SPEAKERS CONTENTS INSERTS
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OVERSIGHT OF THE PUBLIC COMPANY
ACCOUNTING OVERSIGHT BOARD
Thursday, June 24, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and,
Government Sponsored Enterprises
Committee on Financial Services,
The subcommittee met, pursuant to call, at 10:03 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Gillmor, Oxley (ex officio), Capito, Tiberi, Sherman, Inslee, Lucas, Clay, Matheson, Emanuel, Scott and Velazquez. Also present was Representative Maloney.
Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Markets Subcommittee to order. Today, the committee meets for the purpose of reviewing the progress to date of the Public Company Accounting Oversight Board, created in an environment where the professional conduct of the accounting profession had been brought into significant question pursuant to relevant disclosures over the method by which public reporting had failed to meet professional standards.
In the light of that environment, the creation of this board and the assignment of the new responsibilities identified was indeed a significant task for the participants to engage in. Over the course of the past months, the board has engaged in a number of significant steps, including the most recent action on June 18 requiring even higher standards of audit independence. I have found the actions of the board to date to be highly appropriate and very responsive to the express concerns, and certainly should be commended for the manner in which the identified conduct of concern has been addressed.
Page 2 PREV PAGE TOP OF DOC More importantly, I think the actions taken extend to market participants and market observers a higher level of confidence than ever that the financial statements presented to those who are interested can be more likely relied on as being a true and accurate statement of financial condition of the corporation than ever before.
It was of concern to me that in the course of the committee's work prior to the adoption of Sarbanes-Oxley, we actually had those in management appear before the committee who indicated that the preparation of a financial statement was a mutual endeavor which was the joint property of management and shareholder. The view had developed apparently that managing the statement to meet or beat earnings expectations was somehow in the shareholder's best interest, as opposed to giving a true and accurate condition of the corporation's actual condition. For these reasons, it was important to have individuals of the highest professional standing in order to bring about the necessary accountability. I am very pleased we have the Chairman of the Board, Mr. William McDonough here this morning to give us his insights into the steps taken and to identify any other areas that the Congress may need to address in light of the work engaged in.
I commend him highly and the board for their great work in the midst of most difficult conditions, and have confidence that their efforts will give many benefits to a prosperous and growing marketplace. That is a goal which I am sure all of us are very pleased to see pursued.
With that, I would recognize Mr. Emanuel who may have an opening statement.
Mr. EMANUEL. Mr. Chairman, thank you for holding this hearing today. I would also like to thank Chairman McDonough for taking the time to be with us, and for your leadership over the last 18 months, and most importantly, for restoring trust and accountability to the accounting profession and the financial markets, given the shaky last 2 1/2 years that have existed in the private sector.
Page 3 PREV PAGE TOP OF DOC I would also like to thank the Chairman for calling a public roundtable on July 14 for auditors' independence. I wish it could have been July Fourth, which would have been more fitting for auditors' independence, but I do appreciate your doing that. Hopefully, Congress can be invited to participate in some capacity. This issue has been raised both in the public and private sector, dealing with auditors' independence and the issues associated with it. There has also been bipartisan legislation in both the House and Senate. Chairman Oxley and Chairman Baker must be somewhat tired of hearing me gripe about it.
So I do think this is an issue that we need to deal with, and hopefully we can move on the legislation at some point, or if not, for a hearing or a markup, because in the last 6 months we have had an unprecedented suspension of one of the Big Four. It has never been done before, to my knowledge, and maybe you can shed some light on that, and continuing revelations just last week in The Wall Street Journal about one firm which has been offering advice to companies both on the tax side and on the auditing side that I think raises questions.
What this is truly in my view not so much that they are doing something wrong. It is that they are operating in a zone with a flashing yellow light. It is neither a red light nor a green light. The consequences of the lack of that what we would call independence or separation of those functions, how does that spill out and affect the American people? According to the GAO, we face a $311 billion tax gap, much of it due to under-reporting, some of it coming from either the corporate or high-end sector where people are receiving tax advice based on unclear rules.
I would hope that we in this committee can begin to deal with these issues. I would hope that the Board's July 14 roundtable will mark the beginning of not just a public discussion, but a clearer focus on what actions we can take. It is one of the rare moments here that we have bipartisan agreement and bicameral agreement, and we need to deal with this. The consequences are at the end of the day when you have a $300 billion shortfall of under-reporting or not paying, is that that burden shifts to middle-class, working-class families. And nobody then believes the system is fair or that everybody is playing by the same set of rules. And the system, and we represent that system, loses confidence by the American people.
Page 4 PREV PAGE TOP OF DOC So I look forward to your hearing today, asking questions on the subject, and your leadership on this very one particular point. Not only your last 18 months, but I hope the next 18 months are as fruitful for the private sector as the first 18 months.
With that, I yield back.
Chairman BAKER. I thank the gentleman.
Mr. OXLEY. Thank you, Mr. Chairman.
Less than 1 year ago, this committee held a hearing entitled Accounting Under Sarbanes-Oxley: Are Financial Statements More Reliable? That was the first time that our distinguished witness, Chairman McDonough, appeared before Congress as Chairman of the Public Company Accounting Oversight Board.
I am pleased to report that, due in no small part to his exemplary leadership and that of the other board members, the answer to the question we posed 9 months ago appears to be a resounding ''yes.''
While the problems that led to the passage of the Sarbanes-Oxley Act nearly 2 years ago have by no means disappeared, the Act's wide-ranging corporate reforms and the effective actions of the PCAOB have helped to restore the faith of America's investors.
In his brief tenure, Chairman McDonough has transformed the board, the centerpiece of Sarbanes-Oxley, into a rigorous, effective and highly respected overseer of public accounting firms. The board has spread a little fear, and Chairman McDonough has hit the proper tough-but-fair tone, in my estimation. I have been reading your speeches. He has listened to practical implementation problems and has worked to ease them, provided it does not interfere with Sarbanes-Oxley or the PCAOB's mission. The PCAOB has been a vast improvement in accounting industry regulation.
We will learn today about the inspection process that the board began during its startup year of 2003 and the auditing and professional practice standards that the board has both adopted and proposed. I would particularly like to commend Chairman McDonough for his accommodations on foreign firm inspections.
Page 5 PREV PAGE TOP OF DOC I am pleased that the Securities and Exchange Commission recently approved the board's final internal control standard as required by Section 404 of the Act. The internal control requirement of the Act has been the focus of some criticism from sectors of the business community. My view is that these costs, although never pleasant, are offset by great benefits.
In implementing the protections of Section 404 and, indeed, all of the Sarbanes-Oxley Act, it is essential that regulators seek to minimize the cost of compliance as much as possible, consistent with the Act's goals. The board has done exactly that, and we will learn more about that today. At the same time, we must keep the appropriate perspective. According to one report, there were 323 companies that restated their results last year. In 58 of those instances, the outgoing accounting firm reported problems related to internal control. Clearly, the need for strong internal control has not diminished.
Equally important, I am pleased by reports of the positive effects of the internal controls requirements on public companies' business. General Electric's finance chief recently stated, ''We have seen value in the section 404 work. It helps build investors' trust and helps give them more confidence. We have gotten positive benefits from it.'' This is precisely the purpose of this requirement.
There is much more work to be done, but I remain confident that Chairman McDonough and his colleagues will continue to ensure that financial statements are more reliable.
Again, Mr. Chairman, welcome you back to the committee. It is good to see you again. We look forward to your testimony.
I yield back.
[The prepared statement of Hon. Michael G. Oxley can be found on page 30 in the appendix.]
Chairman BAKER. I thank the Chairman.
Are there further opening statements? Mr. Scott?
Page 6 PREV PAGE TOP OF DOC Mr. SCOTT. Thank you very much, Mr. Chairman.
I, too, want to welcome you, Chairman McDonough, to our hearing. I want to thank Chairman Baker and Ranking Member Kanjorski for holding this hearing today on the progress of the Public Company Accounting Oversight Board.
This hearing is particularly timely, given that the board issued its first annual report last week. The Sarbanes-Oxley Act of 2002 was enacted to end self-regulation for the accounting profession. Historically, auditors were regulated by the American Institute of Certified Public Accountants. The board was created to serve as the regulator for auditors of public companies and set higher corporate standards for auditing.
