Congress is preparing to act to try to restore public confidence
in the way that companies state their earnings, which has been
deeply shaken by the continuing scandals and indictments. The
revelation that WorldCom had inflated its profits by almost $3.8
billion over the past 15 months, following the irregularities and
frauds uncovered at companies such as Enron, Adelphia
Communications, Dynegy, Tyco International, and Global Crossing,
clearly shows that something is deeply wrong with American business
practices. There is wide agreement in Congress and among the public
that accounting standards must be revised and industry oversight
strengthened. But there is a huge difference between correcting an
obvious problem and creating a legislative straitjacket that ends
up hurting more than it helps. While deep anger is justified,
Congress should not pass legislation that merely seeks
The House of Representatives and the Securities and Exchange Commission (SEC) have proposed intelligent approaches that would not only correct today's problems, but also provide enough legal and regulatory flexibility to address future situations. This is especially important because accounting is extremely complex and business practices change rapidly. What fixes today's problems may be completely inadequate tomorrow. Worse, by locking accounting into an obsolete structure, an overly specific law could actually make it harder to prevent future problems. H.R. 3763 and the regulations proposed by the SEC propose significant reforms to improve accounting practices.
The Senate Banking Committee, however, has taken a step in the
opposite direction. The Public Accounting Reform and Investor
Protection Act proposes setting up a new unnecessary
quasi-government agency and locks into law existing regulations and
explicit requirements, which could become outdated rapidly. It also
includes punitive restrictions that may sound good to voters but
make little logical sense.
In the long run, an overly strict bill may prove to be worse for
consumers and investors than no legislation at all. Locking
auditing into an inflexible regulatory scheme could actually reduce
the accuracy of future financial statements. If Congress cannot
agree on legislation that takes the House's flexible approach, it
should do nothing and simply allow the SEC to continue its
responsible approach to accounting reform.
CURRENT ACCOUNTING STANDARDS AND OVERSIGHT
The current accounting oversight structure is fragmented and, in
disciplinary situations, often ineffective. It includes a series of
independent oversight and standards groups that work with various
state and federal regulators.
The Securities and Exchange Commission has jurisdiction over the
accounting and audit requirements of publicly traded corporations.
Securities law requires these corporations to be audited by an
independent firm, as well as requiring the timely disclosure of
specific information on their financial condition. In practice, the
SEC has left actual oversight of accounting firms to a variety of
state regulators and self-regulatory bodies. As shown below, the
agency has reacted to the recent scandals by proposing a stronger
public oversight organization.
State boards of accountancy license certified public accountants
(CPAs) to practice in their jurisdictions and issue standards of
conduct. They are also the only agencies that can revoke that
license. In some cases, usually having to do with issues of
honesty, these boards also investigate and punish violations of
The first level of independent oversight concerns standards for
financial accounting and auditing. Decisions on how specific
financial items and situations should be treated for accounting
purposes are made for the most part by the Financial Accounting
Standards Board (FASB), a private group made up of accounting and
financial professionals. A similar group, the Auditing Standards
Board (ASB), sets standards for corporate audits. In both cases,
their decisions are subject to SEC review. Standards of auditor
independence, which determine whether a firm is qualified to audit
a publicly traded corporation, are set by the American Institute of
Certified Public Accountants (AICPA); state boards of accountancy;
the SEC; and, in the case of U.S. government agencies, the U.S.
General Accounting Office (GAO). 1
Their passing examinations and meeting other requirements set by
professional organizations such as the AICPA usually certifies the
professional competency of accountants. As with most other
professionals, accountants are required to keep up with
developments in their profession through regular continuing
The AICPA has also been intimately involved with most of the
self-regulatory efforts through its SEC Practice Section. That
group monitors the compliance of CPAs and firms with professional
standards. The section is further divided into sub-groups that
handle peer reviews of audits, review of firm quality control
requirements, and similar issues. The groups are made up of
volunteers, all of whom are CPAs and AICPA members. Audit firms
review other firms' quality control systems to ensure that various
standards are met, while other sub-groups investigate audits that
resulted in court cases or regulatory investigations to see whether
the firm that did the audit complied with all professional and
legal standards. Where a firm has violated these standards, the
AICPA's Quality Control Inquiry Committee has the power to require
changes in procedures. If an individual or firm is suspected of
violating professional standards, that individual or firm is
referred to the AICPA Ethics Division, which can investigate and
impose disciplinary sanctions.
