Wednesday, April 06, 2011

Senate Hearings Examine Role of Accounting and Auditing in Financial Crisis

Hearings conducted by the Senate Securities Subcommittee focused on the role played by accounting standards and financial statement auditing in the financial crisis and what steps have been taken to prevent another crisis. Senator Jack Reed (D-RI), subcommittee chair, expressed grave concern to both panels before the subcommittee with off-balance sheet accounting and the concomitant use of special investment vehicles. Senator Reed was troubled by the fact that Congress thought it had fixed the problems around off-balance sheet accounting in Section 401 of Sarbanes-Oxley only to find the same problems surfacing during the financial crisis six years later. Section 401 requires periodic reports filed with the SEC to disclose all material off-balance sheet transactions, arrangements and contingent obligations and other relationships of the company with unconsolidated entities that may effect, among other things, the company’s financial condition, results of operations, or liquidity.

He said that Congress designed Section 401 to address fundamental Enron accounting issues involving off-balance sheet transactions and intentionally crafted a broad statute in permitting what the regulations should cover. The Senator said that if Section 401 had been fully and effectively implemented by strong regulations some of the problems during the financial crisis may have been avoided. He advised that good regulations and standards should be adopted with some alacrity and, if need be, they can be improved over time. But searching for the right regulation for six years is a problem. He reiterated that Congress is troubled that off-balance sheet accounting was a central facet of the financial crisis in 2008 when Congress thought they had fixed it in 2002.

FASB Chair Leslie Seidman noted that off-balance sheet transactions is a broad term that even encompassing derivatives. She noted that in the wake of Enron FASB issued a revised generally quantitative standard on special purpose entities. FASB also worked with the IASB to develop a global standard for special purpose entities, which represents a more principles-based approach to determine who actually controls the entities, using judgment on the consolidation of such entities. The standards also call for improved disclosure regardless of whether there has been consolidation or not. Disclosure is less dependent on an evaluation of whether it is on or off the balance sheet, dealing with whose assets and liabilities are they, and a detailed analysis of specific forms of involvement. Disclosure is designed to give investors complete and neutral information about these vehicles, including the off balance sheet financing and the key players.

Senator Reed also asked the panelists why auditors did not provide an early warning on the financial crisis. PCAOB Chair James Doty said that auditors should have gone deeper into items such as evaluation issues and significant transactions at the end of reporting periods that may not have had business substance, adding that Board inspection reports beginning in 2006 showed defects in pursuing these issues. The PCAOB is looking into the question of whether auditors are taking deficiencies to heart and presenting them to audit committees. More broadly, Chairman Doty said that the Board will work closely with the SEC on bringing more transparency to the process. The Board is disturbed that the auditors were not more self-reliant and did not go to the audit committee and sound the alarm. Chairman Doty observed that the auditing profession knows that it is on the brink of change.

FASB Chair Seidman told the Senators that FASB has procedures in place to monitor if the accounting standards are producing complete and neutral information or if there is a lack of a standard in some areas. FASB has advisory committees that help the Board quickly respond to issues, she noted, and it has the Emerging Issues Task Force to timely identify financial reporting issues and catch emerging problems. She also noted that beginning in July the SEC, FASB and the PCAOB will convene meetings with interested parties to discuss financial reporting issues. One aspect of these convocations will be to determine if a given issue is an accounting standard matter, an auditing standard matter or an enforcement matter. Moreover, in conjunction with the IASB, FASB convened a special advisory group to react to the financial crisis. In addition, FASB issued a revised standard on fair value and is making progress on impairment.

SEC Chief Accountant James Kroeker said that, when management and the accountants were aware of risk and it went undisclosed, then enforcement is the proper mechanism to hold them accountable. There should be broader early warnings signals for auditors around going concern, he noted, adding that there is a duty to highlight substantial doubts. Management does not have a similar duty on going concern, he observed, and FASB has an active project on that issue. At the end of the day, it is a binary determination, namely, is there or is there not a substantial doubt on going concern.

Lehman bankruptcy examiner Anton Valukas said that to a large degree the outside auditor can control the early warning process. He said that if the auditors had walked into the Lehman boardroom and said that the firm was engaging in $50 billion of off balance-sheet transactions to reduce leverage, the transactions would have ended.