I am very much concerned about the issue of the inspections and I am very delighted and pleased to learn that the inspections, according to you, Mr. McDonough, will go beyond the traditional peer review and technical compliance, to look at firm culture and practices to ensure that compliance is encouraged. This is very, very important. You went on to further note that these limited inspections disclosed significant audit and accounting issues, and the need for enhanced standards, and you emphasized the importance of the information gained through individuals and auditing engagements.
The board's new standard of guidelines for accountants was approved by the Securities and Exchange Commission on June 18. There have been some complaints by public companies about the costs of complying with these new standards and the clarity of guidance on complying with the new rules. While some resistance is expected to new regulations, I would like to better understand the depth of these concerns, especially on the compliance costs to small firms.
I look forward to your testimony today, Chairman McDonough, to detail the progress from the board.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Page 7 PREV PAGE TOP OF DOC Ms. Velazquez.
Ms. VELAZQUEZ. Thank you, Mr. Chairman.
First, I want to thank Chairman Baker for holding this oversight hearing on the PCAOB. The committee's recent series of oversight hearings has illuminated many important issues with our nation's capital markets regulators, many of which would have not been addressed had we not undertaken these very hearings. So I am thankful that this committee has taken its oversight responsibilities seriously.
I believe that the success of our capital markets is dependent on accurate and truthful information. Without such information, investors will not be able to make informed decisions. This is why Sarbanes-Oxley is so important, because it provides investors with greater confidence in the information they rely on.
The investor population is more diverse today than ever, from union workers investing through pension plans to professionals investing through 401(k)s to retirees investing through IRAs. They all have money invested in public companies. For this new class of investors, who typically rely on professionals to guide their investment decisions, increased scrutiny of corporate audits is essential. It provides these investors with some additional comfort that there is someone watching the shop on their behalf.
While Sarbanes-Oxley is in the process of bolstering audit requirements and providing increased scrutiny of corporate audits, I would like to raise one specific issue here today: the potential need for an alternative audit standard for smaller non-public companies. Although Sarbanes-Oxley was intended for public companies, it appears that many smaller, non-public companies may be adopting PCAOB standards. Often, the adoption of these enhanced standards is voluntary, but I have a concern that the adoption of the PCAOB standard may become a quasi-requirement for many non-public companies.
In many of these cases, the adoption of the standards is not driven by a desire to protect the investing public, but rather to satisfy other private interests. In addition, the cost of obtaining a full PCAOB quality audit is quite significant, requiring both a substantial startup investment as well as considerable ongoing costs. In pursuing this one-size-fits-all approach, I have great concerns that this will create an excessive burden for many smaller non-public companies, while at the same time doing little to benefit the investing public.
Page 8 PREV PAGE TOP OF DOC These companies represent about half of the U.S. companies and are a major driver of economic growth in our communities. By unnecessarily diverting significant resources to PCAOB compliance, these smaller companies will be unable to expand their operations or hire new employees. As a result, we may be unnecessarily hindering growth at a time when we need more high-quality new jobs.
I hope to learn more about this issue today and I look forward to hearing Chairman McDonough's perspective on this issue.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentlelady.
Mr. Lucas, did you have a statement this morning?
Mr. LUCAS OF OKLAHOMA. I am looking forward to the Chairman's testimony.
Chairman BAKER. Great statement.
If there are no further opening statements, at this time I would like to recognize Mr. William J. McDonough, chairman of the Public Company Accounting Oversight Board. Welcome sir. Please proceed as you choose.
STATEMENT OF WILLIAM J. MCDONOUGH, CHAIRMAN, PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
Mr. MCDONOUGH. Thank you.
Chairman Baker, Chairman Oxley, members of the subcommittee, I am pleased to appear before you today, and I want to thank the members of the subcommittee and the entire House Financial Services Committee for your strong bipartisan support of the Public Company Accounting Oversight Board. We benefit greatly from your wisdom and encouragement.
With the landmark Sarbanes-Oxley Act of 2002, Congress took a giant step toward restoring investor confidence in financial reporting and in the auditing of public companies. No one should doubt that it is the faith of investors that fuels the growth and competitiveness of our economy, not the freedom of corporate managers from public regulation and oversight. The Sarbanes-Oxley Act sets out the blueprint for rebuilding investors' faith.
Page 9 PREV PAGE TOP OF DOC Over the last 18 months, we have turned the Sarbanes-Oxley blueprint into an operating organization. Today, the PCAOB is well on its way to maintaining a continuous program of auditor oversight, to quote from the statute, ''in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.'' Registration of public accounting firms that audit public companies is the foundation of the board's authority. Since October 22, 2003, it has been illegal for any U.S. public accounting firm to prepare, issue or play a substantial role in an audit report on the financial statements of a U.S. public company unless the firm is registered with the board. As of July 19, the same restriction will apply to non-U.S. firms. As of yesterday, we have registered 1,003 U.S. and non-U.S. public accounting firms that audit or may wish to audit U.S. public companies, and we continue to receive registration applications.
Once a firm is registered, it is subject to board inspections. The Act and the board's rules require annual inspections of the firms that audit more than 100 public companies. Smaller firms that have at least one public company client will be inspected every three years. Although regular inspections began this year, we launched limited procedure inspections of the Big Four firms in 2003. We recently made our draft reports on those limited procedures available to the Big Four firms.
Even with limited inspections, we learned a great deal about quality control in the largest firms. In numerous interviews, we heard audit partners and staff express their perceptions of a renewed focus on audit quality. We have seen some evidence of this renewed focus in firm policies generally, and in internal firm communications about those policies. Even so, we alerted the firms to quality control concerns and we will continue to look hard at whether the firms' conduct mirrors their words.
We also learned that there is tremendous wisdom and value in the Act's requirement that we review selected audit engagements. Although we reviewed only a small number of engagements in 2003, we identified significant audit and accounting issues. As we examine more engagements in the future, we expect the prospect of scrutiny to alter the relative risks and rewards to individual engagement partners who might otherwise consider short-cutting audit steps or bending to pressures to please clients.
Page 10 PREV PAGE TOP OF DOC Our inspections also provide valuable information about the need for enhanced standards. In reviewing audit engagements in 2003, we became concerned that auditors may place insufficient emphasis on the importance of thorough documentation of audit work. The Act expressly required us to adopt an auditing standard on documentation and we were able to use what we had learned about existing documentation practices to develop the new standard.
Situations will inevitably arise in which standard setting and inspections are inadequate tools for addressing auditing problems. When we find serious violations of PCAOB standards or the securities laws, we will use our authority under the act to investigate and, as appropriate, to seek disciplinary sanctions against the firms and auditors under our jurisdiction. Those sanctions include monetary penalties and even revoking a firm's registration, thus preventing it from auditing public companies.
We will continue to push forward step-by-step toward the world envisioned in the Act. It is a world in which public accounting firms are strong, reliable businesses that compete based on virtue. It is a world in which the investing public has enough confidence in the fairness of our capital markets and in the auditors who stand in their place, to invest their and their children's futures in those markets. And it is a world in which U.S. companies have access to rich capital markets funded by those investors to grow new businesses, to develop new products, and to hire new employees to design and produce those products.
Mr. Chairman, thank you for the opportunity to describe our progress towards this goal. I will be happy to answer any questions.
[The prepared statement of William J. McDonough can be found on page 34 in the appendix.]
Chairman BAKER. Thank you, sir. Once again, I express my appreciation for what appears to be a very well done job over the past 18 months.
I would be interested in your view with regard to the effect of the new standards, the accountability that is now required with regard to a corporation's ability to attract capital or investors. Do you see any measurable improvement, any measurable concern as a result of the implementation of the standards? There was the view at the outset by some that this would simply raise the cost to the corporations without any measurable benefit. Perhaps a better way to say it, from a cost-benefit analysis, forgetting for the moment the concerns raised by inappropriate conduct, in real business dollars has this been a net gain for corporate America or is it a net expense?
Page 11 PREV PAGE TOP OF DOC Mr. MCDONOUGH. I would say thus far it is a net gain. However, we did try to put into the internal control standard, our auditing standard number two, as much cost-benefit thinking as we possibly could. I must admit that we stretched the statute as much as we thought the statute could be stretched in order to do that.