Until recently, all of the AICPA groups noted above had been
under the direction of a Public Oversight Board (POB), which was
composed of five non-CPA public members with business, legal,
legislative, and/or regulatory experience. It also had a
professional staff and was funded through AICPA. However, this
structure was criticized as not being sufficiently aggressive in
disciplinary cases. After the Enron situation was discovered, SEC
Chairman Harvey Pitt proposed the creation of a new public
regulatory structure. Angry at not being consulted in advance, the
POB voted to dissolve, and did so on May 1, 2002.
WHAT POSITIVE REFORM SHOULD LOOK LIKE
In light of both the continued series of corporate scandals and
the POB's decision to dissolve itself, action needs to be taken to
provide the public with accurate information on corporate earnings
and to restore public confidence in that information. Whether this
action is taken by Congress or the SEC makes little difference as
long as the result provides a solid but flexible framework to
prevent future scandals.
Positive steps should include:
Providing the framework for a new private oversight body.
The new body, whether created by the SEC or by statute, should establish professional standards for audits and ethics and regularly review firms to ensure that these standards are being met. As part of this review process, the new body should have the power to compel firms to provide documents and testimony. It should also have the power to severely discipline both individual auditors and firms if necessary. The body should also have a stable funding source that is not dependent on the accounting profession. Finally, it should be mandatory that auditors of public corporations be subject to the new board and its rules.
Preserving auditor independence without crippling firms or their clients.
There is a good case to be made for prohibiting an accounting firm from both providing internal audit services and doing the annual corporate audit. However, the contention that providing most other non-audit services compromises auditor independence is tenuous at best. The SEC should have the ability to monitor accounting firm services closely, but it should be limited in its ability to prohibit non-audit services outright unless there is a clear pattern of abuse.
Prohibiting corporate officers and directors from attempting to influence an audit.
One factor in the Enron failure was the ability of corporate executives to influence decisions of a supposedly independent auditor. Attempting to do so should be prohibited, and willful violations should be punished as a criminal offense.
Improving information for the public and investors.
Investors should receive significant financial data rapidly and in easily understandable form. While there may have been a reason in the past for the delayed reporting of certain financial information, today there is no reason not to require almost instant disclosure of financial performance, condition, and risks to the corporation.
Requiring CEOs and CFOs to vouch personally for their company's financial statements.
There is no excuse for a CEO or CFO not to know and understand what is contained in his or her company's financial statements. Senior corporate officers should be required to certify that they have discussed this information with the firm's audit committee before its release. This step would ensure that top executives make every effort to ensure accuracy.
Preventing corporate executives from profiting from false accounting.
Corporate executives should be required to return investment profits made as a result of improper accounting of their firm's financial position. They should also return losses avoided for the same reason.
THE HOUSE BILL: A STEP IN THE RIGHT DIRECTION
H.R. 3763 is an appropriate legislative response to the recent accounting irregularities and was approved by a bipartisan vote of 334-90 on April 24.2 Rather than seeking to provide a statutory answer for every problem, it recognizes that this is a job for experts and gives the SEC the authority necessary to prevent future abuses. The bill creates Public Regulatory Organizations (PROs), privately organized entities that would review audits and auditors and take disciplinary action when necessary. Any disciplinary actions would be reported immediately to the SEC. No publicly audited company could submit required financial statements to the SEC unless its accountants are in good standing with a PRO.
