Congress is preparing to act to try to restore public confidence in the way that companies state their earnings, which has been deeply shaken by the continuing scandals and indictments. The revelation that WorldCom had inflated its profits by almost $3.8 billion over the past 15 months, following the irregularities and frauds uncovered at companies such as Enron, Adelphia Communications, Dynegy, Tyco International, and Global Crossing, clearly shows that something is deeply wrong with American business practices. There is wide agreement in Congress and among the public that accounting standards must be revised and industry oversight strengthened. But there is a huge difference between correcting an obvious problem and creating a legislative straitjacket that ends up hurting more than it helps. While deep anger is justified, Congress should not pass legislation that merely seeks retribution.

The House of Representatives and the Securities and Exchange Commission (SEC) have proposed intelligent approaches that would not only correct today's problems, but also provide enough legal and regulatory flexibility to address future situations. This is especially important because accounting is extremely complex and business practices change rapidly. What fixes today's problems may be completely inadequate tomorrow. Worse, by locking accounting into an obsolete structure, an overly specific law could actually make it harder to prevent future problems. H.R. 3763 and the regulations proposed by the SEC propose significant reforms to improve accounting practices.

The Senate Banking Committee, however, has taken a step in the opposite direction. The Public Accounting Reform and Investor Protection Act proposes setting up a new unnecessary quasi-government agency and locks into law existing regulations and explicit requirements, which could become outdated rapidly. It also includes punitive restrictions that may sound good to voters but make little logical sense.

In the long run, an overly strict bill may prove to be worse for consumers and investors than no legislation at all. Locking auditing into an inflexible regulatory scheme could actually reduce the accuracy of future financial statements. If Congress cannot agree on legislation that takes the House's flexible approach, it should do nothing and simply allow the SEC to continue its responsible approach to accounting reform.

CURRENT ACCOUNTING STANDARDS AND OVERSIGHT

The current accounting oversight structure is fragmented and, in disciplinary situations, often ineffective. It includes a series of independent oversight and standards groups that work with various state and federal regulators.

The Securities and Exchange Commission has jurisdiction over the accounting and audit requirements of publicly traded corporations. Securities law requires these corporations to be audited by an independent firm, as well as requiring the timely disclosure of specific information on their financial condition. In practice, the SEC has left actual oversight of accounting firms to a variety of state regulators and self-regulatory bodies. As shown below, the agency has reacted to the recent scandals by proposing a stronger public oversight organization.

State boards of accountancy license certified public accountants (CPAs) to practice in their jurisdictions and issue standards of conduct. They are also the only agencies that can revoke that license. In some cases, usually having to do with issues of honesty, these boards also investigate and punish violations of those standards.

The first level of independent oversight concerns standards for financial accounting and auditing. Decisions on how specific financial items and situations should be treated for accounting purposes are made for the most part by the Financial Accounting Standards Board (FASB), a private group made up of accounting and financial professionals. A similar group, the Auditing Standards Board (ASB), sets standards for corporate audits. In both cases, their decisions are subject to SEC review. Standards of auditor independence, which determine whether a firm is qualified to audit a publicly traded corporation, are set by the American Institute of Certified Public Accountants (AICPA); state boards of accountancy; the SEC; and, in the case of U.S. government agencies, the U.S. General Accounting Office (GAO). ¹

Their passing examinations and meeting other requirements set by professional organizations such as the AICPA usually certifies the professional competency of accountants. As with most other professionals, accountants are required to keep up with developments in their profession through regular continuing education programs.

The AICPA has also been intimately involved with most of the self-regulatory efforts through its SEC Practice Section. That group monitors the compliance of CPAs and firms with professional standards. The section is further divided into sub-groups that handle peer reviews of audits, review of firm quality control requirements, and similar issues. The groups are made up of volunteers, all of whom are CPAs and AICPA members. Audit firms review other firms' quality control systems to ensure that various standards are met, while other sub-groups investigate audits that resulted in court cases or regulatory investigations to see whether the firm that did the audit complied with all professional and legal standards. Where a firm has violated these standards, the AICPA's Quality Control Inquiry Committee has the power to require changes in procedures. If an individual or firm is suspected of violating professional standards, that individual or firm is referred to the AICPA Ethics Division, which can investigate and impose disciplinary sanctions.