We think that is particularly important because of the concerns that Congresswoman Velazquez mentioned earlier, and that is the effect on small-and medium-size companies. If you look at a large company, as Chairman Oxley mentioned, the excellent remark from General Electric, they invested I think they said about $30 million, which is not a great deal of money for General Electric, in 404 implementation and they thought it was money well-spent. In the case of large firms, first of all, they should have had good internal control standards, and if they did not and they have new expense to put in the internal control standards, what it tells us is they should have done it in the past. I do not have much sympathy for the large firms in this regard.
There is a requirement, of course, that they document the internal controls. I always though, in my days of being a chief financial officer, if you have internal controls, you ought to document them in any regard, but in some cases they actually had the controls, but had not documented them very well. That is a new expense. There is no question that the attestation by the auditor of the adequacy of internal controls is a new expense, one that I think is justified.
When you get to small-and medium-size companies, I think what has to be used and what we try to push very hard is that both the issuers themselves and private companies, for that matter, have to use good judgment. I think one of the greatest things in God's work in creating human beings is the giving of judgment. A small-or medium-size company simply does not need the bells and whistles on internal controls that General Electric needs. It would be very ill-advised and a terrible waste of money for them to have all those bells and whistles. So we expect them to look at the nature of their business, how complicated it is, how difficult are the internal controls, to make sure that they have the level of internal control that they really need.
Page 12 PREV PAGE TOP OF DOC Then we also expect the audit firms to use their judgment to say, given the reality of this firm, do the internal controls set up by management actually meet the test of good judgment? If the answer to that is yes, then in our inspections I will expect our inspectors to say, if the firm used good judgment, if the company used good judgment, whether or not our inspector would have done it exactly that way is not important.
The important thing is, did the company and the audit firm use good judgment? If the answer to that is yes, we should bless it, because we do not want to have unnecessary expense. I believe vehemently and have for years, small-and medium-size companies are the guts of the American economy. They are the net creators of new jobs. We do not want, and especially I do not want, because of my long record on this issue, to have anything that PCAOB does step in the way of growth of the American economy.
Chairman BAKER. Thank you. I have time just to get one more question in here.
I note that you have made an observation with regard to executive compensation, and reasonableness. I recently had a document published by some organization that not single-line businesses, but complex, sophisticated financial organizations, that the average salary, not benefits, was $12 million a year and the average value of stock held in the institution which they managed was $800 million. I do not want to call it disturbing, but I was surprised by the numbers. These are averages. These are not the extremes.
Is there a better way to have disclosure of compensation packages so shareholders can make the appropriate judgments? I am not second-guessing anyone. I am certain there are individuals worth those dollars. I just think that if you are in an environment where the company may be losing money, that might be one area where one would want to focus some attention. Do you have views on that?
Mr. MCDONOUGH. Mr. Chairman, I have probably reached the point of being notorious for having views on the subject of executive compensation. The first time I spoke on the matter was in the sanctuary of Trinity Church at the foot of Wall Street on the first anniversary of 9-11, and have been speaking about it ever since. Why do I think it is important? I think it is important because the nature of this greatest of all countries is the belief that we are all in it together; that if you were born in humble circumstances, I was, that you have full opportunity to participate in the American Dream.
Page 13 PREV PAGE TOP OF DOC I think that everybody probably thinks from your district, I hope that every kid in the district thinks that he could be your successor some day. I think that a lot of people think they can be President of the United States. But I am really worried about whether people think that they can get to the top rungs of business because of this very high pay, as to whether it is becoming a closed club. I think the nature of the American society works much better in the old days; in 1980, the average Fortune 500 CEO made 40 times more than the average person who worked for him or her. That sounds pretty reasonable. Now, by 2000, it was between 400 and 500 times, and last year I believe that same study said it was about 530 times.
There is no economic theory on God's planet that can justify that. It was a breakthrough of greed in the 1990s, which is understandable because it looked as if we had the great economic miracle. I do not think that there is a way that, and I think your remarks suggested it, that we can figure out how to legislate a control over it or how the SEC or anybody else can figure out how to do it.
I think what it comes down to is the common sense, never mind good judgment, of the people running these major companies. As I have suggested publicly, if the CEOs do not have enough sense, well then their boards of directors should decide they probably need a new CEO. Somebody with such lousy judgment probably should be replaced anyway.
So I do think that on a firm-by-firm basis, the private sector has to, and I spend a lot of time trying to encourage them to take over the responsibility for doing the right thing. Disclosure I think is very important, but if what is being disclosed with all the detail that one can imagine is excessive and inappropriate greed, well, it will make it more obvious. But I think mainly what we need to do is to correct a problem that I think is really a difficulty for our society that simply must be overcome.
Chairman BAKER. Thank you, Mr. Chairman.
Page 14 PREV PAGE TOP OF DOC Mr. EMANUEL. Thank you, Mr. Chairman.
Chairman McDonough, some Fortune 500 companies have complained about the costs associated with Sarbanes-Oxley. Could you compare the compliance costs associated with Sarbanes-Oxley to some of the Fortune 500 compensation packages for CEOs?
Mr. MCDONOUGH. I suppose an easy remark, Congressman Emanuel, would be that in most cases the cost of implementation of Sarbanes-Oxley is less than the pay to the CEO.
That is an interesting comparison. I think, as I mentioned earlier, in the case of large companies, it is very clear that the Congress of the United States, 97 to nothing in the Senate, three negative votes in the House of Representatives, decided that the American private sector had to be run in a somewhat different way, a bill which I applauded at the time and now am spending a lot of my life trying to implement.
I think that the money in large companies that is spent for a reasonable implementation of the Sarbanes-Oxley requirements, especially the internal controls, is fully and unquestionably justified. I do have the belief, as I mentioned earlier, when you get to small-and medium-size companies, we ought to size the thing properly.
Mr. EMANUEL. Let me go back to the issue of auditor independence. I do believe what we have is not a right and wrong. We have a flashing yellow light and people are unsure of the terrain, the people being those in the financial services industry and financial services advice industry to boards and to management, top management.
Since four major accounting firms basically audit close to 80 percent of the public companies, if we do not act here in Congress and set some clear guidelines, which is why I think we do need to act, how do those on the regulatory side deal with the fact that four companies monitor, audit and offer financial advice to nearly 80 percent of the public companies, and without enacting measures or penalizing wrongdoers in ways that would harm the financial markets?
Page 15 PREV PAGE TOP OF DOC Mr. MCDONOUGH. Congressman, I think we have to distinguish between some of the things that we are reading about in the papers about the large firms, which are things that they did in the past I spent a lot of time talking with the leadership of the four firms, and if there are any people in this world who want to get that behind them, it is they.
Mr. EMANUEL. I would agree with that.
Mr. MCDONOUGH. Let's say now looking forward, what our responsibility is . As you know, it is limited to the activities of the accounting firms in dealing with their audit clients. I think the area in which you are particularly interested is the area of tax, which is what our July 14 roundtable is about is auditor independence as it refers to tax advice. What I have been telling the leadership of the Big Four is that what they have to do is to restore the faith of the American people in the accounting profession as a profession and in their firms in particular. The American people do not make a whit of distinction between the audit practice of the firms and the rest of the firm. For the American people, it is one thing, one firm.
Therefore, I have been very strongly and very vehemently suggesting to them that even though I do not have the legal capability to tell them what they can do for their non-audit clients, if they are doing anything that is sort of towards the creative end of just where the IRS might let somebody get away with it, it is an extraordinarily ill-advised thing for them to be doing because they will destroy any possibility of restoring the faith of the American people. So I think the good judgment of the people running the firms, if they swing into gear and carry out that which I think they should in their own best interest, then I would have to leave it up to you and the Congress as to whether you need legislation or not.
Mr. EMANUEL. Let me follow up on that last point. Is it your view then, that we should be patient here, and see how the market handles this, both from a regulatory and legislative perspective? Or should we begin to do something from the legislative side that sets clearer rules of the road?
Page 16 PREV PAGE TOP OF DOC Mr. MCDONOUGH. That is a question that comes very close to one's personal philosophy, so I will have to share mine with you. I think that the Congress and those of us who are created by the Congress have the responsibility to serve the best interests of the American people and that comes first. We have loaded the private sector with an awful lot of new things to do, like internal controls. We have loaded on the accounting firms a new era of oversight, of very penetrating inspections by the PCAOB people.