According to the House bill, a PRO would be composed of five
members: one public member (i.e., not an accountant), two
accountants with recent experience in auditing public companies,
and two who could be either accountants or non-accountants. All
five members would be required to have a detailed knowledge of
finance and financial dealings. Since the PRO would be dealing with
extremely complex financial issues, it is especially important for
them to have the background to understand the implications of
questions that come before them.
The frequency of the PRO meetings, and other details such as
whether the five members would be full-time or part-time, are to be
determined by the SEC. However, any rules or rule changes proposed
by the PRO would have to be submitted in advance to the SEC and
published for public comment.
Funding for the PROs is not specified in the legislation, other
than a requirement that each PRO must be self-funded and not
entirely dependent on accounting organizations for its support. In
practice, this probably means that it would have to collect fees
from both accounting firms and any public company that the firm
audits. The PRO as organized must have the ability to review
accountants' work products that are related to the audit of public
companies. The organization would not be authorized to review
non-audit work or any work performed for non-public
Once the SEC has recognized a PRO, the organization would have
the authority to impose sanctions on accountants after a fair
hearing has been held. The PRO would have the authority to request
a subpoena from the SEC or otherwise collect testimony and other
Sanctions may be imposed if an accountant or firm:
1) Has violated professional standards of conduct, competence, or ethics;
2) Has been convicted of violating securities laws or regulations;
3) Has violated new standards of auditor independence; or
4) Has obstructed or failed to cooperate with the PRO's investigation.
A key requirement of H.R. 3763 is that both the SEC and state
boards of accountancy must be notified of the results and findings
of any PRO review.
Importantly, rather than establish a restrictive list, H.R. 3763
would require the SEC to revise its regulations to prohibit the
same accounting firm from both auditing a company and providing its
internal audit services or financial information systems or
services. Current law requires that an independent accountant
perform public company audits, and any firm that provides these
services would not be considered to be independent. In addition,
the SEC would be required to review other non-audit services
provided by accounting firms and would have the ability to add them
to the list of prohibited activities. This approach to non-audit
services is far better than a legislatively imposed list that could
become rapidly outdated or unnecessarily restrictive.
In addition, the House bill strengthens corporate responsibility
by prohibiting any director or officer from improperly seeking to
influence an audit. Any who do can be barred from serving as an
officer or director of any publicly traded corporation. Further,
major stock exchanges would be required to implement codes of
ethics for senior managers, and only companies that have adopted
these codes of ethics could have their stock listed. Any waiver or
change that a company makes in its code of ethics would have to be
H.R. 3763 also provides for increased transparency of a firm's
financial status by requiring the SEC to improve regulations
dealing with adequate disclosure of off-balance sheet transactions
and insider transactions or affiliations and relationships. In
addition, companies would be required to make public disclosures
much faster than they do now. Once these steps have been taken,
important information on a company's financial condition and
operations would be available almost immediately.
Just as important, the House-passed bill mandates studies of
sensitive issues rather than overreacting to sensational headlines.
These include activities of stock analysts and credit rating
agencies, whether an officer or director should be required to
repay stock profits when there is a restatement of earnings, the
need for additional improvements in corporate governance practices,
and similar issues. Once these studies have been completed, the
results and any recommendations for legislative action would be
sent to Congress. Even though there would be a delay while the
study is being conducted, this approach is far more likely to
result in legislation that actually corrects problems than quick
legislative fixes that fail to understand the true cause of a
THE SEC'S COMPREHENSIVE APPROACH: GOOD STEPS
The SEC, acting in case Congress fails to agree on legislation, has also developed a good approach to accounting problems. 3 In proposed regulations, the agency would facilitate the creation of Public Accountability Boards (PABs), which are very similar to the House-proposed review and disciplinary organizations. Like the House proposal, these organizations would be privately organized and funded, and all publicly held corporations could be audited only by accountants who belong to and are in good standing with a PAB. Under the SEC plan, PABs would be able to impose fines or censures, or even to ban a company from auditing public corporations.
