[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
OVERSIGHT OF THE PUBLIC COMPANY
ACCOUNTING OVERSIGHT BOARD
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
JUNE 24, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-98
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96-165 WASHINGTON : 2004
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida DAVID SCOTT, Georgia
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona JOSEPH CROWLEY, New York
JIM RYUN, Kansas STEVE ISRAEL, New York
VITO FOSSELLA, New York, MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
June 24, 2004................................................ 1
Appendix:
June 24, 2004................................................ 29
WITNESSES
Thursday, June 24, 2004
McDonough, William J., Chairman, Public Company Accounting
Oversight Board................................................ 6
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 30
Gillmor, Hon. Paul E......................................... 32
Kanjorski, Hon. Paul E....................................... 33
McDonough, William J. (with attachments)..................... 34
Additional Material Submitted for the Record
Oxley, Hon. Michael G.:
Study prepared by the staff of the House Financial Services
Committee.................................................. 82
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,
Washington, D.C.
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.
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.
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.
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.
Chairman Oxley?
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.
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?
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.
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.
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.
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.
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?
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.
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.
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.
Mr. Emanuel.
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?
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?
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.
Chairman Oxley?
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.
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.
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.
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.
[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.
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.
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.
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.
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.
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.
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.
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.
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.
Ms. Velazquez. Thank you.
Chairman Baker. Thank you, Ms. Velazquez.
Mr. Sherman.
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.
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?
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.
[Laughter.]
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?
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.
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.
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.
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.
Ms. Maloney.
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?
Mr. McDonough. Congresswoman, thank you for the kind words.
I do, indeed, live in your district and continue to vote there.
[Laughter.]
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.
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.
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.
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?
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?
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.
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.
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.
[Laughter.]
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.
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.]
A P P E N D I X
June 24, 2004
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