That would lead me to believe as a generalization that it would be wise to let see how it is working out, and especially since I am seeing in the leadership of the private sector generally, except on the compensation issue, and in the leadership of the accounting profession, a view that they really did get the message of Sarbanes-Oxley.
If that is true, one might, at least my philosophy would be to let's give it some time and see if it works. If it does not, it is rather what we say to the accounting profession, you will either restore the faith of the American people voluntarily or we will make you do it. It is going to work a lot better if it is done voluntarily.
Chairman BAKER. I thank the gentleman.
Mr. OXLEY. Thank you, Mr. Chairman.
I want to explore a little bit with you, first of all, I totally concur with your statement about stretching the statute to accommodate as best we can the small-and medium-size company. That clearly is an issue. It is one that comes up quite a bit in my conversations with CEOs and CFOs. I applaud your foresight and ability to do that within the bounds of the statute. I think it is critically important.
It is also true that in the cost area for Section 404 that we look at some interesting numbers. The average salary of a Fortune 500 CEO in 2004 was $6.6 million. Richard Scrushy, the former CEO of HealthSouth, his bonus in 1 year alone was more than $10 million, about 10 times what it would cost for a company of that size to comply with the act. So I think when we put it into that perspective, clearly we did some things right. I want to applaud you and your colleagues there on the board for recognizing that. I think it is clearly important.
Page 17 PREV PAGE TOP OF DOC Also, is it not true that once the internal controls are set up, that is what incurs the most expense in my view of things. That is, once you have to set up the infrastructure essentially for compliance, which assuming it is done correctly and approved by you and the SEC, will be ongoing. So isn't it true, Mr. Chairman, that a lot of those costs are a one-shot cost?
Mr. MCDONOUGH. Mr. Chairman, setting up the controls is a one-time cost. I think, however, that the issuers themselves, the companies themselves will have to be very careful to keep an eye on whether their internal controls, which may have been perfectly wonderful in the year 2004. Perhaps with new information technology or whatever comes along, you might want to modernize them in 2007.
When I was Chief Executive Officer of the Federal Reserve Bank of New York, we put in the COSO implementation of internal controls. After about 3 years, I found that my people were getting a little relaxed, so I upped the ante and made the internal controls tougher. I think a CEO might want to do that. The auditor also will have to take a look and make sure that the internal controls have not changed, the application of them. So although the first year expense will be considerably higher, the expense on an ongoing basis will be higher than it was in 2003.
Mr. OXLEY. I accept that. I understand that. Let me also commend you on using what lawyers would call the ''reasonable man test,'' because ultimately that really is critically important that we allow some judgment here, and that we do not get ourselves so boxed in on compliance that we lose sight of the goals that we are trying to accomplish. So I applaud you for that attitude.
There will be some people in some quarters, as you know, that will be more than willing to second-guess and to say that you need even more strict controls and that you have to go literally by the letter. Obviously, it just does not work under those conditions. So I really thank you for your judgment in that area.
Page 18 PREV PAGE TOP OF DOC One of the things that I think concerns me and others, with the demise of Arthur Anderson, we are really down to the final four in terms of a national accounting industry. Does that give you some pause in terms of the lack, or at least apparent lack of competition out there? Do you see anything in the future that would maybe provide that some of these companies actually, and it has been suggested in some quarters, that they split into different parts, or perhaps the large regional accounting firms kind of stepping up and becoming national firms? What are your views on that?
Mr. MCDONOUGH. Mr. Chairman, I think that it is the single most difficult issue in public policy in this area. The GAO was required by Sarbanes-Oxley to do a study of concentration in the accounting profession. It came to the conclusion, to just slightly oversimplify, that we have four firms; that the idea of growing a number five of anything like comparable size out of one of the regional firms would look pretty tough to do. Therefore, one is left with the notion of what do you do about the Big Four.
One of the things that came to my mind immediately is you may remember that I was probably the most vocal person at the Federal Reserve on the notion that there was no such thing as a bank too big to fail, largely because I think as soon as you say a bank is too big to fail, you have de facto nationalized it. We can also not say that it is absolutely essential to the American people that each of the Big Four survive if, heaven knows I hope it does not happen, if one of the Big Four should so mismanage itself that it does not deserve to survive.
Now, my conversations with the leadership of the Big Four make me think that is a very remote likelihood, but we have to make sure, and I have made very clear to the leadership of the Big Four, both individually and collectively, that their future depends on them, not the PCAOB. What I am not sure anybody can figure out is, if the Big Four either voluntarily or somebody pushing them, divided into the Big X, would the Big X be on average better and therefore the public interest is served? Or on average less good and therefore the public interest is disserved, if there is such a word? I do not know the answer to that question and I am not sure anybody does. It is an immensely important question and I think we have to keep figuring out what the real answer to it is, but as of now I do not know that anybody knows the answer to that.
Page 19 PREV PAGE TOP OF DOC Mr. OXLEY. Thank you. If I could just take 1 more minute, Mr. Chairman, I wanted to just weigh into this executive compensation issue, only to raise the issue. I do not think anyone is proposing that government try to manipulate or to change the current system, is that correct? I mean, in a direct way, we are not going to pass a law to deal with executive compensation.
Mr. MCDONOUGH. I must admit, Mr. Chairman, that I, in my sermons to the CEO corps, hold out that if they do not do it voluntarily and the American people continue to be very upset about it, that legislation would have to be considered. I must admit that I am stepping into the province of the Congress of the United States when I do that, but I think there has to be at least hanging out the possibility that if they do not do it voluntarily, the Congress might try to figure out a way to do it for them.
Mr. OXLEY. What is your view that with the changes taking place in the boardroom with more emphasis on independent directors and the like, won't that in and of itself have a mitigating affect on executive compensation? Won't that at least be partly solved in the marketplace?
Mr. MCDONOUGH. It should be. There is no doubt in my mind that independent directors, members of compensation committees, should take on the responsibility of getting executive compensation back to a more rational level and one which would be more acceptable to the people of the United States. I hope very much that will happen. I think you and I both know the kinds of people who serve on those compensation committees. They are people of good character and I sincerely hope that they will carry out their responsibilities.
Mr. OXLEY. I am somewhat encouraged by that. You are even starting to see that in major league sports today, a kind of a leavening of that. I would hope at some point we could get to a point where some banjo-hitting utility infielder does not necessarily make $2.5 million a year, but I digress.
Page 20 PREV PAGE TOP OF DOC [Laughter.]
I do think it is an issue worth going after. Mr. Chairman, I would ask unanimous consent, we had a study done by the committee on the compliance costs for Section 404, based on revenue of various corporations. I think it really is a quite extraordinary study, where it says the average salary of a Fortune 500 CEO in 2004 was $6.6 million and the average cost of compliance for domestic companies is $1.92 million. So it is a very interesting statistic and I would ask unanimous consent that the study be made part of the record.
Chairman BAKER. Certainly, without objection.
[The following information can be found on page 82 in the appendix.]
Mr. OXLEY. Again, Mr. Chairman, thank you for your appearance again. It is always good to have you here, and most enlightening testimony.
I yield back.
Chairman BAKER. Thank you, Mr. Chairman.
Mr. SCOTT. Thank you very much, Mr. Chairman.
Chairman McDonough, it seems to me that one of the most effective tools that you have at restoring investor confidence is within the periodic inspections. Could you share with us how that is working, particularly what success it has had in detecting fraud, and making sure that there is compliance in terms of professional auditing standards? That is the first part of my question.
The second one is, is the board making adequate progress in terms of addressing the concerns of foreign regulators in terms of overlapping areas of compliance?
Mr. MCDONOUGH. I think we are making good progress on both of them. The nature of our inspection is we go into a firm and the main thing is that we start by looking at what we call the tone at the top. Do the people who run the institution understand what their requirements are under the Sarbanes-Oxley Act and the fact that the American people, I always remind them it is the American people as represented by the Congress, have decided that their profession needed an outside overseer in the PCAOB.
Page 21 PREV PAGE TOP OF DOC We want to make sure that they understand that audit is their most important product. We get into their relative compensation of partners. We want to see that the good audit partners get well rewarded and not, for example, that the people who are very good at bringing in new business get most of the additional compensation. We also talk with everybody involved in the firm, especially down to the kids that they hired in the last few years, because we have to assume that the people running the firm would really have to be pretty dimwitted if they did not tell us what we want to hear and what the law says. But that does not do a whole lot of good unless they get that message really understood by all the people who work for them. So we look into that.