PABs would have nine members, no more than three of whom could
be practicing or retired accountants. PAB members with accounting
backgrounds would not be allowed to participate in disciplinary
actions or in sanctions voted on member firms. The PAB would
receive its funding from both accounting firms and member
corporations. The organization would have the power to review the
audit practices and procedures of large accounting firms at least
annually, with smaller firms being audited at least every three
years. Both firms and individuals would be required to cooperate
with any investigations, and failure to do so could result in being
forbidden to conduct audits of publicly owned corporations.
A key feature of the proposal is that rather than setting
specific regulations dealing with non-audit services, rotation of
audit personnel and/or firms, and other areas, the PABs would have
the power to decide those issues as part of their reviews. This
flexible approach allows these issues to be dealt with if necessary
while not placing unrealistic or burdensome requirements on either
corporations or auditors.
The SEC's PAB proposal is only part of a comprehensive plan of
action proposed by Chairman Harvey Pitt in a June 17 letter to
President Bush. Other elements include requiring the CEO of a
corporation to vouch personally for the company's financial
statements 4 and forbidding
corporate officers from being allowed to profit from false
financial statements. The SEC has also asked Congress for the legal
authority to ban directors from serving in that role for any
publicly owned corporation. The agency has also proposed
regulations requiring prompt reporting of stock transactions by
senior executives or directors and loans granted by the company to
them, as well as faster reporting of a wide variety of corporate
Regulations will require companies to have independent audit
committees that will have the sole authority to hire and firm
auditors and to approve contracts for non-audit services. The SEC
has also proposed a rule requiring companies to disclose when its
accounting policies differ from those of other companies in their
industries. In addition, it has required the disclosure of
off-balance sheet financing.
While the SEC plan is a significant step toward improving
accounting standards, it would be enhanced by legislation granting
the agency additional authority. However, in the event of a
legislative deadlock, the agency plan would ensure that significant
action would be taken.
THE SENATE BANKING COMMITTEE BILL: THE WRONG STEP
The Senate's Public Accounting Reform and Investor Protection Act (S. 2673) 5 is a far less satisfactory approach. Approved by the Senate Banking Committee on June 18 by a bipartisan vote of 17-4, the bill would create a Public Company Accounting Oversight Board (PCAOB) instead of setting standards that a privately established board would have to meet, as the House bill and the SEC propose. Even though the legislation refers to the board as a private corporation, in reality it would become a new government agency with virtually unlimited power to regulate accounting firms.
As described in this bill, the PCAOB would consist of five
full-time members appointed by the SEC, no more than two of whom
could come from the accounting industry. If one of those two is
named the PCAOB chairman, he or she could not have been active in
the profession for at least five years. An annual accounting
support fee that would be paid by the audited corporation would
fund the board. It would have the power to set audit standards,
thus replacing the current practice of having such standards set by
professional groups. The PCAOB could also adopt quality control
procedures, auditor independence standards, and ethics and
competency standards. However, in a bow to the current structure,
the PCAOB "may" instead adopt another group's existing standards
and any future standards proposed by other groups. The SEC must
approve any standards and rules. In addition, the PCAOB would have
jurisdiction over both domestic accounting firms and any foreign
firm that audits a publicly held company, even if that foreign firm
only assists with the audit of a local subsidiary of a firm whose
stock is traded on a U.S. stock exchange.
The Senate Banking Committee bill gives the PCAOB the authority
to enforce securities laws and to perform other duties or functions
that it deems necessary to further the public interest. This broad
grant of power reinforces the belief that it is essentially nothing
more than a new government agency. The Senate Banking Committee
bill would take this step regardless of the fact that an existing
agency (the SEC) has both the expertise and the motivation to
Unfortunately, the structure of the PCAOB is not the
legislation's only major failing. The Senate Banking Committee bill
sends a dangerously mixed message on non-auditing services. On the
one hand, it would write into law various restrictions on
accounting firms' ability to offer eight non-audit services to
auditing clients-limitations that go well beyond those contained in
the House bill. The PCAOB would also have the power to expand the
list of prohibited services. Accounting firms could offer certain
tax and other services to audit clients, but only if the contract
has been approved in advance by the client's audit committee. Also,
contracts for a few non-audit services could be approved
retroactively by a firm's audit committee, but only if the fees
paid for those services amount to less that 5 percent of the total
fees paid to the auditing firm.
