Many observers complain that the financial reforms proposed so far by Congress, the Securities and Exchange Commission, and other government bodies in the wake of Enron Corp.'s collapse are a case of too little, too late. That's clearly so for Enron's shareholders and employees. But critics also worry that congressional hearings into the debacle amount to political grandstanding, and that any legislative or regulatory change in their wake will fall short of what's necessary to prevent future Enrons. Those demanding more draconian action have already blasted proposals by SEC chairman Harvey Pitt aimed at better oversight of auditors, for instance, as Band-Aids for the emergency room.
To address the growing controversy, CFO invited representatives of the SEC, the Financial Accounting Standards Board, and Wall Street's nexus of banks, credit agencies, auditing firms, and investors to take part in a roundtable discussion of the issues raised by Enron. The participants were Peter Clapman, chief counsel for TIAA-CREF, one of the nation's largest pension funds; Cliff Griep, head of credit-ratings policy for Standard & Poor's; Chuck Hill, director of research for Thomson Financial/First Call; Edmund Jenkins, chairman of FASB; Ed Nusbaum, CEO of Chicago-based accounting firm Grant Thornton; former SEC commissioner Laura Unger; and Robert Willens, a managing director at Lehman Brothers. The roundtable was moderated by CFO deputy editor Ronald Fink.
Given the participants' divergent interests and agendas, it's no surprise that their views often differed as to potential solutions. Yet they reached something of a consensus on important issues. Accounting rules for special-purpose entities (SPEs), everyone agreed, should be tightened. And no one disputed the need to assure greater auditor independence in light of Arthur Andersen's failure to alert investors to Enron's problems.
But the assumption that reform must go much further struck them as counterproductive and even dangerous. The system may need repairs, but it's still the solution, not the problem, agreed the roundtable. So is the market, whose punishment of companies that indulge in Enron-like accounting may be the most effective deterrent of all.
Indeed, the roundtable expressed deep concern over the long-term consequences of what several participants labeled the potential "federalization" of accounting standard-setting. The fear is that due process could be distorted, if not stymied, by political interference. It's hardly an irrational fear, as anyone who is remotely familiar with how politicians have pressured FASB in the past knows. Accounting for stock options is the prime example, but political interference also explains why FASB's work on SPEs is unfinished, 20 years after the board first took up the subject.
Still, the panelists expressed confidence that, ultimately, cooler heads will prevail — and that the playing field of the capital markets will receive a necessary, but subtle, releveling.
We all know numerous proposals have been floated to deal with the implications of the Enron collapse. I'd like to go around the table and ask each of you, which are the most important proposals? What changes need to be made?
Edmund Jenkins: The proposals are pretty wide-ranging, so it's hard to prioritize them. But one thing that concerns me as chairman of the FASB would be the point Sen. [Richard] Shelby makes, to federalize financial accounting standard-setting. All our accounting standard-setting in the U.S. has been independent of the private sector. There's some concern expressed as to whether the FASB is under the influence of the preparers and auditors. I don't believe that that's the case, and I'd be happy to explain why. But I think that would pale in comparison to the pressures we would be under if we were subject to the political whims of Capitol Hill.
Chuck Hill: I think [Enron] is basically a cyclical problem. We've seen excesses come in the frothy part of the business cycle. Then, when things start to slow down, people tend to push the envelope, whether it's a company's management or the analysts or whoever. And when we get into a market correction, all the warts start to show, and everybody panics.
This time the poster child may be bigger, and what they did may be more egregious than in other cycles. But even that shouldn't be surprising, because we had a bigger and longer bubble that led up to this. So I think it's important to get the message out to Congress that this is a cyclical problem.
Isn't it possible that aggressive enforcement of existing rules is proving to be a sufficient deterrent to abuse, given the punishment that investors are now exacting on companies with even the barest hint of dodgy numbers?