Until recently, all of the AICPA groups noted above had been under the direction of a Public Oversight Board (POB), which was composed of five non-CPA public members with business, legal, legislative, and/or regulatory experience. It also had a professional staff and was funded through AICPA. However, this structure was criticized as not being sufficiently aggressive in disciplinary cases. After the Enron situation was discovered, SEC Chairman Harvey Pitt proposed the creation of a new public regulatory structure. Angry at not being consulted in advance, the POB voted to dissolve, and did so on May 1, 2002.

WHAT POSITIVE REFORM SHOULD LOOK LIKE

In light of both the continued series of corporate scandals and the POB's decision to dissolve itself, action needs to be taken to provide the public with accurate information on corporate earnings and to restore public confidence in that information. Whether this action is taken by Congress or the SEC makes little difference as long as the result provides a solid but flexible framework to prevent future scandals.

Positive steps should include:

THE HOUSE BILL: A STEP IN THE RIGHT DIRECTION

H.R. 3763 is an appropriate legislative response to the recent accounting irregularities and was approved by a bipartisan vote of 334-90 on April 24.² Rather than seeking to provide a statutory answer for every problem, it recognizes that this is a job for experts and gives the SEC the authority necessary to prevent future abuses. The bill creates Public Regulatory Organizations (PROs), privately organized entities that would review audits and auditors and take disciplinary action when necessary. Any disciplinary actions would be reported immediately to the SEC. No publicly audited company could submit required financial statements to the SEC unless its accountants are in good standing with a PRO.

According to the House bill, a PRO would be composed of five members: one public member (i.e., not an accountant), two accountants with recent experience in auditing public companies, and two who could be either accountants or non-accountants. All five members would be required to have a detailed knowledge of finance and financial dealings. Since the PRO would be dealing with extremely complex financial issues, it is especially important for them to have the background to understand the implications of questions that come before them.

The frequency of the PRO meetings, and other details such as whether the five members would be full-time or part-time, are to be determined by the SEC. However, any rules or rule changes proposed by the PRO would have to be submitted in advance to the SEC and published for public comment.

Funding for the PROs is not specified in the legislation, other than a requirement that each PRO must be self-funded and not entirely dependent on accounting organizations for its support. In practice, this probably means that it would have to collect fees from both accounting firms and any public company that the firm audits. The PRO as organized must have the ability to review accountants' work products that are related to the audit of public companies. The organization would not be authorized to review non-audit work or any work performed for non-public companies.

Once the SEC has recognized a PRO, the organization would have the authority to impose sanctions on accountants after a fair hearing has been held. The PRO would have the authority to request a subpoena from the SEC or otherwise collect testimony and other evidence.
Sanctions may be imposed if an accountant or firm:

A key requirement of H.R. 3763 is that both the SEC and state boards of accountancy must be notified of the results and findings of any PRO review.

Importantly, rather than establish a restrictive list, H.R. 3763 would require the SEC to revise its regulations to prohibit the same accounting firm from both auditing a company and providing its internal audit services or financial information systems or services. Current law requires that an independent accountant perform public company audits, and any firm that provides these services would not be considered to be independent. In addition, the SEC would be required to review other non-audit services provided by accounting firms and would have the ability to add them to the list of prohibited activities. This approach to non-audit services is far better than a legislatively imposed list that could become rapidly outdated or unnecessarily restrictive.

In addition, the House bill strengthens corporate responsibility by prohibiting any director or officer from improperly seeking to influence an audit. Any who do can be barred from serving as an officer or director of any publicly traded corporation. Further, major stock exchanges would be required to implement codes of ethics for senior managers, and only companies that have adopted these codes of ethics could have their stock listed. Any waiver or change that a company makes in its code of ethics would have to be disclosed immediately.