Then we look into their individual engagements. The amount that we looked into in the case we did, just the Big Four, as you know, and we looked at 16 engagements for each of the firms. That is a very, very small sample and one has to be careful that you do not draw too many conclusions from that small a sample, but we think we have some pretty good ideas.
The inspections that we are doing this year will be much more detailed. In the case of the Big Four, we will be looking at about 5 percent of their engagements, and the biggest firm has about 3,600 engagements. So 5 percent is a pretty important statistical sample. In the case of the next lot of firms, we will be looking at about 15 percent. We look at a combination of what looks like high-risk clients, very complicated companies, for example, and then we do a statistical sample so we pick up the rest, a random sample.
When we get to the smaller accounting firms, as we get in there, we will have to figure out, we are doing those inspections now, and some of them will probably think, we better look at pretty much all of their engagements because we are not really sure how good they are. On the other hand, with others that really seem to be very, very well organized and really very good, and we look at one or two engagements and say, wow, they are terrific, well then it would not be wise to spend their time and money and our time and the public's money to do it further. I think that this will be a very effective tool to restore confidence.
Page 22 PREV PAGE TOP OF DOC On the second part of your question
Mr. SCOTT. Before you leave that part about the periodic inspections, are there notices given to the firms? Is there leeway time or is it a surprise inspection?
Mr. MCDONOUGH. We give them a very small amount of notice because it is better if you see them as they really are.
Mr. SCOTT. When you say small amount of notice, how long?
Mr. MCDONOUGH. The typical amount would be just a couple of days, so they cannot pretty themselves up. They know we are coming so, for example, they know that the top of the shop should be there, but we quite deliberately want a certain level of surprise in the inspections.
Mr. SCOTT. And you have given them during this last year, is that right? It has been a year?
Mr. MCDONOUGH. Last year, we did a limited inspection, as we call it, of the Big Four. They, by the way, volunteered to do that because we began those limited inspections in June and legally we did not have the right to inspect them until October. By the way, I thought that was a good sign of good will on their part.
This year, we have a legal requirement to inspect each year eight firms, because there are eight firms in the United States and one in Canada which have more than 100 public company clients, issuers, so we have to inspect them annually. All the rest, which have one client or one issuer or more, we have to inspect every three years. That, by the way, is going to be a real chore this year because we are still a startup and we are still assembling our staff. Whether I will be able to get to one-third of the rest of them this year or whether we will have an extra burden in the second and third year, unfortunately it is likely we will have a bigger burden in years two and three.
Page 23 PREV PAGE TOP OF DOC Mr. SCOTT. I want to get to my second question, too, so bear in mind my time, Mr. Chairman, but what has been the finding? What has been the result? In other words, you have given these periodic inspections to the top four. They have been limited inspections. Any surprises? What have been the findings?
Mr. MCDONOUGH. We have made available to the four firms our reports. They have 30 days from when they got them, which was in the last day or two, for them to respond. However, the general feeling that we have, which is what I think you are looking for, is they are in fact paying attention to doing audits better, but they did not really have a whole lot of time to improve their performance before we were in there looking at them.
Therefore, we found some situations where their issuing clients and the engagements we looked at did not appear to follow GAAP. That then becomes the province of the SEC, because SEC is in charge of accounting policy, not the PCAOB, but the auditor should bring it to the attention of the issuer, which then deals with the SEC if there is a restatement involved.
In terms of overall really tough application of quality, there is room for improvement. One thing that I am very certain of is the inspections are a very good idea. I thought so before we did these and I am even more sure now.
Mr. SCOTT. I think so, too. I think they are the most effective way to get confidence.
And if you could, my other question concerning the foreign regulators and their concerns over overlapping.
Mr. MCDONOUGH. There were enormous concerns and a great deal of noise coming from quite a number of foreign countries on the alleged extraterritoriality of Sarbanes-Oxley. The extraterritoriality comes for a very good reason. Foreign firms and foreign companies issue securities in the United States and the Congress wants to protect the American people and other investors in those securities.
Page 24 PREV PAGE TOP OF DOC What we have been able to do is essentially the whole thing has been calmed down. We have had very good discussions with the Canadians. About one-third of foreign issuers are Canadian. We have had excellent discussions with the European Community. I made three trips to Brussels. Fortunately in my previous life at the Fed, I had worked with exactly the same people. We all figured out that they are trying to protect investors. We are trying to protect investors. Why don't we just do this together?
So the way we are working it out, we have what we call a sliding scale. If an audit overseer in another country has, it kind of looks like the PCAOB, essentially that it be free of the profession both organizationally and financially, and therefore can oversee it as a true third party. In that case, we would ask that our inspection be actually conducted by the audit overseer in that country.
So let's say we are talking about the United Kingdom, we would ask the United Kingdom overseer to do our inspection. We would send a couple of people over to make sure that they understood how we do things. Conversely, if there is an American company which sells securities in the London market and the UK would decide that they would like to do an inspection, we assume that the UK audit overseer would ask us to do their inspection for them.
So it is 100 percent reciprocity. If we have a country in which the audit overseer either does not exist or would not have full confidence, then we will have to do much, much more of the inspection ourselves.
Chairman BAKER. Mr. Scott, your time has expired.
Mr. SCOTT. Thank you very much, Mr. McDonough, for your fine answers, sir.
Chairman BAKER. Ms. Velazquez.
Ms. VELAZQUEZ. Thank you, Mr. Chairman.
Mr. Chairman, while Sarbanes-Oxley was intended to apply to public companies, it is clear, and we discussed that already, that many smaller non-public companies are adopting the new PCAOB audit standards. For instance, not-for-profits with outstanding municipal debt, private companies with a large private shareholder base, or private companies seeking venture capital are finding that they might have to adopt in full or in part increased audit and internal control standards.
Page 25 PREV PAGE TOP OF DOC What is your perspective on the adoption of PCAOB standards by non-public companies?
Mr. MCDONOUGH. I think, Congresswoman, that there is much, much to be achieved if we can have essentially single audit standards. As a legal matter, we have the authority to set the audit standards for public companies. So there is a question of, well, what should private companies do? Should they have a separate set of standards? There is a certain amount of discussion about that, and I fear that there may be a certain amount of desire in certain parts of the accounting profession to keep some areas of responsibility, also known as turf, that they used to have.
David Walker, who is a wonderful colleague, the head of the GAO, as you know, and I invited the head of the Accounting Standards Board to work with us in a forum so that as much as possible we could get the yellow book standards for the government, the public standards which are set by the PCAOB, and standards for private companies to be as close as possible.
Why would you want the public company audit standards to set the way? The reason is that there are some public companies that actually go private, but not very many. Lots of private companies go public and you would not want an obstacle of vastly different auditing standards to be in the way.
What I think is helpful, because I very much share the concern behind your question and your opening comment, is we have to ask everybody involved, including in the companies and in the audit firms, would you please use your heads? Figure out how much you really need in the way of what would be required for a huge company for the auditing, the methodology, the bookkeeping of a private company depending on its size. A large private company, as you suggested, with lots of private participants in its ownership probably needs something that looks very much like a public company.
Page 26 PREV PAGE TOP OF DOC On the other hand, a rather small public company probably needs something in the real world that would look much more like a private company. So in trying to insert what you could either call cost-benefit or, what I say, really use judgment, we are really trying to make it as possible as I can conceivably make it for smaller public companies and for small-and medium-size private companies to participate in this greater insight and credibility of financial statements without it being a cost which is just not, in some cases they just cannot bear the cost. They do not make enough money to do it.
Ms. VELAZQUEZ. At this point, you do not think that we need to develop, or that there is a need for an alternative standard that would apply only for nonprofit companies?
Mr. MCDONOUGH. I do not think that there is such a standard, but we do not have the authority to do anything except state an opinion on that.
Ms. VELAZQUEZ. Okay. The PCAOB only annually examines firms that audit 100 or more public companies. For all others, it examines on a 3-year cycle. Do you believe that those firms receiving an annual inspection will be perceived by the marketplace to be the gold standard, and thus lead to further concentration in the public accounting industry?
