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Fraudulent Financial Reporting: 1987“1997 An Analysis of U.S. Public
Companies (visit the AICPA website, www.aicpa.org.)
Independence Standards Board
No. 1 “Independence Discussion with Audit Committees” (Visit the ISB
website, www.cpaindependence.org; see also Appendix D on this book™s
website.)
2000 Public Oversight Board
Panel on Audit Effectiveness (O™Malley Panel),
The Panel on Audit Effectiveness,
Report and Recommendations
Recent Developments in Corporate Accountability 11


2001 Chairman Arthur Levitt™s Letter to Audit Committees
Public Oversight Board, Final Annual Report
(May 1, 2002 the POB terminated its existence; visit the POB website,
www.POB.org.)
2002 The Business Roundtable
Principles of Corporate Governance
NYSE Corporate Accountability and Listing Standards Committee,
Report on Proposed Changes to the Corporate Governance Listing
Standards
Nasdaq Listing and Hearing Review Council, Letter of recommendations
proposing corporate governance reforms (Visit the NASD website,
www.nasdaqnewsroom.com.)
U.S. Congress, Corporate Responsibility Act and the Public Company
Accountability Public Oversight Board
(Sarbanes-Oxley Act of 2002)
CEO/CFO Certification Statement Day
(Visit the SEC website, www.sec.gov.)
Public Company Accounting Oversight Board
(Visit the SEC website, www.sec.gov.)
2003 Implementation of the sections of the Sarbanes-Oxley Act of 2002
through amendments to Sec. 10A of the Securities Exchange of 1934


Public and Private Sector Initiatives
In September 1998, Arthur Levitt,
Securities and Exchange Commission
chairman of the Securities and Exchange Commission and now chairman emeri-
tus, expressed his concerns about “hocus pocus accounting” in a keynote speech
entitled “The Numbers Game.” In addition to his remarks regarding the decline in
the quality of financial reporting (e.g., earnings management strategies to meet
analyst and market quarterly expectations via creative acquisition accounting, pre-
mature revenue recognition, restructuring charges, “cookie jar reserves,” and ma-
teriality judgments) as well as the related decline in market capitalization, Levitt
stated that with respect to audit committees:

qualified, committed, independent and toughminded audit committees represent the
most reliable guardians of the public interest. Sadly, stories abound of audit com-
mittees whose members lack expertise in the basic principles of financial reporting
as well as the mandate to ask probing questions.14

Recognizing the problem with respect to the decline in the integrity and cred-
ibility of financial reporting, Levitt set forth the SEC™s nine-point action plan (see
Exhibit 1.1). Strengthening the audit committee process was number 8 of the ac-
tion items. As a result, the SEC, the New York Stock Exchange (NYSE), and the

14
See remarks by Chairman Arthur Levitt, Securities and Exchange Commission, “The Numbers
Game,” NYU Center for Law and Business, New York, September 28, 1998, (www.sec.gov/news/
speeches/spch220.txt).
12 Corporate Accountability: The New Environment



Exhibit 1.1 Summary of the Securities and Exchange™s Nine-Point Action Plan

First, I have instructed the SEC staff to require well-detailed disclosures about the
impact of changes in accounting assumptions. This should include a supplement to the
financial statement showing beginning and ending balances as well as activity in
between, including any adjustments. This will, I believe, enable the market to better
understand the nature and effects of the restructuring liabilites and other loss accruals.
Second, we are challenging the profession, through the AICPA, to clarify the ground
rules for auditing of purchased R&D. We also are requesting that they augment existing
guidance on restructurings, large acquisition write-offs, and revenue recognition
practices. It™s time for the accounting profession to better qualify for auditors what™s
acceptable and what™s not.
Third, I reject the notion that the concept of materiality can be used to excuse deliberate
misstatements of performance. I know of one Fortune 500 company who had recorded a
significant accounting error, and whose auditors told them so. But they still used a
materiality ceiling of six percent earnings to justify the error. I have asked the SEC staff
to focus on this problem and publish guidance that emphasizes the need to consider
qualitative, not just quantitative factors of earnings. Materiality is not a bright line cutoff
of three or five percent. It requires consideration of all relevant factors that could impact
an investor™s decision.
Fourth, SEC staff will immediately consider interpretive accounting guidance on the do™s
and don™ts of revenue recognition. The staff will also determine whether recently
published standards for the software industry can be applied to other service companies.
Fifth, I am asking private sector standard setters to take action where current standards
and guidance are inadequate. I encourage a prompt resolution of the FASB™s projects,
currently underway, that should bring greater clarity to the definition of a liability.
Sixth, the SEC™s review and enforcement teams will reinforce these regulatory
initiatives. We will formally target reviews of public companies that announce
restructuring liability reserves, major write-offs or other practices that appear to manage
earnings. Likewise, our enforcement team will continue to root out and aggressively act
on abuses of the financial reporting process.