H.R. 3763 also provides for increased transparency of a firm's financial status by requiring the SEC to improve regulations dealing with adequate disclosure of off-balance sheet transactions and insider transactions or affiliations and relationships. In addition, companies would be required to make public disclosures much faster than they do now. Once these steps have been taken, important information on a company's financial condition and operations would be available almost immediately.

Just as important, the House-passed bill mandates studies of sensitive issues rather than overreacting to sensational headlines. These include activities of stock analysts and credit rating agencies, whether an officer or director should be required to repay stock profits when there is a restatement of earnings, the need for additional improvements in corporate governance practices, and similar issues. Once these studies have been completed, the results and any recommendations for legislative action would be sent to Congress. Even though there would be a delay while the study is being conducted, this approach is far more likely to result in legislation that actually corrects problems than quick legislative fixes that fail to understand the true cause of a situation.

THE SEC'S COMPREHENSIVE APPROACH: GOOD STEPS

The SEC, acting in case Congress fails to agree on legislation, has also developed a good approach to accounting problems. ³ In proposed regulations, the agency would facilitate the creation of Public Accountability Boards (PABs), which are very similar to the House-proposed review and disciplinary organizations. Like the House proposal, these organizations would be privately organized and funded, and all publicly held corporations could be audited only by accountants who belong to and are in good standing with a PAB. Under the SEC plan, PABs would be able to impose fines or censures, or even to ban a company from auditing public corporations.

PABs would have nine members, no more than three of whom could be practicing or retired accountants. PAB members with accounting backgrounds would not be allowed to participate in disciplinary actions or in sanctions voted on member firms. The PAB would receive its funding from both accounting firms and member corporations. The organization would have the power to review the audit practices and procedures of large accounting firms at least annually, with smaller firms being audited at least every three years. Both firms and individuals would be required to cooperate with any investigations, and failure to do so could result in being forbidden to conduct audits of publicly owned corporations.

A key feature of the proposal is that rather than setting specific regulations dealing with non-audit services, rotation of audit personnel and/or firms, and other areas, the PABs would have the power to decide those issues as part of their reviews. This flexible approach allows these issues to be dealt with if necessary while not placing unrealistic or burdensome requirements on either corporations or auditors.

The SEC's PAB proposal is only part of a comprehensive plan of action proposed by Chairman Harvey Pitt in a June 17 letter to President Bush. Other elements include requiring the CEO of a corporation to vouch personally for the company's financial statements ⁴ and forbidding corporate officers from being allowed to profit from false financial statements. The SEC has also asked Congress for the legal authority to ban directors from serving in that role for any publicly owned corporation. The agency has also proposed regulations requiring prompt reporting of stock transactions by senior executives or directors and loans granted by the company to them, as well as faster reporting of a wide variety of corporate financial information.

Regulations will require companies to have independent audit committees that will have the sole authority to hire and firm auditors and to approve contracts for non-audit services. The SEC has also proposed a rule requiring companies to disclose when its accounting policies differ from those of other companies in their industries. In addition, it has required the disclosure of off-balance sheet financing.

While the SEC plan is a significant step toward improving accounting standards, it would be enhanced by legislation granting the agency additional authority. However, in the event of a legislative deadlock, the agency plan would ensure that significant action would be taken.

THE SENATE BANKING COMMITTEE BILL: THE WRONG STEP

The Senate's Public Accounting Reform and Investor Protection Act (S. 2673) ⁵ is a far less satisfactory approach. Approved by the Senate Banking Committee on June 18 by a bipartisan vote of 17-4, the bill would create a Public Company Accounting Oversight Board (PCAOB) instead of setting standards that a privately established board would have to meet, as the House bill and the SEC propose. Even though the legislation refers to the board as a private corporation, in reality it would become a new government agency with virtually unlimited power to regulate accounting firms.