Mr. MCDONOUGH. I do not think it should. Is that a very good question? You bet. On the other hand, the Big Four really deal with big companies. The next four tend to deal with the remainder of the ones in the United States that we inspect annually. They tend to specialize on essentially medium-size companies. Since they are to a degree regional, they are medium-size companies in their own area, and they find that that is the best market niche for them.
I think if I were a small-or medium-size company and I had an accounting firm that as on the 3-year cycle and I had confidence in that accounting firm, I would not spend a nano-second thinking about changing to a big firm just because it got inspected annually. I just do not think there would be any need to do that.
Page 27 PREV PAGE TOP OF DOC Ms. VELAZQUEZ. I know that the PCAOB has thought long and hard about how the results of examinations are going to be made available. Obviously, providing both investor and corporate clients with information concerning the degree of the reliability of audit work is relevant to a whole host of decisions. Could you tell me what information the public and corporate clients will receive and in what form?
Mr. MCDONOUGH. In the area of quality control, the statute makes it very clear that if we find things that need improvement, that is, criticisms in the area of quality control, the firm has a full 12 months from the date of the report to fix those matters. If they do so within 12 months, it remains confidential forever. There were people who kind of wondered about that. My own view is that that gives us a very effective tool to say, fix it within 12 months or it goes public and you probably do not want it to go public. It is a wonderful discipline. It is like telling your kid you have to pass school this year.
More broadly, we do believe that we have an obligation to the public to have as much to say in the examination reports as the statute permits. So rather than say we will put out a statement that says we examined firm X, period, which would be of no earthly interest to the public or no value to the public, we are interpreting the statute as one that says, very definitely in the quality control area, confidential. If we have a discussion of something that had to do with the experience, say, in accounting or auditing matters, of a specific issuer, we will discuss the concept, but not mention who the issuer was.
So it is a very delicate balancing act between our keeping the confidentiality requirements of the statute and saying enough so the American people can judge how much progress is being made by the profession in general and the firm in particular.
Ms. VELAZQUEZ. Do you intend to create a rating system?
Mr. MCDONOUGH. No, we will not have a rating system. I think that is too simplistic and too given to people interpreting it, taking it too seriously.
Page 28 PREV PAGE TOP OF DOC Ms. VELAZQUEZ. Thank you.
Chairman BAKER. Thank you, Ms. Velazquez.
Mr. SHERMAN. Thank you.
We have been shaken, of course, by the failures, the two kinds of failures, if I can categorize them. One is exemplified by Enron, where the auditor pretended that what he saw was okay, and was being properly described in what turned out to be phony financial statements; and the WorldCom example where they pretended not to see the basic facts. There is no accounting principle where you can take a couple of billion bucks worth of operating expenses and capitalize them. It is not a matter of twisting a gap; it is more a matter of covering your eyes.
With that in mind, one of the things I have been talking about before my colleagues, perhaps more often than they would like to hear it, is the need to look at the balance of power within the accounting firm, between on the one hand the client partner, who golfs with Ken Lay; who becomes useless to Arthur Anderson if Ken Lay takes his business elsewhere, if your job is to service a client that produces $50 million in revenue and that client goes elsewhere.
And then the other side of that balance is the review department. At Arthur Anderson, perhaps unique among accounting firms, and this may oversimplify, it had a 100 percent balance of power in favor of the client partner. The review department was on a don't ask/don't tell basis. If the client partner does not feel he needs any advice, the review partner does not even see the questions.
I have urged my colleagues here to provide by statute, it may in the view of many in Congress be more appropriate for your board to do this, but what are you doing to make sure that that Arthur Anderson structure is never allowed and that people whose job it is to assure quality control, people who never golf with any one client because they are involved in 100 audits a year as reviewers, have the balance of power in their direction, and that if the reviewer does not think it flies, it does not go out the door, and that the reviewer actually gets to look at it before it goes out the door.
Page 29 PREV PAGE TOP OF DOC Mr. MCDONOUGH. Congressman Sherman, I think that there are various aspects. We will be looking very closely at quality control in the firm. That has a lot to do with the review by the concurring partner.
Mr. SHERMAN. A concurring partner in the same office?
Mr. MCDONOUGH. The reviewing partner.
Mr. SHERMAN. Or a review partner probably in the headquarters office?
Mr. MCDONOUGH. It varies a bit with the firm. Essentially what you want is that there be a quality control in the firm. By the way, we had a very interesting discussion of this in our standing advisory group which advises us on how to look at auditing standards. The person who reviews the engagement partner's work gives what is called a negative assurance. Now, would it be better, and it is a question, and we are not quite sure
Mr. SHERMAN. I have limited time here. If you have a circumstance where you have a two-partner office and A is reviewing B's work and B is reviewing A's work, that may not assure your objective.
Mr. MCDONOUGH. I believe we would point them in the direction that B should not be reviewing A's work.
Mr. SHERMAN. The way I have seen this best is if a firm has a centralized, maybe not one, but several review departments. But to cut matters short, are you in a position where the reviewing partner must complete a review and if that reviewing partner decides that a clean opinion cannot be issued, that a clean opinion is not issued. Or are you going to allow the client partner to override the reviewing partner?
Mr. MCDONOUGH. In I believe all four of the big firms, first of all, even in the period when Arthur Anderson had that arrangement, the remaining Big Four did not.
Mr. SHERMAN. Are we going to leave it to the Big Four to decide, when they have forgotten Arthur Anderson, to go to a more aggressive marketing model? Or are you going to prevent them from adopting the Arthur Anderson approach or hope that their memory does it for them?
Page 30 PREV PAGE TOP OF DOC Mr. MCDONOUGH. Oh, of course, of course.
Mr. SHERMAN. So you are going to require that the reviewing partner, that you cannot issue an opinion unless the reviewing partner agrees?
Mr. MCDONOUGH. If the reviewing partner says there should not be a clean opinion, the statute really requires that the reviewers review and approve. That is in the statute. So if the reviewing partner was a patsy, he or she is violating the law.
Mr. SHERMAN. Got you.
Mr. MCDONOUGH. The law is very effective. The other thing we do is we look at who gets paid how much. So if Joe the big business developer is being very well paid, and a good audit review partner is not, we will have a great deal to say to the management of the firm in our inspection.
Mr. SHERMAN. I can say this because I was on track to become a reviewing partner long ago. I have never been so happy since I watched the movie Revenge of the Nerds to hear that the reviewing partners may get paid nearly as much as the client development partners.
I say that only because that could have been me.
One of the other things that we saw in the Enron statement is that if you read the financial statements, they beg questions. They were obviously unclear. They hinted that something was being covered up.
One of the ways for you to do your work is to actually read the financial statements and see, because there are limited number of audits where you can go out and look at the working papers. You could read, well, your agency could read the financial statements of at least the top 1,000 companies. We have urged the SEC to do so as well. Are you reading financial statements and circling the parts where it seems like something is being hidden, particularly in the footnotes?
Page 31 PREV PAGE TOP OF DOC Mr. MCDONOUGH. Since the SEC does have the responsibility to read them, and they have a much bigger staff than I do, we are now cowering at 202 people. We are, however, starting what we are calling a financial risk analysis group which will start in July. That will be the organization within my shop, but as of July it will have two people in it. We will grow it, as we do the rest of the PCAOB, as rapidly as we can. I think realistically, Mr. Chairman, that we will have to assume that the SEC will just have more eyes to look at them than the PCAOB will for at least a while.
Mr. SHERMAN. Finally, financial auditing is the only game where one of the teams gets to pick the umpire. I do not know whether this is even an idea worthy of discussion, but I will bring it up. I certainly do not know if it would be a good idea. One could imagine at some distant point that your agency, rather than the audited client, selected based on bids and a review of quality and price, which qualified auditing firm did the auditing. Would that be a better system or because then the client would have virtually no power over its own auditor, or should we stick with pretty much the present system?
Mr. MCDONOUGH. The statute really envisions, and I think it is a big step forward, that it is not the CEO/CFO who decides who the outside auditor is, but the audit committee. Now, since that is new, in the real world we do not know how it is going to work. I doubt very much that there is a whole lot of enthusiasm, including by the way on my part, for our selecting who should do the audit, but there is obviously pressure on the audit committees to do their jobs properly so that that does not happen.
