The 2003 Randolph W. Thrower Symposium Business Law: The Impact of Competition on Regulation Article

THE REGULATION OF ACCOUNTANTS AND PUBLIC ACCOUNTING BEFORE AND AFTER ENRON, 52 Emory Law Journal 1325

George J. Benston *

* John H. Harland Professor of Finance, Accounting, and Economics, Emory University. The Article was improved from comments by and conversations with my colleague, Greg Waymire.

Enterprises used the services of independent public accountants (IPAs) long before governments regulated them or their profession. In the United States, IPAs can obtain the designation "certified public accountant" (CPA), which is granted by state boards of accountancy. IPAs need not be CPAs, although no publicly traded corporation would employ as its independent auditor an accountant who was not a CPA. However, the provision of auditing and other accounting services generally is not limited by law to CPAs. Consequently, I use the designation "IPA," rather than "CPA," to refer to auditing firms and independent auditors.

Until passage of the Securities Act of 1933, the contents of financial statements included in prospectuses were regulated only by some state laws and securities exchanges' listing agreements. The contents of periodic financial statements of corporations were regulated only by securities exchanges until passage of the Securities Act of 1934, which also established the Securities and Exchange Commission (SEC). A consequence of this legislation has been the formal establishment and regulation of standards governing financial statements produced by publicly traded corporations and also by other companies, if they are audited by IPAs.

The Securities Act of 1934 gave the SEC the authority to dictate both accounting and auditing standards. The SEC has largely delegated the development and formalization of generally accepted accounting principles (GAAP) to the accounting profession, although it has had and continues to have a very strong influence on those principles. The SEC also has authority over generally accepted auditing standards (GAAS). However, the American Institute of Certified Public Accountants (AICPA) had almost entirely controlled GAAS, until 2003.

[*1326] Enron's bankruptcy and the role assumed to have been played by one of the "Big Five" auditing firms, Arthur Andersen, resulted in the first large-scale federal regulation of IPAs--the Sarbanes-Oxley Act of 2002. 1 This Act substantially increased the role and power of audit committees of the boards of directors of publicly traded corporations. It also provided for the examination of audits and the disciplining of both individual IPAs and their firms by a government agency, the Public Company Accounting Oversight Board (PCAOB). 2 In 2003, the PCAOB took unto itself responsibility for GAAS, thereby displacing the AICPA.

In this Article, I describe the situation that preceded and followed the establishment of the SEC and developments in the regulation of public accounting and accountants before Sarbanes-Oxley. I pay particular attention to the recent accounting "scandals" and try to put these into perspective. This analysis leads me to conclude that the SEC has been lax in disciplining IPAs whose attestations of misleading financial statements were either incompetent or dishonest. I then consider the extent to which Sarbanes-Oxley is likely to improve the situation or make it worse, on balance.

I. Pre-SEC (Market) Regulation of Financial Accounting and Accountants

A. The Basic Market Functions of Financial Accounting and IPAs 3

IPAs have audited financial statements since the mid-nineteenth century, because owners of and creditors to enterprises have good reason to question the validity of financial statements prepared by their managers. 4 Their earlier and still present role has been to provide absentee owners particularly with attestations that the reports rendered by their hired managers represent fairly the financial condition and performance of the enterprise. These reports also have provided assurance to creditors and prospective owners that the numbers presented in the financial reports are what they purport to be. This does not [*1327] mean that the numbers are "representationally faithful," in that they effectively reflect economic market values, but rather that the numbers objectively follow generally accepted practices, unless specified otherwise, as can be verified by other independent accounting experts.

Managers and controlling owners have several incentives to render false accounts to absent owners and creditors. First, they would prefer that potential investors (new owners and creditors) make a favorable assessment of the enterprise's present condition and prospects. Second, if their management of the enterprise has been poor, they would want to hide or delay recognition of their inadequacy from present and potential owners and creditors. Third, if they stole or misused the resources entrusted to them, they would want to conceal these misdeeds, particularly from absent owners who otherwise might not learn what they did.

