC staff. Participants questioned whether, given the
current funding restraints, existing models for generating revenues
for the SEC were workable. Participants believe that models that
provide temporary resources to SEC, such as through fellowships
from the accounting profession, are not the answer to its funding
and staffing problems and can raise conflict of interest issues.
Accordingly, some participants believed that it is time to think
about having the SEC operate independently in setting its own
funding levels, like the Federal Reserve, and to let the SEC
determine and set its own fees, with industry participation, for
the activities it conducts. If the SEC were able to establish its
own annual budget and collect fees, the SEC would be better able to
conduct its
10Prior GAO reports and testimonies discuss SEC resource issues
and the need for the SEC to improve its strategic planning to more
effectively manage its operations and limited resources. See U.S.
General Accounting Office, SEC Operations: Increased Workload
Creates Challenges,
GAO-02-302, Washington, D.C.: Mar. 5, 2002) and U.S.
General Accounting Office, Protecting the Public's Interests:
Considerations for Addressing Selected Regulatory Oversight,
Auditing, Corporate Governance, and Financial Reporting Issues,
GAO-02-601T, Washington, D.C.: Apr. 9, 2002).
Reconsidering the Existing Approach to Enforcement Actions to
Restore Public Confidence
activities, attract the best people, and enhance its technology
to more efficiently and effectively operate. Participants noted
that even if the SEC were independent regarding its funding, the
Congress could still oversee the SEC.
Participants discussed the importance of effective SEC
enforcement actions as a means of restoring investor confidence in
the markets. The SEC tries to create deterrence and be measured in
imposing sanctions. If there are no clear negative consequences to
securities violations or wrongdoing, investors may perceive that
the system is not working properly. Although the SEC has an array
of sanctions available, all SEC enforcement actions are civil
based, which ultimately results in shareholders bearing the burden
of the costs of legal proceedings and sanctions. Some participants
believed that shareholders were benefiting from litigation and
questioned the appropriateness of civil-based enforcement actions,
citing the fact that shareholders have already been financially
hurt by the actions that lead to the sanctions. Participants also
discussed whether the right people were being held accountable and
whether the SEC's civil-based enforcement actions were sufficient
to discourage the bad actors.
Participants raised questions about whether the SEC should
reconsider the amount and targeting of its civil sanctions and more
frequently use other types of remedies, such as criminal sanctions,
to hold people accountable for wrongdoing. In that respect,
participants noted that the SEC should be effectively using the
option of referring cases when appropriate to the Department of
Justice for investigation for possible violation of criminal
statues. Participants questioned how well that process was
working.
The Sarbanes-Oxley Act of 2002 provides for additional
enforcement authority for both the SEC and the newly created PCAOB.
In response to the question of whether the Sarbanes-Oxley Act of
2002 should be revisited, participants believed that although
ultimately some technical changes to the act may be necessary, the
SEC and the PCAOB needed to move forward to implement the act.
Also, the SEC and the PCAOB should explore integrating their
activities to get the new enforcement mechanisms in place to
determine how well they may address some of the issues
discussed.
Establishing Priorities for the PCAOB
Participants believed that the PCAOB needs to be quickly set up
and establish its priorities so it can begin the difficult task of
restoring public confidence. Many participants believed that the
PCAOB's most immediate priority should be implementing a
disciplinary process to let the public know that failed auditing
will be dealt with and trust can be restored. The disciplinary
process needs to have the necessary incentive measures to serve as
preventative measures before problems can become more serious.
Other immediate priorities should be setting up an inspection
function of auditors that audit SEC registrants and determining how
standards that govern the work of the accounting profession, such
as auditor independence rules and standards for conducting audits,
should be set. Some participants believed that the existing
inspection process could be improved by looking less at the
accounting firms' internal systems for quality control and more at
the quality of the judgments that were made by the auditors in
conducting the audit.
Participants also believed that the PCAOB also needs to evaluate
the events that have lead to the lack of public confidence in the
markets and take a fresh look going forward. For example, the PCAOB
should consider the reasons the accounting profession is organized
the way it is, including federal/state regulation such as the
licensing structure, reasons accounting firms practice as
partnerships, the effects of private litigation, and the structure
and role of the state boards of accountancy. Participants also
noted that the PCAOB should take advantage of the fact that under
the current environment no one has more motivation for getting "bad
auditors off the street" than the accounting firms themselves. The
accounting firms do remove "bad auditors," but this is accomplished
without publicity so that their efforts are not well known.
Participants also believed that a challenge facing the new PCAOB
will be dealing with the complex relationship between federal and
state governments involved in regulating the accounting
profession.11 Participants identified the need for better
communication and sharing of information between federal entities
such as the SEC and the new PCAOB and the state licensing and
regulating entities. For example, states are often hampered in
their ability to take appropriate regulatory actions because
11Our report, The Accounting Profession: Status of Panel on
Audit Effectiveness Recommendations to Enhance the Self-Regulatory
System
(GAO-02-411,Washington, D.C.: May 15, 2002) discusses
the various bodies that regulate the accounting profession.
Page 25 GAO-03-419SP Governance and Accountability Forum
they do not get referrals from the SEC and the AICPA, or because
those organizations have made the information confidential. Also,
ongoing litigation impedes information flow. In addition,
participants stated that some states have been independently trying
to address accountancy reform and, in some cases, have proposed
reforms that have gone further than the Sarbanes-Oxley Act of 2002
because they feared that the federal government would not act. This
has led to additional inconsistency in requirements between
states.
Participants encouraged the SEC and the PCAOB to work closely
with the states in taking actions to restore public confidence and
ensure an appropriate degree of consistency needed for viable
interstate commerce. Some participants suggested that the PCAOB
consider the banking industry to provide examples of the
integration of federal and state regulation and lessons learned
about that structure from the savings and loan and banking crises.
Participants noted that with increased globalization of businesses'
operations and the need for harmonization of accounting and
auditing standards, as well as the need for preemptive measures,
there may be more federal involvement such as the Sarbanes-Oxley
Act of 2002.
Appendix I
GAO's Governance and Accountability Forum
Tom L. Allen
Participants
Lawrence F. Alwin
Raymond L. Bromark Roel C. Campos Richard E. Cavanagh Peter
Clapman
James L. Cochrane
J. Michael Cook Jackson Day Daniel Dustin Michael Emen William
Ezzell
Stephen R. Ferrara Chairman, Government Accounting Standards
Board
President, National Association of State Auditors, Comptrollers,
and Treasurers
Partner, Pricewaterhouse Coopers, LLP
Commissioner, U.S. Securities and Exchange Commission
President and CEO, The Conference Board
Senior Vice President and Chief Counsel Corporate Governance,
TIAA-CREF
Senior Vice President, Strategy and Planning New York Stock
Exchange
Retired Chairman and CEO, Deloitte & Touche, LLP
Acting Chief Accountant, U.S. Securities and Exchange
Commission
Executive Secretary, New York State Board for Public
Accountancy
Senior Vice President Listing Qualifications, NASDAQ
Chairman, Board of Directors, American Institute of Certified
Public Accountants
Assurance Practice Leader, BDO Seidman, LLP
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