Mr. SHERMAN. But the audit committee in many of these companies, every member of the audit committee has stock options and therefore a vested interest in the company showing positive results.
Mr. MCDONOUGH. Yes, but I think that we are going to be able to see whether, perhaps despite that, the audit committees are carrying out their responsibilities to the investors. The law is actually pretty tough, and the PCAOB is certainly not giving any impression to the accounting profession that we are patsies. So I think that there is a new era of Sarbanes-Oxley, of its creation of the PCAOB, and I think we just have to see. A little bit of skepticism might be in order.
Page 32 PREV PAGE TOP OF DOC Mr. SHERMAN. I am confident that as long as the whole financial world remembers vividly the mistakes that we have just seen that the current structure is likely to work. But when those lessons are forgotten, there may be some backsliding to old cultures. We have seen cycles of this, scandal, people get religion, then people forget it, then people see the immediate financial rewards, and then we go to another series of scandals.
So I think in today's world, audit committees are going to be, dare I say it, religious. I think I have given way too long a homily here. I thank the Chair.
Chairman BAKER. Always a pleasure, Mr. Sherman.
Mr. McDonough, in the hearing, I just had a follow-up question. The Sarbanes-Oxley Act's creation of the PCAOB, the focus on audit independence, on professional conduct by auditors, all are certainly important and significant steps moving us in the right direction.
I am curious, not in your capacity as chair or as a member of PCAOB, but given your general willingness to make a personal observation on matters of some controversy, I am concerned that a retrospective rules-based system in a world which moves so quickly, and even with the best of professional conduct, tells you where the corporation was 91 days or more in the past. It does not really indicate to you where the corporation might be going in the future.
There are certain academic views in the world. A book called Value Reporting was recently written which made some pretty common sense points. Many of your observations are rooted in the ''reasonable man'' standard. Whether the highest level of accounting methodology is appropriate for a small firm or not ought to be judged by the CEO and the CFO, and other such examples.
I am wondering, not that we should set aside what we have accomplished with Sarbanes-Oxley, but might there not be advisability in examination of and consideration of a more real-time disclosure methodology as perhaps ostensible business reporting language now and pilot by the FDIC; perhaps material fact disclosure; if you are losing a customer that is 30 percent of your income, if you have a need for a particular commodity and the supply is running out, customer satisfaction surveys, people are buying your widget by the thousands, but they are returning them by the thousands.
Page 33 PREV PAGE TOP OF DOC Should the committee concern itself in going forward about looking at a more forward-looking system, perhaps principles-based as opposed to rules, in providing the kind of disclosure to the markets that really is helpful to markets, as opposed to strictly the current system?
Mr. MCDONOUGH. Mr. Chairman, I think the answer is yes, but let me put it in context. I think that one of the most pernicious things that came along in the 1990s was the intense concentration on quarterly earnings and on forecasting quarterly earnings and making the forecasts. It was a terrible development because it is essentially what led to a certain number of companies cooking the books. Some of them were sources of the scandal and some others were probably being aware that on an accounting statement, every number there is an estimate, including cash if you are involved in more than two countries where you have to a currency conversion.
I think what we need to do, and what you suggest would be part of it, would be that all of us have to work on the corporate leadership of America to say what is really important is the future of your company. We ought to be building for the future. If part of the cost of building for that future is that this quarter does not look all that great, responsible, sensible investors should be saying that is good, because that company is going to have a more powerful future.
I started in one of my other activities to say we need about 20 of the greatest companies in America who would decide, we are not going to sweat the quarterly earnings. We are going to build our company for the future, and since we, let's say you could get 20 of them, that we are going to be the leaders. The investors will say, those are the companies that really make sense. And then getting number 21 to 3,002 is easy because leadership is there.
I think anything that Congress could do which would point in the direction of what is the company going to be like in the future, and then the kinds of disclosures you describe would be very helpful. I think it is much to the good.
Page 34 PREV PAGE TOP OF DOC Chairman BAKER. When I learned that a tel-com could report revenue in the current quarter from the sale of broad-band capacity for a system that is not yet built, it said to me we may have a great system, but I do not know if it is giving me useful information.
Mr. MCDONOUGH. Precisely.
Chairman BAKER. I think that there has got to be a way to incentivize that type of long-term growth and earnings. I completely agree with the insidious effect of the 90-day earnings report. When you had a brick and mortar company that had never had a loss in the preceding 20 quarters, and they make seven cents instead of eight and they get hammered; then you have a principals-based company with no physical location of operation and they only lose four cents instead of five and their stock price goes up, the world is upside down.
Mr. MCDONOUGH. You bet.
Chairman BAKER. Thank you.
Mrs. MALONEY. Thank you for holding this oversight hearing. I would like very much to welcome Bill McDonough, who happens to be a constituent, and congratulate him on his really outstanding career in New York at the New York Fed, and now taking on one of the great challenges for the safety and soundness and restoring the confidence in our financial markets.
I know from talking to other New Yorkers, he was offered many, many other positions and he turned them down to take this one because he thought it was very important for the country. I truly do want to welcome you here.
I would like to ask, what do you think about FASB's recent proposal to expense stock options? As one who is really trying to get a good accounting of what is happening, do you think companies should be required to expense stock options?
Page 35 PREV PAGE TOP OF DOC Mr. MCDONOUGH. Congresswoman, thank you for the kind words. I do, indeed, live in your district and continue to vote there.
Mrs. MALONEY. I better behave myself.
Mr. MCDONOUGH. We have an enormously full plate, as you can easily imagine, and accounting policy, which is what we are discussing here, is not part of it. So if you would forgive me doing something which you know is enormously uncharacteristic, I would like to say that since that is the responsibility of FASB and the SEC, that the PCAOB cannot have an opinion on it and should not have an opinion on it, and as Chairman of the PCAOB, ergo, I should not.
Mrs. MALONEY. Okay. Then getting back to Sarbanes-Oxley, which is your responsibility, I hear both sides from my constituents. Some feel that we were not as strong as we should be. Some firms tell me that is absolutely killing them; that they have to spend millions and millions of dollars on accounting that they feel is in some cases unreasonable.
Could you comment on it? You have been implementing it now. What is your reaction? Do you think we became too strict? Do you think we should be stricter? Do you think we have put too much of a burden on businesses? Could you just give a sense of how you feel about what we did?
I would like to say that Congress does not like to really dictate to the private sector. We want to respect the private sector and support them. They are the engine that runs this country. But when there are abuses, we are forced to act and we try to do it as reasonably and as professionally and as balanced as possible. Were we balanced? Is it working? Were we too strong? Were we not strong enough? Do you have a sense of it for us?
Mr. MCDONOUGH. There were two main products of Sarbanes-Oxley that the business community looked at, the requirement that the CEO and CFO say that the financial statements are accurate or they are in violation of a criminal statute. There was much shock when you passed that, however, everybody has been doing it, and you do not hear very much about it anymore, which I think is a good thing.
Page 36 PREV PAGE TOP OF DOC What they are concerned about now is the internal control at a station. The management, as you know, has to assess the adequacy of internal controls over financial reporting, and the outside audit firm has to attest to it, which as we established is essentially a second audit of internal controls. Is that justified? For large companies, I think there is no question it is.
Chairman Oxley quoted General Electric, its management said that they had spent $30 million worldwide on the Sarbanes-Oxley Section 404 assessment and they thought it was money well spent. I thought that was a very accurate and sensible statement and much to be applauded. The fact that they said it publicly is the part that should be applauded. I can assure you it was very helpful to us.
In the case of large firms, if they had good internal controls, which they should have had, there is only the additional expense of actually documenting the internal controls. They probably should have had that also. So I am not very sympathetic to any protestations by the large issuers on the cost of Sarbanes-Oxley implementation. I think it is necessary expense, important expense, and the Congress very correctly interpreted the view of the American people that it simply had to be done better.
Especially in response to your colleague, Ms. Velazquez's concerns about the affect on small-and medium-size companies, what we are trying to do is to say that in both the case of the companies themselves and the audit firms, they should be using good judgment. The amount of internal control you need for a small-and medium-size company clearly is not what a big complicated company needs. Therefore, the extent of the internal controls should reflect the reality of the company and the auditor should use good judgment in establishing whether the amount of internal controls put in place are adequate.