Robert Willens: I think it is. I think we're going to find that whenever there is a choice to be made, with respect to the reporting of a transaction or an item, that a company is going to err on the conservative side. I'm not sure that's necessarily a good thing, either, because you can go too far on the other side as well. You can do violence to the matching principle of accounting. So there's a bit of hysteria. But I think the horse has left the barn, unfortunately. Things are going to have to happen to satisfy the politicians.
Peter Clapman: From an investor perspective, I think there is going to be a greater focus on broader corporate-governance issues that emerge out of the Enron situation — how the board is functioning, whether it appears to investors that there's board independence, and committees that have the competence and the ability to do the job. How stock options are being used today — this is one of TIAA-CREF's key issues.
Laura Unger: I think we're seeing a convergence of several issues. One is the economic downturn. Another is the increased complexity of Corporate America. Another is the accountability of the industry, the professionals — the lawyers, the auditors, the corporate executives — and then below that, the investment community — the analysts, the underwriters, and the standard-setters. How can you improve everybody's accountability in this process, so that we have the most transparency of information and the most-liquid capital markets in the world, with integrity?
Cliff Griep: From a rating-agency perspective, the increased focus on disclosure and transparency is very meaningful. There's a presumption by many participants in the marketplace that because it has occasional access to confidential information, the ratings industry can serve a policing function. But the industry isn't set up that way. While we do have access to confidential information, our ability to get it is dependent on the willingness of the management to provide it. So clearly, anything that facilitates incremental disclosure and transparency will help the analytic community, not just the rating agencies.
Ed Nusbaum: My own view — I'm an auditor, so I'm a bit more skeptical — is there will always be people, companies, pushing to the edge of what's right. And that's in business, and it's in accounting, and it's in financial reporting, and in everything you do. So we have to have a series of mechanisms and controls in place to make sure that we produce a good set of financial information. If there's a silver lining to the Enron situation, it's that Enron gives us an opportunity to take a giant leap forward in many areas.
Complexity and Conflicts
Willens: Isn't that an inherent problem — the fact that, on the auditing side, you're supposed to be looking with a critical eye at the very entity that's paying you? It's the same on Wall Street. An analyst is supposedly looking critically, on behalf of the investor population, at the accounts and the statements of a company — from which we're all hoping to get investment-banking business.
Nusbaum: I think you're right. There are inherent conflicts of interest about business in general, and there is no easy solution.
Willens: To me, to separate consulting from auditing — assuming that that's something that ultimately gets implemented — is almost counterproductive. If you're going to have real reform, you have to attack the obvious conflict, that you're supposed to be examining the very entity that's paying for it.
A possible implication is that not only does the government have to federalize accounting standards, but you have to have a super SEC to enforce them.
Unger: Let me put it into perspective, in terms of the resources the SEC has to examine the filings. There are 17,000 public companies. We have 100 lawyers and 90 accountants reviewing those filings. We review each and every IPO in depth. There's a formula — a secret formula [Laughter] — for how we review the filings, the 10-K, 10-Qs, and 8-Ks. We can never have the sufficient resources to examine in depth each and every filing as it's made.
So we have self-regulation.
Unger: Exactly. And we have the discipline imposed by the market. And yes, we could use more resources. One of the provisions in Chairman Oxley's [Rep. Michael G. Oxley, chairman of the House Committee on Financial Services] bill is to increase our budget to $700 million from roughly $485 million. Also, the President recently signed the pay-parity legislation that will give the SEC staff the same pay scale as the other federal banking regulators. That funding is critical for us to attract the caliber of staff we need.
Hill: I'd like to go back to a couple of points from the perspective of my cyclical thesis. The conflict-of-interest and complexity issues are more than just a cyclical problem. There is a secular trend going on in both of those, and that's where we need more focus on changing things.
Hill: The complexity of the transactions. If you were a superb professional analyst and Enron had not done anything illegal, you still couldn't analyze that company. With the complexity of derivatives and a company that has essentially morphed into a hedge fund, how do you analyze that?