Of course, potential investors and creditors have reason to expect this sort of behavior. They also realize that, once they have invested or committed their funds, it will be very difficult for them to enforce truthful and adequate reporting by managers and controlling owners. Consequently, they either will not fund enterprises, discount the amounts they are willing to invest, or increase the interest rate charged on debt to compensate for expected, though undisclosed, losses. The compensation offered to the managers also is likely to be less, if owners cannot trust their reports. The moral-hazard cost, therefore, of potential investor and owner distrust is borne by the present owners and managers.

Managers and controlling owners can reduce moral-hazard cost by engaging IPAs to attest that the financial reports are "true and fair," which is to say that the assets are not overstated, liabilities are reported, and net income is not inflated. 5 The value of IPAs' attestations is based on two factors: (1) their expertise in conducting audits and in determining that the reports follow recognized rules governing the meaning of the items reported in the financial [*1328] statements (which is the operational meaning of "true and fair") and (2) their reputations for exceptional probity.

IPAs in most countries have established their expertise by membership in professional organizations. In the United Kingdom, from whence U.S. IPAs initially came, that organization is the Institute of Public Accountants in England and Wales. It has rules for membership that include academic requirements, passage of examinations, and work under the supervision of members of the organization. When a candidate has satisfactorily completed the requirements, he (and now she) is allowed to use the title "Chartered Public Accountant." A Chartered Public Accountant can be disciplined by the Institute for bringing disgrace to the organization, particularly if convicted of a serious crime or gross abuse of clients or professional standards. In the United States, the equivalent title, "Certified Public Accountant," is granted by state-government agencies, which establish experience and education requirements, and require passage of a several-day examination. 6

B. Concerns About the Role of IPAs

Two questions about the licensing and role of IPAs might be considered. One is: "Does licensing result in barriers to entry into the auditing profession and cartel pricing of auditing services?" The other is: "Why should investors trust IPAs who are hired and can be fired by company managers whose statements they attest; that is, who audits the auditors?"

Members of professional organizations could use their control over professional designations to restrict entry and fix prices, to the detriment of consumers. Indeed, one AICPA rule made it unethical for one member firm to attempt to hire away the employees of another accounting firm. 7 Another rule forbade members from advertising their services, soliciting clients, and competitive bidding. 8 In 1972, the rule against competitive bidding was declared null and void as a result of a lawsuit brought by the Department of Justice. 9 Federal Trade Commission opinions similarly dealt with the other competition-restraining rules, and they were repealed by vote of the membership in 1978. 10

[*1329] Another restraint on entry could be an unreasonably difficult-to-pass professional examination, an onerous education requirement, and a long experience requirement. Although in the United States the CPA certificate is granted by state boards of accountancy and can be withdrawn by them, in fact the examination is prepared and graded by the AICPA. 11 Furthermore, the accountancy boards tend to be dominated by practicing CPAs. However, while there is reason to believe that these requirements have been used as barriers in other countries (notably Japan and Korea), there is little evidence of such use in the United States. 12 I believe it is generally accepted that the uniform CPA examination is a fair test of professional ability and that it has not been too strictly graded. Individual states determine the passing grade their candidates must achieve and impose educational and experience requirements. Most states require a bachelor's degree with a specified number and kind of accounting and related courses required, such that a fifth year or master's degree often is necessary. Only one year of experience with a CPA firm usually is required if a candidate has a master's degree. With the notable exception of Florida, most states permit accountants certified in one state to practice in another state by application, assuming they meet that state's basic requirements. 13