If in both cases they say, we passed the test, then our inspectors when they inspect the accounting firm, and if they look at that particular engagement, as I said earlier, I think that they should say, if the company issuer showed good judgment and the audit firm in its attestation showed good judgment, whether our inspector would have done it exactly the same way is not particularly relevant. We should decide whether the judgment that was expressed by the issuer and the auditor were appropriate. If so, it passes.
Page 37 PREV PAGE TOP OF DOC I think this sort of judgment, also known as common sense approach, which is what we tried to work in to get as much cost-benefit consideration into the statute as we could push it to deliver, that is how we are trying to come up with a realistic, but I think also appropriate under the statute, reaction to not having the stuff become so expensive that it is really making firms spend money that simply is not justified.
Mrs. MALONEY. My time is up. We thank you for taking this very challenging position. Any time you create and put into place something new, it is always particularly a huge challenge. At this time, it is very important to have respect in our markets and the accuracy of them. So I appreciate your work and thank you for being here today.
Thank you, Mr. Chairman.
Chairman BAKER. The gentlelady yields back.
Mr. SHERMAN. Yes, I wonder if I could ask some additional questions.
Chairman BAKER. Okay.
Mr. SHERMAN. I would like to pick up on where your members of Congress left off, and that is, what can you do as a board to describe, provide examples, provide guidance so that smaller issuers and their accounting firms can tangibilitize your words right here before us that only a reasonable amount of internal control, documentation of internal control, and auditing and proving that the internal control exists and is documented, will be engaged in by small firms? Because there is a tendency, especially in the period right after the falsehoods are revealed in the culture, to go in the direction of saying, well, if GE has to do it, then the small issuer has to do it as well. Are you able to issue some guidance or some explanation so that if GE spends $30 million, that is fine, but some company with $100 million of revenue is not spending $300,000?
Page 38 PREV PAGE TOP OF DOC Mr. MCDONOUGH. In our auditing standard number two, Congressman, we aligned our internal control standards with the COSO approach. I am very familiar with that because that is what we used at various institutions that I ran before I came to the PCAOB. COSO is a broad, highly flexible framework for internal control that can be used by a variety of companies. It does not require that all companies have the same internal control. It is very flexible.
What is important is that all public companies have effective internal control and we are very much aware that what is needed to be effective at a large company might not be needed at a smaller one. In fact, I would go so far as to say it clearly is not needed.
Mr. SHERMAN. Again, with limited time, there may be some unique circumstances or some companies that have bad internal control that really need to get their act together, but looking at the average $100 million revenue company in the United States, what should be, under the rules that you are trying to make clear, the costs for the average $100 million a year company to comply?
Mr. MCDONOUGH. We try not to answer that, not to duck, but you could have two companies in two different
Mr. SHERMAN. I am not saying that any one company can do this. That is like saying, what is the price of an average car. That does not mean you get a Lexus for that price, but for all, say, 1,000 companies that fit that, or hundreds of companies that fit that, not any one, what should be the range? How expensive should this be to the American economy for that sector?
Mr. MCDONOUGH. I really cannot give you a reasonable answer to that, because I want it so much to be that which makes sense for the individual company and not a penny more.
Mr. SHERMAN. But you think if we did that, that the average $100 million company would be spending $500,000 on this?
Page 39 PREV PAGE TOP OF DOC Mr. MCDONOUGH. I frankly do not know.
Mr. SHERMAN. Okay. I hope that there would be some cost-benefit thinking, and that even if you do not know now, that your board would know.
Mr. MCDONOUGH. You know why I hope you would come to the point of wishing I would not do that? It is because as soon as we put out a number, the company that really does not need to spend that much would think it had to spend that much.
Mr. SHERMAN. Then you would put out a range, would be nice, which would indicate that there are a variety of factors like what industry you are in, not just what
Mr. MCDONOUGH. Could I leave it if we think that we could put something out that would make sense and be positive, we would do it. I am not sure that we can do it.
Mr. SHERMAN. Okay, because there are a lot of folks who feel they need to do something that I think if you and I looked at it, it would be overboard.
I just want to comment on some of your comments. It would be great to live in a world in which investors did not just look at earnings per share, and did not just look at this quarter's earnings per share. I do not think we will get there. There are so many people who want to trade a stock today; want to compare a stock to any one of 50 other stocks; and want to do it online before they go to work in the morning. Likewise, I hope that the religion, the fear of God inspired by the imprisonment of at least a few, and it has not been enough, will last.
But I would hope that we would build our structure for what happens when the culture gets lazy and the investors stay lazy. I will not say lazy, but stay surface and immediate and quick, because no one wants to hold a stock if they think it is going to go down for a month. They can always buy it back later, unless there is a tax reason, and to think that they are going to say, well, I will ignore quarterly reports. I will ignore the fact that I believe the stock is going to go down for the next 6 months, because I think 10 years from now it is going to be a good stock. There are just a lot of investors who are going to look at quarterly reports, not just annual reports.
Page 40 PREV PAGE TOP OF DOC Finally, what can you do so that auditors are opining on something other than just a fund statement and income statement and a balance sheet? It is not just how accurately we report that which was decided for the important stuff over a century ago as relevant, and was decided to be relevant for every industry. When are we going to have standards on how auditors can report on employee turnover, backlog, and hundreds of other things where the numbers, I mean, I would rather know some of those numbers than know earnings per share for a quarter about a company.
Will we have standards coming from your shop or elsewhere as to how these audit firms can start opining on something worth opining on?
Mr. MCDONOUGH. I think the first thing you do is change, if necessary, the accounting standards, which is SEC's area.
Mr. SHERMAN. Backing off from this, the accounting standards will say, generally accepted accounting principles will say, here are the rules for creating an income statement; here are the rules for creating. I do not know of anybody who has an accounting standard for defining backlog or employee turnover rates.
Mr. MCDONOUGH. Actually, they could mandate disclosure of anything.
Mr. SHERMAN. They could. You could also say, here is how you audit that, and for different industries, there are going to be different numbers. But an accounting firm, an auditing firm ought to be able to say, here is what we mean by employee turnover for this issuer, or here is what the issuer says it defines it, and we opine that under that definition their employee turnover rate is 3.2 years.
Mr. MCDONOUGH. Congressman, as we work on the auditing standards, which is a huge work in progress, we will have to
Mr. SHERMAN. I am not saying you have to do it this week.
Page 41 PREV PAGE TOP OF DOC Mr. MCDONOUGH. We will have to establish what we really think auditors should do.
Mr. SHERMAN. I hope that you would think that they should opine upon and give people confidence in some number that would not be part of the accounting statements issued by every issuer in the year 1901. But rather, that you would give them guidance on how to opine on some of the things that investors today want to know about companies in particular industries.
Chairman BAKER. Mr. Sherman, I just want to point out, it was four or five questions ago when you said ''finally.''
Mr. SHERMAN. That is a device I use to try to get more time to ask for.
Chairman BAKER. A typical accountant. You drag it out and drag it out.
Mr. SHERMAN. It is more like a typical lawyer.
Chairman BAKER. Thank God I am neither.
Mr. McDonough, I just want to express again my appreciation for your appearance here today and commend you for the good work of your own and of the board to date. I particularly am appreciative of your continued repetitive statement concerning the ''reasonable man or woman'' standard, as the case may be, being the guide by which these decisions are being made.
The consequence of this, however, is because of the manner in which you conduct your business and the board's significant responsibilities for the conduct of corporate reporting, there is a high level of confidence by members of this committee in the work you are doing.
Page 42 PREV PAGE TOP OF DOC That therefore brings about a significant standard of reliance on your judgments. I would hope that in the course of your future work, that as your findings lead you to conclusions, that the Congress needs to either be informed of or needs to act on, that you would feel quite free in not waiting for the committee to seek out your guidance, but to unilaterally opine at will as warranted for us to be able to work closely with you in this effort.
It is clear to me that our rules do need constant scrutiny; that our current system, and I am going to agree here briefly with Mr. Sherman, does need modification to give the markets the information we really need; and that is a long-term project, as well as doing something about the insidious earnings report. But I wholeheartedly agree with your representations here this morning, and thank you very much.
Mr. MCDONOUGH. Thank you, Mr. Chairman.
Chairman BAKER. Our meeting stands adjourned.
[Whereupon, at 11:52 a.m., the subcommittee was adjourned.]