When I raised this issue in December before the House Committee on Financial Services, I was asked, Well, what can you do about it? I said, Maybe it ought to be a different kind of security — where you've identified it as a high-risk situation that can't be analyzed the way a normal company could be, and therefore it's subject to some different kind of regulation. There would be an understanding that this was a different kind of animal.
Jenkins: It would be sort of a scarlet letter. [Laughter] Of course, we don't want to say that derivatives are bad per se, because in fact they can be very good for investors if they're properly used. But we do need to account for them properly. Our standard [SFAS 133], as complex as it is, is complex because it reflects complexity. And I think it does provide new information that we're just now learning how to deal with in the marketplace.
Griep: I'd like to comment on this point. Fundamental analysis — to the extent that it's difficult because of complexity to understand the nature and risk of the business as disclosed in the financials — has shifted to focusing on the risk-management function. The more opaque the financials are, the more that fundamental analysis has to focus on the systems in place to control risk.
It's interesting to look at the energy-trading companies. Many of them have risk-management systems in place, but no two approach the valuations with the same kind of assumptions. No two have the same VAR [value-at-risk] methodology or system in place.
Clapman: If I could just pick up on this point of complexity and conflicts. When Enron was the seventh-largest company in America, how many analysts were saying, "We just can't understand this company — therefore, we are neutral and have no recommendation on it?" I am concerned that the analysts with the conflicts that have been identified here were affecting the market [on Enron].
Hill: On the eve of the third-quarter report from Enron that started the ball rolling, of the 16 analysts that covered it, 13 had a strong buy or their equivalent terminology, and 3 had a buy. There were no holds, no sells, no strong sells, and nobody with no recommendation.
How do we get rid of the conflict? Should we go back to fixed brokerage commissions?
Hill: I don't know if fixed rates are the ultimate solution, but that's the problem: How does a brokerage firm get paid for research? In the old days, you got paid by doing good fundamental research. If you did something for the investment-banking side of the house, there might be a little sweetener there, but it was the frosting on the cake. Today it's the cake.
Nusbaum: I think the majority of people involved in this — from the analysts to the accounting firms to the regulators — all have the same goals in mind. What you're talking about is getting back to some of the fundamentals: the research done, the disclosures done so you can get the research, what kinds of disclosures are really needed to do the right research.
Willens: To do better research — that's so intangible. I think the public is going to demand some concrete steps.
Nusbaum: The worst thing, as Ed [Jenkins] pointed out, would be to have the government take over the setting of accounting standards, the setting of auditor standards, the setting of standards for analysts.
Certainly there will be a demand for new rules on off-balance-sheet accounting, as with SPEs.
Jenkins: Remember, it was only a year or two ago that our process was being criticized because we were moving too fast [on pooling-of-interests accounting]. Now we're being criticized for being too slow — for not having properly addressed special-purpose entities in particular, and some other things as well. So it depends on which side of the bed you wake up on, so to speak, and I think there are some lessons to be learned: that we absolutely have to have a full due process for our standards, but there are ways that we can respond to legitimate concerns about financial reporting more quickly.
One thing we can do is take things in smaller chunks. And that is exactly what we are doing on the SPE side. We've decided to focus on just some of the issues on SPEs, the ones where we think we can make the most progress the fastest. It's important that we come up with quality management reporting that has good transparency for analysts and investors to use.
Some people wonder whether there should be any off-balance-sheet activities — that is, if you're giving up control of assets, then what economic purpose does it serve?
Willens: As an investment banker, I have found through the years that the principal objective a company and client will have with respect to any transaction or project is to quote-unquote keep the debt off the balance sheet. Which is fine with us; that seems to be a legitimate goal. And I would ask S&P, is that effective? If a company is properly not consolidating an SPE, will you take that at face value? Or will you make adjustments to that based on your analysis, and therefore the objective the company had of keeping the debt off the balance sheet is thwarted?