Perhaps of greatest importance, before the establishment of the SEC there was no governmental requirement for companies to use the services of CPAs. 14 Indeed, many alternative firms have offered accounting services to companies, including bookkeeping, preparation of financial statements, development and installation of information systems, and tax advice and preparation. 15 Creditors can and often do accept financial statements that are not attested to by CPAs. Unlike the situation in the United Kingdom before passage of the securities acts, investors could invest in companies with financial statements not attested to by CPAs. Even now, companies not registered with the SEC are not legally required to have financial statements audited by CPAs. These alternative suppliers of accounting services have been an important source of potential competition, particularly for audits of smaller companies. Nevertheless, almost all corporations with publicly traded stock did have independent CPAs attest to their statements even before the SEC required them to do so. 16

[*1330] For SEC-required audits and attestations a CPA certificate is a necessary, though not sufficient, condition for this designation. CPAs also must be independent of the companies they audit. This requirement, as such, has not limited competition among IPA firms. The increasing complexity of GAAP and the demise of one of the Big Five auditing firms, though, have reduced the number of IPA firms that can serve large corporations.

From the pre-SEC history, it is clear that investors have trusted the expertise and probity of IPAs, particularly those with CPA licenses. But, considering that IPAs have been (until enactment of Sarbanes-Oxley) hired and fired by the managers of the companies they audit, why have investors accepted IPAs' attestations? The answer, I believe (aside from the obvious reason that CPAs--such as myself--almost always have been persons of superior ability and honesty) 17 is that it generally is in the economic interest of IPA firms to be worthy of trust. Although individual clients may want to have their IPA attest to their false or misleading financial statements, those attestations would be worthless if users of financial statements believe or suspect that the IPA's attestations are for sale. Dishonest clients would want an IPA who would lie only for them. However, even if a partner in an IPA firm were willing to sell out for his or her client, the firm's partners should consider whether the present value of the "bribe" is greater than the present value of the loss of other clients' business when and if the false attestation is discovered. If an IPA firm has many clients, it would be rare, indeed, if selling out or even appearing to have been suborned were a good economic decision for the firm, as Arthur Andersen recently learned. 18

Indeed, prior to enactment of the securities acts, there were almost no reported instances of major or even minor IPA firms falsely and deliberately attesting to the validity of a client's financial statements. In a comprehensive study of accountants' legal liabilities, Wiley Rich reports: "An exhaustive search has revealed not a single American case in which a public accountant has been held liable in a criminal suit for fraud." 19 Nor were many instances of fraudulently prepared financial statements cited during the extensive hearings before the U.S. Senate that preceded passage of the securities acts. 20 One reason could be that such cases were very difficult to pursue, because of the [*1331] prevailing rule of privity, which maintained that only the party for whom the statements were directly prepared (usually the company) could sue, unless the auditor participated in a fraud or made a reckless misstatement or an insincere profession of an opinion from which gross negligence could be inferred. 21 This situation changed after 1933. Now, whether or not they even see the financial statements, any person who acquires securities registered with the SEC may sue the accountant who certified the statements, so long as the statements include a false statement or misleading omission. 22 Nevertheless, almost no cases were filed until the 1950s, and very few cases were filed until the 1960s. Thus, the paucity of pre-SEC lawsuits does not appear to have been due to the previous difficulty of bringing such actions. 23

Nevertheless, the securities acts and the later application of Rule 23 class action lawsuits have given IPAs reason for concern. When a corporation experiences severe financial difficulty, such that its stock prices decline sharply and, in the extreme, goes bankrupt, the attesting IPA is likely to be sued, if for no other reason than IPA firms have "deep pockets." This situation and the existence of a government agency (the SEC) that has the power to determine what must and may not be included in financial statements have led to the increasingly detailed formal compilation of disclosure rules known as GAAP.