On the other hand, the proposed Senate bill also would allow the
PCAOB to permit accounting firms to offer the explicitly banned
non-audit services to auditing clients on a case-by-case basis.
While this flexibility does allow audit clients to take advantage
of situations where their auditor is the best or only provider of
non-audit services, the net result is likely to be a large volume
of requests for case-by-case approvals. If they are carefully
considered by the PCAOB, resources badly needed to deal with
oversight will be tied up looking at applications. If they are not,
then the legislative ban becomes either meaningless or overly
strict. In either event, the net result is likely to be a situation
that will be very hard to administer.
The Public Accounting Reform and Investor Protection Act also
forbids the lead accounting firm partner responsible for reviewing
a specific company's audit from working with that client for more
than five years. After that, he or she must transfer to a new
client and someone else must operate in that capacity. It also
requires the GAO to study whether it would be desirable to require
companies regularly to change auditors. While there is a
superficial case for both requirements, and a few specific examples
where such a move would have been a good idea, there is no proven
general need for such a disruptive change. Essentially, the
committee is imposing a new burden on business because of a few bad
examples. It is true that in some cases, a new audit review partner
or firm could identify problems that have slipped by the old
partner or firm. However, there is also a significant learning
curve when a new partner or firm takes over an audit, and some
questions that should be asked may not be because the new audit
partner is not as familiar with the business as he or she could be.
A better approach would be to require the GAO or the SEC to study
whether such a move would actually be beneficial.
Finally, the Senate Banking Committee bill forbids an accounting
firm from auditing a company if that company's CEO, CFO, or
equivalent position had worked on the audit as an employee of the
accounting firm during the previous year. The reasoning appears to
be that if an executive had such a recent past affiliation, he or
she would be able to influence the audit improperly. The one-year
limitation is similar to that which forbids lobbyists from
attempting to influence their former legislative or executive
branch office. However, in this case, it makes even less sense. The
primary function of most high-level executives is to manage, and
not to be associated with an audit. Many corporations have picked
extremely successful executives from the ranks of their accounting
firms because of their ability and knowledge of the corporation. It
is simply not cost-effective for a major corporation to change
auditors for one year, so companies would be forced to choose
between their auditing firm and potentially the perfect person for
the job. While a one-year restriction might make sense in a
lobbying context, it makes no sense in the corporate world.
The Senate Banking Committee also considered a plan by Senator
Phil Gramm (R-TX) 6 to create a
new independent agency specifically to regulate accounting while
continuing to leave accounting standards to FASB. Gramm's
independent agency would include seven members, with two-one from
the accounting field and one who is not an accountant-being
appointed by the SEC, the CFTC, and the Federal Reserve, while the
chairman would be appointed by the President. While the Gramm plan
does have the major advantage of being much more flexible than the
committee bill because it does not legislate specific rules, it is
still deeply flawed. Although his regulating body is described as
an ethics committee, it would be given the authority to oversee and
enforce ethical standards, as well as conflicts of interest and
issues of auditor independence. This is still very broad
jurisdiction, and it would be easy to see Senator Gramm's proposed
regulator eventually gathering even more power over accounting than
would be likely under the committee's proposal. In addition,
Gramm's plan would create yet another federal agency. There already
are too many financial regulators, and Congress should not make
matters worse by adding one more.
WHAT CONGRESS SHOULD AVOID
Because of the complex and constantly changing nature of financial accounting, congressional overreaction to the recent series of corporate scandals could have lasting consequences. Attempting to lock the profession into an explicit legal framework could sharply limit its ability to respond to changes in the market. As a result, investors could end up with even less reliable information than before.