Griep: From a rating-agency perspective, we make adjustments. We will reflect the rate to what we believe to be economic reality.
Willens: Well, isn't the accounting supposed to capture the economic reality? Then you're telling me that there's some problem with the accounting principle.
Griep: But we would make adjustments. So wherever there is risk retained or some obligation retained...
Willens: But if there's risk retained, it's supposed to be consolidated.
Jenkins: No, not necessarily. To the extent that the transferor or sponsor continues to have exposure to risk, that is either supposed to be recognized on the financial statements or disclosed. For securitized assets in an SPE, SFAS 140 specifically requires disclosures about those assets.
I think one difference is — and this is an issue for financial reporting — S&P is supposed to be forward-looking. Financial statements are point-in-time. That's at least one reason why you make adjustments. What we try to do, and what I think we'll be doing more of, is put into footnotes information that helps on the forward-looking portion of the whole scheme.
Griep: We're constantly making adjustments to the financials, but they have to be value oriented or adjusting cash flow in some way. We're looking at the quality of earnings and adjusting cash flow or reported earnings based on what we believe to be the quality.
Willens: But doesn't that bother you a little, that you have to make substantial adjustments from reported numbers?
Griep: No, I think it's part of fundamental analysis, and I do think it's a part of looking forward.
Willens: I guess I'm looking for something that maybe doesn't exist. What I would like to see, and what a lot of people I speak to would like to see, would be one operating-earnings number that would have been created and blessed and certified by FASB. The components of it would be something that everyone would agree belonged in the computation of this ultimate number. I understand that that may be an impossible goal.
Jenkins: We are working right now on a project on financial performance reporting. Its purpose is to look at not only how the income statement is structured and the way it displays information, but also at certain cash flows and, to some extent, the balance sheet — to see if there's a better way to display or aggregate or disaggregate the information, so that investors can have the opportunity to come to their own conclusions about what set of earnings is likely to be replicable in the future.
Willens: But people want to be guided here. I think they want more than just a framework.
Jenkins: We keep talking about how complex business is today, how complex the transactions are. I don't think it's possible to distill all that into one per-share number.
Hill: I think FASB could do some things that would get us a little closer, but you're never going to have a standardized number that everyone is going to accept.
I think everyone would agree that there are times when it's not only legitimate to adjust GAAP earnings, but desirable. The problem is that you use earnings for different things.
The SEC's cautionary advice [on the use of pro forma financial information in earnings releases] that came out recently was a big step forward on this issue. The advisory said you had to provide some sort of trail from how you got from GAAP to the pro forma earnings.
Willens: But doesn't that bother you, the fact that virtually no one is using GAAP net income for analytical purposes? That everyone is using their own formulas?
Hill: That's what analysis is all about.
Griep: This is a very big issue on the equity-analytic side of our business, and with the index business as well. I know they've proposed a definition of operating earnings to try to bring standardization to that aspect, and it's the one that we would use internally for valuation purposes.
Hill: But you can't do that. The problem is, everyone agrees that the extraordinary items as defined by FASB should be excluded from the GAAP net earnings. But the sticky wickets are the footnotes, the restructuring charges, the asset-sale gains and losses, the acquisition charges, litigation, inventory write-downs. All these kinds of things can come in a lot of different shapes and flavors.
Rethinking Rating Triggers
Let's turn to another post-Enron issue: rating triggers. The rating agencies are going to take a closer look at those, but S&P seemed to suggest that a lot of change wasn't necessary.
Griep: Enron was a catalyst for us to undertake a review of what the actual exposure was of, in particular, lower-investment-grade companies — those rated in the triple-B, single-A range — to contingent commitments that involved significant debt repayment or collateral pledge. While it's been played up in the media as a focus on credit-rating triggers, the questionnaire we put together actually focuses on rating, equity-price, and other kinds of operating-performance triggers that are built into borrowing arrangements and counterparty arrangements. The problem of how to factor these triggers into the rating process is a challenging one, and one that we're still reviewing.