C. GAAP Before the SEC

GAAP predates the SEC, although the rules were not stated explicitly before the Securities Exchange Act of 1934 gave the agency responsibility for determining accounting rules. GAAP serves both companies and users of financial statements by reducing the transaction costs of understanding and using financial statements. It provides a set of rules that define the meaning and general contents of financial statements. Specific line items in those statements--such as "Accounts Receivable," "Buildings and Equipment," "Depreciation," and "Sales"--have known and accepted meanings. For example, "Accounts Receivable" and other current assets are expected to be converted into cash or its equivalent within a year or the accounting cycle, whichever is longer. The amount that is not expected to be collected is shown in a contra-asset account, "Allowance for Doubtful Accounts," which is [*1332] deducted from "Accounts Receivable" on the balance sheet. The amount presented as "Buildings and Equipment" on the balance sheet is not the economic market value of those assets, but the amounts expended to acquire them. "Depreciation" is the periodic amount of limited-life fixed assets that is allocated to income-statement expenses in accordance with specified rules, such as an equal amount each year ("straight line"). "Sales" is the increase in the owners' equity claim over the firm's resources as a result of the operations of the enterprise from exchanges of products, usually in market transactions, where the title to the products and control over them has passed to the purchasers. Goods that are transferred to others on consignment are not "sales."

The first "official" statement of GAAP was adopted in 1917 by the American Institute of Accountants (AIA, predecessor to the AICPA) in a memorandum, "Approved Methods for the Preparation of Balance Sheet Statements." 24 This memorandum, rewritten and entitled "Verification of Financial Statements," was approved by the Council of the AIA and endorsed by the Federal Reserve Board in 1929. 25 In 1930, the New York Stock Exchange (NYSE) began a cooperative venture with the AIA to formalize acceptable accounting and auditing policies and practices. 26 They published five "principles" on which audited statements should be based in 1932. 27 In 1933, the NYSE adopted the principles and required newly listed companies to send audited financial statements to their shareholders, a practice already followed by almost all listed companies. 28

II. Post-SEC Regulation of Financial Accounting and Accountants

A. GAAP After the SEC

In accordance with Sections 19a of the 1933 Act and 13b of the 1934 Act, the SEC could prescribe:

the items or details to be shown in the balance sheet and the earnings statement, and the methods to be followed in the preparation of [*1333] reports, in the appraisal or valuation of assets and liabilities, in the determination of depreciation and depletion, in the differentiation of recurring and nonrecurring income, in the differentiation of investment and operating income, and in the preparation, where the Commission deems it necessary or desirable, of separate and/or consolidated balance sheets or income accounts... . 29

In its early years, the SEC used its power to remove from registrants' financial statements appraisals, estimates of future income, and other deviations from numbers based on actual market transactions, because such items tended to increase asset values and reported net income. Such departures from historical costs had been severely criticized when, during the Great Depression of the 1930s, they were seen as clearly wrong and deliberately misleading. The SEC also sought to avoid criticism that might follow if, ex post, it appeared as if it had allowed registered corporations to overstate assets or net income. Otherwise, the SEC did not use its power to define GAAP.

Instead, the SEC delegated its authority to the AICPA (then the AIA). In 1938, in Accounting Series Release 4, the SEC ruled:

where financial statements filed ... are prepared in accordance with accounting principles for which there is no substantial authoritative support, such financial statements will be presumed to be misleading or inaccurate despite disclosure contained in the certificate of the accountant or in footnotes to the statements provided the matters involved are material. 30

"Substantial authoritative support" was defined, operationally, to be procedures adopted by the public accounting profession, although the SEC could and, on occasion, has intervened to countermand or establish a rule. 31 In 1936, the AICPA created the Committee on Accounting Procedure (CAP), which issued fifty-one Accounting Research Bulletins (ARBs) until it was disbanded in 1959. 32 The ARBs suggest rather than demand specific practices and allow alternative methods. Because the SEC (and others) criticized the CAP for making insufficient progress in crafting accounting rules, it was replaced by the Accounting Principles Board (APB). 33 Before the APB's [*1334] replacement in 1973 by the Financial Accounting Standards Board (FASB), it issued forty-three Opinions and four Statements. 34