As described in this bill, the PCAOB would consist of five full-time members appointed by the SEC, no more than two of whom could come from the accounting industry. If one of those two is named the PCAOB chairman, he or she could not have been active in the profession for at least five years. An annual accounting support fee that would be paid by the audited corporation would fund the board. It would have the power to set audit standards, thus replacing the current practice of having such standards set by professional groups. The PCAOB could also adopt quality control procedures, auditor independence standards, and ethics and competency standards. However, in a bow to the current structure, the PCAOB "may" instead adopt another group's existing standards and any future standards proposed by other groups. The SEC must approve any standards and rules. In addition, the PCAOB would have jurisdiction over both domestic accounting firms and any foreign firm that audits a publicly held company, even if that foreign firm only assists with the audit of a local subsidiary of a firm whose stock is traded on a U.S. stock exchange.

The Senate Banking Committee bill gives the PCAOB the authority to enforce securities laws and to perform other duties or functions that it deems necessary to further the public interest. This broad grant of power reinforces the belief that it is essentially nothing more than a new government agency. The Senate Banking Committee bill would take this step regardless of the fact that an existing agency (the SEC) has both the expertise and the motivation to act.

Unfortunately, the structure of the PCAOB is not the legislation's only major failing. The Senate Banking Committee bill sends a dangerously mixed message on non-auditing services. On the one hand, it would write into law various restrictions on accounting firms' ability to offer eight non-audit services to auditing clients-limitations that go well beyond those contained in the House bill. The PCAOB would also have the power to expand the list of prohibited services. Accounting firms could offer certain tax and other services to audit clients, but only if the contract has been approved in advance by the client's audit committee. Also, contracts for a few non-audit services could be approved retroactively by a firm's audit committee, but only if the fees paid for those services amount to less that 5 percent of the total fees paid to the auditing firm.

On the other hand, the proposed Senate bill also would allow the PCAOB to permit accounting firms to offer the explicitly banned non-audit services to auditing clients on a case-by-case basis. While this flexibility does allow audit clients to take advantage of situations where their auditor is the best or only provider of non-audit services, the net result is likely to be a large volume of requests for case-by-case approvals. If they are carefully considered by the PCAOB, resources badly needed to deal with oversight will be tied up looking at applications. If they are not, then the legislative ban becomes either meaningless or overly strict. In either event, the net result is likely to be a situation that will be very hard to administer.

The Public Accounting Reform and Investor Protection Act also forbids the lead accounting firm partner responsible for reviewing a specific company's audit from working with that client for more than five years. After that, he or she must transfer to a new client and someone else must operate in that capacity. It also requires the GAO to study whether it would be desirable to require companies regularly to change auditors. While there is a superficial case for both requirements, and a few specific examples where such a move would have been a good idea, there is no proven general need for such a disruptive change. Essentially, the committee is imposing a new burden on business because of a few bad examples. It is true that in some cases, a new audit review partner or firm could identify problems that have slipped by the old partner or firm. However, there is also a significant learning curve when a new partner or firm takes over an audit, and some questions that should be asked may not be because the new audit partner is not as familiar with the business as he or she could be. A better approach would be to require the GAO or the SEC to study whether such a move would actually be beneficial.

Finally, the Senate Banking Committee bill forbids an accounting firm from auditing a company if that company's CEO, CFO, or equivalent position had worked on the audit as an employee of the accounting firm during the previous year. The reasoning appears to be that if an executive had such a recent past affiliation, he or she would be able to influence the audit improperly. The one-year limitation is similar to that which forbids lobbyists from attempting to influence their former legislative or executive branch office. However, in this case, it makes even less sense. The primary function of most high-level executives is to manage, and not to be associated with an audit. Many corporations have picked extremely successful executives from the ranks of their accounting firms because of their ability and knowledge of the corporation. It is simply not cost-effective for a major corporation to change auditors for one year, so companies would be forced to choose between their auditing firm and potentially the perfect person for the job. While a one-year restriction might make sense in a lobbying context, it makes no sense in the corporate world.