The alternative methodologies are to factor it directly into the rating, in the form of reduced financial flexibility; or, secondarily, just signal the presence of this contingent risk in a way that's incremental to the rating. But we're going through a process of differentiating the degree to which these triggers represent risks.
You know, rating agencies are in a difficult position. Our goal is to opine on creditworthiness, not create it. So where we have a company that is rated triple B minus and has substantial triggers, if they were to fall to noninvestment grade, the debate internally is the extent to which we lower that rating. It becomes self-fulfilling. Is there another way to signal that risk?
The related issue, from our perspective, is what we call "credit cliff" situations, which are situations where if a happens, the company is rated triple B, but if a doesn't happen, the company is rated single B or triple C. And the market demands ratings to be forward-looking.
We base the rating on what we believe is the most likely scenario, encompassing some range of other scenarios as well. But when you run into a case where the alternative scenarios are widely divergent, it becomes challenging to make that into a single symbol. So we're in dialogue with market participants, particularly investors, on how they would like us to share that information in those situations — whether it's by completely discounting all these remote but very negative scenarios in the rating itself, or whether they would like more disclosure from us in the form of our rationale on the credit implication of alternative scenarios.
Auditors and Consulting
How do we eliminate auditor conflicts of interest? Should accounting firms split off their consulting arms?
Unger: I spent a lot of time analyzing auditors' conflicts of interest. Part of it is competition: a firm doesn't want to do more than its competitor in terms of conservative approaches. Because if a company isn't happy, if that conservative approach is [depressing its] earnings, it will walk down the street to accounting firm number two — taking with it not just its auditing fees, but also its consulting fees. The question is whether you can manage that conflict sufficiently, or whether it's too overwhelming to have a firm with both of those components servicing one company.
Clapman: From our point of view — and I'm not saying that the accounting firms themselves should split consulting and the auditing function — we strongly believe that a company being audited should not use the same firm for consulting services. That's our basic position.
Ed, if your firm were forced to split off auditing and consulting, could you attract the people you need?
Nusbaum: If you limited auditing to audit services as currently defined in proxy rules, that would be overly limiting. But I think [we could continue to attract new auditors] if you expanded audit services to include the things that accounting firms traditionally provided, which is the audit, tax services, general business advice — even while avoiding the multimillion-dollar system implementations that really do create conflicts of interest.
So you don't think that the conflict of interest that even the auditors have with their clients is unmanageable?
Nusbaum: Auditors, like analysts, are paid by the companies, either directly or indirectly, and there's an inherent conflict of interest associated with that. But it's still the best system we could possibly have. There are alternatives. You could have the auditors paid by the stock exchanges, or paid by the investors: every securities transaction contributes to an audit. Those things are possible, but that's a pretty radical change. I don't see that happening in the near future.
Willens: I assume that even when it's priced correctly, auditing is still the least-profitable activity. But if you do separate the auditing out, how do we make that a profitable situation?
Nusbaum: You have to separate nonaudit services from what's in consulting. There's a lot of stuff in nonaudit services — for example, internal audit outsourcing, which is a conflict of interest, in my view — that is not normally in consulting. Even providing accounting advice or tax advice is not traditionally considered consulting.
Some people would argue that you shouldn't provide any tax services, but I think you need to provide tax services to be a public accounting firm and do a decent job. So there are some things you're going to do. Something as simple as a letter to the underwriters, which is now classified as a nonaudit service, it's hard to believe you would do the audit and not do the letter to the underwriters.
If we're charging appropriate fees, then the auditing should be extremely profitable. So we've got to limit the services that we can provide, and then set up controls.
Ed Jenkins, do you feel that the way FASB is financed is a constraint on your ability to create standards effectively?