Unlike its predecessor organizations, the FASB was given a large budget, professional staff, and a mandate to reduce the scope of choice among alternative accounting practices. Initially, it adopted six Statements of Accounting Concepts (SACs) that were supposed to provide a framework or basis for its authoritative Statements of Financial Accounting Standards (FAS), although the SACs themselves are not part of GAAP. Through August 2003, the FASB has issued 150 FASs (thirty-three of which were rescinded or superceded) 35 and its Emerging Issues Task Force (EITF) has issued hundreds of pronouncements. These are supplemented by Interpretations and by Implementation Guides. The AICPA also issues Statements of Position (SOPs), which are part of GAAP if accepted by the FASB. 36 All told, the number of rules and interpretations of rules that comprise GAAP probably are in the thousands, often covering many pages. The most egregious examples are FAS 133 (issued June 1998), which prescribes rules for marking derivatives to fair values, FAS 137 (which delayed application of FAS 133 for a year), and FAS 138 (which clarified FAS 133). 37 The Standards comprise forty-five pages, the Implementation Guide 158 pages, and the PricewaterhouseCoopers' Guide to Accounting for Derivative Instruments and Hedging Activities, 576 pages. 38

[*1335]

B. The Use and Abuse of GAAP

Accounting standards, as codified in GAAP, serve several important uses. They offer users efficiencies in understanding the numbers presented in financial statements. Standardization of content and presentation tends to reduce investors' information costs, which enhances the value of securities and lowers the cost of debt, to the benefit of enterprise owners. Too much detail, though, can result in "information overload" and can turn an efficient system into an inefficient one. As I discuss later, this has occurred in the United States.

Accounting standards are particularly advantageous to IPAs as a means of withstanding pressure from clients to sign statements that are potentially misleading, if not fraudulent. Should a client threaten to dismiss the IPA unless he or she agrees, say, to allow the client to record consignment sales as actual sales, the IPA can point out that no other IPA could agree to violate GAAP. 39 GAAP similarly protects established IPA firms from deviant firms who have little reputation to preserve and who may engage in free riding on the general expectation that all IPAs subscribe to the same standards of accounting. Without a codified set of rules, deviant firms could acquire clients by doing their bidding (within reason), using the excuse if discovered that, in their professional judgment, the client's accounting was correct.

Accounting standards also serve to protect companies and IPAs from lawsuits. Financial accounting, as it has been codified in GAAP, does not purport to be a system of valuation (at least not until fairly recently, with the partial adoption by the FASB and SEC of fair value accounting). Ex post, valuations can be shown to be clearly incorrect, even if they were based on unbiased and reasonable assumptions. Accountants can avoid this risk by showing that they followed the established rules; hence, they cannot be guilty of presenting and attesting to fraudulent or materially misleading representations of an enterprise's financial condition and performance. 40

[*1336] Why, then, was GAAP abused by Enron, Adelphia, WorldCom, Xerox, Waste Management, Cendant, Qwest, Tyco, and other well-known--and many other not-so-well-known--corporations? Even more important, why did Arthur Andersen and other prestigious IPA firms attest that their statements conformed to GAAP when it now appears that they did not? Or, is it the case that they did technically follow the letter of GAAP, but the statements nevertheless were misleading, because the auditors allowed their clients to violate the spirit of GAAP? Before considering answers to these questions, I outline a few of the abuses of GAAP by Enron. We know more about this corporation than the others because of the published investigation by a committee of its board of directors. 41

C. Enron and Andersen's Abuse of GAAP

Enron clearly violated some important GAAP rules. Some of these appear to be serious errors that resulted in massive restatements of Enron's reported net income. These included a recorded $ 1.2 billion in stock issues that were "paid for" with a receivable. Until cash is received, an increase in equity should not be recorded, as specified in EITF 85-1 42 and Rule 5-02.30 of SEC Regulation S-X. 43 Another was violation of rules governing when special purpose entities (SPEs), enterprises established for the benefit of their sponsor but owned by independent parties, must be consolidated with the sponsor's financial statements. This would have eliminated Enron's gains and losses from dealings with many of its SPEs. One such correction reduced Enron's reported net profit by $ 544 million. 44 Public announcement of these changes in October and November 2001 was followed shortly thereafter by its filing for bankruptcy. 45 A third violation was not reporting details about dealings with entities controlled by its Chief Financial Officer, Andrew Fastow, as required [*1337] by FAS 57 46 and SEC Regulation S-K Item 404. 47 A fourth was not reporting its contingent liabilities for the debt of SPEs it guaranteed, as required by FAS 5. 48