Improved Outside Auditing in the Financial Reporting Process
Seventh, I don™t think it should surprise anyone here that recent headlines of accounting
failures have led some people to question the thoroughness of audits. I need not remind
auditors they are the public™s watchdog in the financial reporting process. We rely on
auditors to put something like the good housekeeping seal of approval on the
information investors receive. The integrity of that information must take priority over a
desire for cost efficiencies or competitive advantage in the audit process. High quality
auditing requires well-trained, well-focused and well-supervised auditors.
As I look at some of the failures today, I can™t help but wonder if the staff in the trenches
of the profession have the training and supervision they need to ensure that audits are
being done right. We cannot permit thorough audits to be sacrificed for re-engineered
Recent Developments in Corporate Accountability 13



approaches that are efficient, but less effective. I have just proposed that the Public
Oversight Board form a group of all the major constituencies to review the way audits
are performed and assess the impact of recent trends on the public interest.

Strengthening the Audit Committee Process
And, finally, qualified, committed, independent and tough-minded audit committees
represent the most reliable guardians of the public interest. Sadly, stories abound of audit
committees whose members lack expertise in the basic principles of financial reporting
as well as the mandate to ask probing questions. In fact, I™ve heard of one audit
committee that convenes only twice a year before the regular board meeting for 15
minutes and whose duties are limited to a perfunctory presentation.
Compare that situation with the audit committee which meets twelve times a year before
each board meeting; where every member has a financial background; where there are
no personal ties to the chairman or the company; where they have their own advisers;
where they ask tough questions of management and outside auditors; and where,
ultimately, the investor interest is being served.
The SEC stands ready to take appropriate action if that interest is not protected. But, a
private sector response that empowers audit committtees and obviates the need for public
sector dictates seems the wisest choice. I am pleased to announce that the financial
community has agreed to accept this challenge.
As part eight of this comprehensive effort to address earnings management, the New
York Stock Exchange and the National Association of Securities Dealers have agreed to
sponsor a “blue-ribbon” panel to be headed by John Whitehead, former Deputy
Secretary of State and retired senior partner of Goldman, Sachs, and Ira Millstein, a
lawyer and noted corporate governance expert. Within the next 90 days, this
distinguished group will develop a series of far-ranging recommendations intended to
empower audit committees and function as the ultimate guardian of investor interests
and corporate accountability. They are going to examine how we can get the right people
to do the right things and ask the right questions.

Need for a Cultural Change
Finally, I™m challenging corporate management and Wall Street to re-examine our
current environment. I believe we need to embrace nothing less than a cultural change.
For corporate managers, remember, the integrity of the numbers in the financial
reporting system is directly related to the long-term interests of a corporation. While the
temptations are great, and the pressures strong, illusions in numbers are only that”
ephemeral, and ultimately self-destructive.
To Wall Street, I say, look beyond the latest quarter. Punish those who rely on deception,
rather than the practice of openness and transparency.


Source: See remarks by Chairman Arthur Levitt, Securites and Exchange Commission, “The
Numbers Game,” NYU Center for Law and Business, New York, September 28, 1998,
www.sec.gov/news/speeches/spch220.txt.
14 Corporate Accountability: The New Environment


National Association of Securities Dealers agreed that both self-regulatory organiza-
tions sponsor a Blue Ribbon Committee (BRC) called Improving the Effectiveness
of Corporate Audit Committees. In September 1998, the BRC was formed. It issued
its final report and recommendations in February 1999. The BRC™s primary goal was
to produce a report “geared toward effecting pragmatic, progressive changes in the
functions and expectations placed on corporate boards, audit committees, senior
and financial management, the internal audit, and the outside auditors regarding fi-
nancial reporting and the oversight process.”15 Furthermore, the BRC noted that its
final recommendations were based on two essentials: “First, an audit committee,
with actual practice and overall performance that reflects the professionalism
embodied by the full board of which it is a part, and second, a legal, regulatory, and
self-regulating framework that emphasizes disclosure and transparency and ac-
countability.”16 (See Exhibit 1.2 for a summary of the BRC™s recommendations.)
During the period between February and December 1999, boards of directors
and their audit committees studied the BRC™s recommendations and reevalu-
ated the responsibilities of their audit committees.17 Additionally, the SEC and