Jenkins: Only to the extent that we don't have enough financing. [Laughter] No, I think it's not an issue. The fund-raising is done by our trustee group. The FASB board members and staff are prohibited by our own charter from getting involved.
We get out of our budget about $20 million. And $14 million comes from the subscriptions and licensing of our own materials. Of the remaining $6 million, about $4 million of that comes from the accounting profession, a good chunk of which comes from a simple check-off in the AICPA News. The rest comes from the accounting firms, but they are limited to a consistent amount. That leaves a couple of million dollars that we raise from the business community generally. The contributions are relatively small.
So you don't feel that the financing of FASB opens the standard-setting process to politicization?
Jenkins: The process certainly does get politicized, but it has nothing to do with contributions. At least not contributions to us. It gets politicized in the Congress. But I think the record will show that, except for stock options — that's the big exception, in 1995 — we basically have stood up to [political pressure]. We now reflect derivatives on the financial statements. We were able to eliminate pooling of interests. So I think we've demonstrated we'll stand up to that kind of pressure, whether it comes through Congress or whether it's direct — and we get some of both.
Cliff, you guys are paid by issuers for your ratings. You are also getting more into the consulting business. At what point do you run up against the same problems that the auditors have?
Griep: With respect to the conflicts, we are paid by the issuers for ratings. They're a dominant source of revenue. The market provides strong discipline. The ratings and the rationale for the ratings are made public; they are under the scrutiny of all our participants. The business is clearly dependent on reputation and the quality of the ratings themselves.
When we move into areas that present potential conflicts, there are clear, established processes and procedures to protect against them, and the track record is extremely strong with respect to conflict avoidance or any evidence of conflict in the ratings themselves.
I know that the ratings industry has fended off questions about political pressures in terms of downgrades at Enron. Are political pressures a problem for Standard & Poor's?
Griep: There is no political pressure. All issuers have a strong interest in what a rating is, and they're lobbying with respect to the outcome of our decisions. But other market participants do not get actively involved in trying to influence that process.
We think the reputation of rating agencies is clearly based on their independence, and so we think maintaining that independence is a fundamental part of the value that rating agencies provide. With respect to maintaining our NRSRO [nationally recognized statistical rating organization] status, we have said that while we acknowledge the need for some oversight in working with the SEC, further regulation would be unwarranted, and could jeopardize that independence.
Peter, what are some of the things that shareholders will be asking for in weeks to come?
Clapman: I can talk about what TIAA-CREF is doing. We've had two continuing shareholder issues: board independence and "dead hand" poison pills, although that practice is pretty much going out because, I think, of our shareholder proposals.
This year we have two new ones. One is a proposal that companies should put stock-option plans to a shareholder vote, even if they are broad-based. The second initiative is to look at companies that have accounting firms of long duration, where there hasn't been a rotation policy for a long time, and where there is a disproportionate degree of nonaudit fees compared with audit fees.
We're asking for reports from the company as to their analysis of the independence of the accounting function. It's a rather broad proposal, because we weren't comfortable getting that precise in that area; and maybe companies will decide, when they speak to us about it, that they'll just do the report rather than have the issue go to a shareholder proposal.
Final question: 50 years from now, will the Enron hearings have the same kind of significance as the Pecora hearings that followed the crash of 1929? That was a sea change, resulting in the creation of the SEC.
Hill: I'd say the only way the Enron hearings would have the same [impact] is if we did a lot of stupid things. But I don't think we have to do that much. There were a lot of things that needed to be done in the 1930s, and we did a lot of them. But this time, we're talking for the most part about tweaking the system, not putting in a whole new system.
What is the worst thing Congress could do? Federalize standard-setting?
Unger: I agree with Chuck, in terms of sea change. I think we arrived at the correct regulatory scheme back in the '30s. The objectives and foundation of that regulatory scheme still make sense. The question is, have the regulators and the industry kept pace with the increasing sophistication of Corporate America?
So I think it's a ripple, but not a sea change.