Senator Reed and Senator Kay Hagan (D-NC) are concerned with regulatory arbitrage. Citing the Lehman Brothers case, Senator Hagan queried if accounting standards were being gamed by global financial institutions. There is also the issue of forum shopping, with Senator Reed noting that Lehman had gone to UK counsel to get a favorable opinion on repo 105 transactions qualifying as a sale.

Lehman bankruptcy examiner Anton Valukas replied that Lehman had obtained an opinion from UK counsel that repo 105 transactions would qualify as a sale under UK law when they could not get a similar opinion from US counsel under US law. Former SEC Chief Accountant Lynn Turner said that the firm’s shopping in the UK for a favorable legal opinion shows flaws within the system. He agreed with Mr. Valukas that no one should be allowed to hide behind materiality if something is not transparent.

Chaiman Seidman noted that repo 105 involved a 1996 FASB standard on distinguishing between sale and financial on repurchase agreement. There is a question of whether the entity retained effective control. FASB was not aware of practice issues until the examiners report and, at that time, the SEC issued Dear CFO letters to evaluate the pervasiveness of the issue. FASB began a review that resulted in a clarified standard that the legal analysis should take place at a consolidated level, which FASB believes should limit forum shopping. Also, there is a question on the continued relevance of maintaining collateral, which may not be determinative of whether it is a purchase or sale.

The SEC Chief Accountant noted that, through its oversight of FASB, the Commission is highly involved in the accounting standard setting process in the US and abroad. High quality global accounting will go a long way to reduce regulatory arbitrage. He emphasized that it is imperative that FASB and the IASB work together on this. Chamber of Commerce VP Thomas Quaadman said that international accounting and auditing standards would help control regulatory arbitrage.

Senator Jeff Merkley (D-OR) asked about PCAOB inspections on valuation. Chairman Doty said that there is a difficulty in obtaining evaluations from issuers, especially third-party evaluations. This means that auditors must do some work on evaluations that the issuer should have done. The Board is working on this issue with the SEC.

Senator Reed queried if auditing is a loss leader for accounting firms. The SEC Chief Accountant sincerely hopes that financial statement audit is not a loss leader. He said that auditor independence rules are designed to cut off other revenue steams so that audit will not be a loss leader.

Chairman Doty said that a significant problem is how to restore the counterweight of the auditor to management expediency. Auditors must challenge management. He noted that the PCAOB has a project on communication with the audit committee. With regard to global audit networks, it is not so much size, but the key is quality control within the network.

Noting a 2008 SEC study, Chairman Reed queried the panel on fair value accounting. The SEC official said that the 2008 study found that many assets of financial institutions were not carried at fair value. There is also the issue of whether it is too late when loans, are marked down for credit impairment and not daily. FASB will address this issue. Ms. Seidman agreed with the Chief Accountant, and added that FASB provided guidance reinforcing the basic principles of fair value accounting, which are being incorporated into the soon to be released standard being finalized with the IASB. The standard will clarify to investors what assets are carried at fair value. Importantly, this information will be on a disaggregated level so that it is very clear what assets are carried at fair value and how subjective the estimates are. Cynthia Fornelli of the Center for Audit Quality praised FASB and the SEC for addressing these accounting issues to enhance transparency to investors, which is the primary goal.

Senator Reed asked whether PCAOB proceedings should be under a more open process. Lynn Turner noted that open SEC enforcement actions have worked well and open proceedings will work similarly for the PCAOB under a process that protects rights. He noted a concern that keeping PCAOB cases under wraps is having a detrimental effect as audit firms employ delaying tactics. Also, non-disclosure of companies that are being audited when the audit was not done right is troubling because this could be useful information in coming to an informed decision to reappoint the auditor.

Finally, Mr. Quaadman of the Chamber outlined a number of recommendations for the regulators and standard setters to consider. He called for a Financial Reporting Forum composed of the SEC, FASB, PCAOB, investors, and businesses to identify and propose solutions to problems before they reach the crisis stage. This will also provide a mechanism to allow for coordination amongst regulators and input from investors and businesses. He also urged the FASB and PCAOB to begin a formal, ongoing, and transparent dialogue to consider the auditability of accounting standards. This would allow for the auditing of accounting standards to work in conjunction with standard development.

The Chamber also urged the PCAOB to form an audit advisory group to provide for expertise in the standard setting process and facilitate the identification and resolution of issues that arise in practice. In the coming weeks the Chamber and other trade associations will call upon the PCAOB to hold a roundtable and for a business advisory group to understand the role of companies as investors and their use of investments.