The Senate Banking Committee also considered a plan by Senator Phil Gramm (R-TX) ⁶ to create a new independent agency specifically to regulate accounting while continuing to leave accounting standards to FASB. Gramm's independent agency would include seven members, with two-one from the accounting field and one who is not an accountant-being appointed by the SEC, the CFTC, and the Federal Reserve, while the chairman would be appointed by the President. While the Gramm plan does have the major advantage of being much more flexible than the committee bill because it does not legislate specific rules, it is still deeply flawed. Although his regulating body is described as an ethics committee, it would be given the authority to oversee and enforce ethical standards, as well as conflicts of interest and issues of auditor independence. This is still very broad jurisdiction, and it would be easy to see Senator Gramm's proposed regulator eventually gathering even more power over accounting than would be likely under the committee's proposal. In addition, Gramm's plan would create yet another federal agency. There already are too many financial regulators, and Congress should not make matters worse by adding one more.

WHAT CONGRESS SHOULD AVOID

Because of the complex and constantly changing nature of financial accounting, congressional overreaction to the recent series of corporate scandals could have lasting consequences. Attempting to lock the profession into an explicit legal framework could sharply limit its ability to respond to changes in the market. As a result, investors could end up with even less reliable information than before.

Thus, in reforming accounting industry practices, Congress should follow sound principles and avoid taking several actions. Specifically:

In the long run, the best approach to accounting regulation may be the legislation that does the least. Despite the justifiable outrage over scandals at companies such as WorldCom, Congress should not rush into a bidding war to see whether the Senate or the House can pass the strictest legislation. It may be tempting for legislators to claim that they have solved the problem and nothing similar can happen again, but the cure may be worse than the problem.

Locking audits into a straitjacket of government regulation may actually increase the chance of future problems. Corporations and financial practices evolve much faster than a government regulatory structure, and if auditing procedures cannot keep pace, the door will be open for even greater inaccuracies in the future. A flexible approach to auditing regulation, such as those proposed by the SEC and the House, combined with criminal prosecution of significant willful violations, will be much more likely to provide the public with accurate financial information.

CONCLUSION

The recent accounting abuses are extremely serious, but ill-considered legislation will not correct the problem. While H.R. 3763 and the regulatory reform proposal by the Securities and Exchange Commission are serious attempts to reform accounting practices, the Senate Banking Committee bill is filled with ill-considered and questionable provisions. Rather than strengthening the ability of the SEC to oversee auditing standards, it would in effect create an entirely new regulator with broad powers: a step that would be worse than doing nothing. Congress should either approve something close to the House legislation or do nothing and allow the SEC to continue its responsible approach to accounting reform.

David C. John is a Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies

1) For a discussion of the current system, see U.S. General Accounting Office, The Accounting Profession: Status of Panel on Audit Effectiveness, Recommendations to Enhance the Self-Regulatory System, GAO-02-411, May 2002.

2) For text of the legislation, see http://financialservices.house.gov/media/pdf/hr3763ah.pdf.

3) Adrian Michaels and Peter Spiegel, "SEC Chief's Regulatory Plan Exceeds Expectations," Financial Times, June 21, 2002, p. 2. For the proposed SEC regulation that would create Public Accounting Boards, see "Framework for Enhancing the Quality of Financial Information Through Improvement of Oversight of the Auditing Process Release No.: 34-46120; 35-27543; IA-2039; IC-25624; File No.: S7-24-02," at http://www.sec.gov/rules/proposed/33-8109.htm.

4) This was implemented on June 27 by an SEC order requiring CEOs and principal financial officers to certify that they have discussed the financial statements with the audit committee or, if there is no audit committee, with the company's independent directors. For the order, "Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934, File No.: 4-460," see http://www.sec.gov/rules/other/4-460.htm.

5) To view the text of S. 2673, see http://thomas.loc.gov.

6) Senator Gramm's approach is described in a press release that is available at http://banking.senate.gov/gramm/061802.htm.