Thus, in reforming accounting industry practices, Congress should follow sound principles and avoid taking several actions. Specifically:
Do not create a new government accounting regulator. While there is need for a new private oversight body to replace the POB, Congress should not create a new government regulator or a supposedly private body that is in reality nothing more than a government agency. Such an agency would attempt to lock the profession into a framework of explicit rules and regulations that ignore the constantly changing financial world. The SEC already has both the ability and the power to provide whatever government guidance is necessary.
Do not explicitly ban non-audit services. As discussed above, the contention that there is a conflict of interest when an accounting firm both audits a corporation and provides non-audit services is not proven. Explicitly banning certain non-audit services such as actuarial or legal services could cripple the ability of auditors to utilize the expertise of those service providers and make it difficult for smaller corporations to afford such advice. Because of the continuously changing nature of finance, an explicit legislative list of "banned" services would be the worst way to deal with this issue.
Do not impose oppressive restrictions on employment. Some legislators have proposed banning companies from hiring anyone from their accounting firm for senior positions unless there is at least a one-year time when the accounting firm does not audit the company. Such a requirement would be meaningless and unnecessary. All that it would do is to prevent companies from hiring qualified people who know their business.
Do not require mandatory audit firm or partner rotation. Requiring companies to rotate auditors every few years or to require accounting firms to shift the partner who supervises an audit make little sense in practice. The learning curve while the new firm or partner becomes familiar with the company being audited would result in less accurate audits and improve little.
In the long run, the best approach to accounting regulation may be the legislation that does the least. Despite the justifiable outrage over scandals at companies such as WorldCom, Congress should not rush into a bidding war to see whether the Senate or the House can pass the strictest legislation. It may be tempting for legislators to claim that they have solved the problem and nothing similar can happen again, but the cure may be worse than the problem.
Locking audits into a straitjacket of government regulation may actually increase the chance of future problems. Corporations and financial practices evolve much faster than a government regulatory structure, and if auditing procedures cannot keep pace, the door will be open for even greater inaccuracies in the future. A flexible approach to auditing regulation, such as those proposed by the SEC and the House, combined with criminal prosecution of significant willful violations, will be much more likely to provide the public with accurate financial information.
The recent accounting abuses are extremely serious, but ill-considered legislation will not correct the problem. While H.R. 3763 and the regulatory reform proposal by the Securities and Exchange Commission are serious attempts to reform accounting practices, the Senate Banking Committee bill is filled with ill-considered and questionable provisions. Rather than strengthening the ability of the SEC to oversee auditing standards, it would in effect create an entirely new regulator with broad powers: a step that would be worse than doing nothing. Congress should either approve something close to the House legislation or do nothing and allow the SEC to continue its responsible approach to accounting reform.
David C. John is a
Research Fellow in the Thomas A. Roe Institute for Economic Policy
1) For a discussion of the current system, see U.S. General Accounting Office, The Accounting Profession: Status of Panel on Audit Effectiveness, Recommendations to Enhance the Self-Regulatory System, GAO-02-411, May 2002.
2) For text of the legislation, see http://financialservices.house.gov/media/pdf/hr3763ah.pdf.
3) Adrian Michaels and Peter Spiegel, "SEC Chief's Regulatory Plan Exceeds Expectations," Financial Times, June 21, 2002, p. 2. For the proposed SEC regulation that would create Public Accounting Boards, see "Framework for Enhancing the Quality of Financial Information Through Improvement of Oversight of the Auditing Process Release No.: 34-46120; 35-27543; IA-2039; IC-25624; File No.: S7-24-02," at http://www.sec.gov/rules/proposed/33-8109.htm.
4) This was implemented on June 27 by an SEC order requiring CEOs and principal financial officers to certify that they have discussed the financial statements with the audit committee or, if there is no audit committee, with the company's independent directors. For the order, "Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934, File No.: 4-460," see http://www.sec.gov/rules/other/4-460.htm.
5) To view the text of S. 2673, see http://thomas.loc.gov.
6) Senator Gramm's approach is described in a press release that
is available at