Exhibit 1.2 Summary of Recommendations of the Blue Ribbon Committee on
Improving the Effectiveness of Corporate Audit Committees

The first two recommendations are aimed at strengthing the independence of the audit
committee:

Recommendation 1
The Committee recommends that both the New York Stock Exchange (NYSE) and the Na-
tional Association of Securities Dealers (NASD) adopt the following definitions of inde-
pendence for purposes of service on the audit committee for listed companies with a
market capitalization above $200 million (or a more appropriate measure for identifying
smaller-sized companies as determined jointly by the NYSE and the NASD):
Members of the audit committee shall be considered independent if they have no rela-
tionship to the corporation that may interfere with the exercise of their independence from
management and the corporation. Examples of such relationships include:
• a director being employed by the corporation or any of its affiliates for the current year
or any of the past five years;
• a director accepting any compensation from the corporation or any of its affiliates other
than compensation for board service or benefits under a tax-qualified retirement plan;
• a director being a member of the immediate family of an individual who is, or has been in
any of the past five years, employed by the corporation or any of its affiliates as an exec-
utive officer;


(continued)

15
The report is available on the Internet at www.nyse.com and www.nasd.com.
16
Ibid., p. 8.
17
See for example, Report of the NACD Blue Ribbon Commission on Audit Committees (Washington,
DC: NACD, 1999); see also Financial Executives Institute and Arthur Andersen, “The Audit Sympo-
sium: A Balanced Reponsibility” (Morristown, NJ: Financial Executives Institute); Fraudulent Finan-
cial Reporting: 1987“1997, An Analysis of U.S. Public Companies (New York: COSO of the
Treadway Commission, 1999).
Recent Developments in Corporate Accountability 15



• a director being a partner in, or a controlling shareholder or an executive officer of, any
for-profit business organizations to which the corporation made, or from which the cor-
poration received, payments that are or have been significant* to the corporation or busi-
ness organization in any of the past five years;
• a director being employed as an executive of another company where any of the corpo-
ration™s executives serves on that company™s compensation committee.
A director who has one or more of these relationships may be appointed to the audit
committee, if the board, under exceptional and limited circumstances, determines that
membership on the committee by the individual is required by the best interests of the cor-
poration and its shareholders, and the board discloses, in the next annual proxy statement
subsequent to such determination, the nature of the relationship and the reasons for that de-
termination.

Recommendation 2
The Committee recommends that in addition to adopting and complying with the defini-
tion of independence set forth above for purposes of service on the audit committee, the
NYSE and the NASD require that listed companies with a market capitalization above
$200 million (or a more appropriate measure for identifying smaller-sized companies as
determined jointly by the NYSE and the NASD) have an audit committee comprised solely
of independent directors.
The Committee recommends that the NYSE and the NASD maintain their respective
current audit committee independence requirements as well as their respective definitions
of independence for listed companies with a market capitalization of $200 million or
below (or a more appropriate measure for identifying smaller-sized companies as deter-
mined jointly by the NYSE and the NASD).
Our second set of recommendations is aimed at making the audit committee more
effective:

Recommendation 3
The Committee recommends that the NYSE and the NASD require listed companies with
a market capitalization above $200 million (or a more appropriate measure for identifying
smaller-sized companies as determined jointly by the NYSE and the NASD) to have an
audit committee comprised of a minimum of three directors, each of whom is financially
literate (as described in the section of this report entitled “Financial Literacy”) or becomes
financially literate within a reasonable period of time after his or her appointment to the
audit committee, and further that at least one member of the audit committee have ac-
counting or related financial management expertise.
The Committee recommends that the NYSE and the NASD maintain their respective
current audit committee size and membership requirements for companies with a market
capitalization of $200 million or below (or a more appropriate measure for identifying
smaller-sized companies as determined jointly by the NYSE and the NASD).

Recommendation 4
The Committee recommends that the NYSE and the NASD require the audit committee of
each listed company to (i) adopt a formal written charter that is approved by the full board
of directors and that specifies the scope of the committee™s responsibilities, and how it


*The committee views the term “significant” in the spirit of Section 1.34(a)(4) of the American
Law Institute Principles of Corporate Governance and the accompanying commentary to that
section.

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