Enron, with the concurrence and apparent help of Andersen, used an aggressive interpretation of GAAP to record as sales transfers of assets to SPEs, which enabled it to record net profits and not record debt. The procedures it used are very complicated. 49 In essence, Enron created subsidiaries to hold major assets it was developing, receiving in return Class A voting and Class B non-voting stock. It then "sold" to SPEs the Class B common stock in those subsidiaries that was entitled to almost all of the subsidiaries' economic interests, but kept the Class A voting-rights stock. Enron either had already written up the stock (a financial asset) to fair value, thereby recording the incresases as current income, or recorded gains from the "sale" of the Class B stock to the SPEs. The SPEs paid for the Class B stock with cash, of which 97% was borrowed from banks and 3% was from equity investments made by an affiliate of the lead bank. At the same time, Enron entered into a "total return swap," wherein it assumed the SPEs' obligation to pay the bank debt in exchange for all the cash flow from the Class B stock less amounts necessary to repay the 3% equity holders' investments, plus a specified (usually 15% per annum) return. The swap was accounted for as a derivative and marked-to-fair value, which enabled Enron to record the change in the present value of expected cash flows as additional current profit (or loss). Through a complicated set of structures and practices, Enron essentially guaranteed repayment of the SPEs' "3%" equity. Nevertheless, Enron did not consolidate the SPEs and accounted for the transactions as if they were true arm's-length sales, based on FASB (through the EITF) and SEC rules that could be interpreted as permitting non-consolidation of SPEs if they had outside investors' equity equal to only 3% of assets. This allowed Enron to keep $ 1.4 billion of debt off its December 31, 2000, balance sheet and report over $ 541 million of additional net income before taxes ($ 352 million after [*1338] taxes) on its 2000 income statement. 50 Put simply, Enron really borrowed the funds, because it was fully liable for their repayment regardless of the value of the assets. It also retained both control over the assets and almost all of the potential gains and losses therefrom, which is to say that it didn't really sell the assets. It does appear, though, that Enron and Andersen conformed to the letter of the GAAP rules. 51

Enron also kept $ 4.9 billion of debt off its December 31, 2000, balance sheet by forming subsidiaries that borrowed the funds and then not consolidating the subsidiaries, even though it held a substantial controlling interest in them. 52 FAS 94 quite reasonably requires corporations to consolidate subsidiaries in which it owns over half the voting shares. However, a GAAP rule (EITF 96-16) allows non-consolidation when the minority interest has participation rights that prevent the majority shareholder from exercising control. 53 Enron gave the minority interest the right to appoint two of four directors. That right only allowed the minority to block actions by Enron, whose employees were the subsidiary's managers. Although it was very unlikely that the minority interest would take such an action, because it would harm its own interests, and even though the minority interest never actually appointed any directors, Andersen accepted Enron's claim that the subsidiary did not have to be consolidated. 54 In total, in its 2000 financial statements Enron should have reported net income after tax of $ 42 million rather than $ 979 million, debt of $ 22.06 billion rather than $ 10.23 billion, and cash outflow from operations of $ 154 million rather than a cash inflow of $ 3.01 billion. 55

D. Why Did Enron's (and Other Corporations') Managers Abuse GAAP?

I believe that some corporate managers, in addition to those at Enron, deliberately structured transactions and aggressively interpreted and applied [*1339] GAAP rules so as to produce financial statements that would mislead investors and other users. To the best of my knowledge, this misbehavior was not common before the late 1990s and, although widely publicized, has not been found to have been widespread even in more recent years. 56 Some of the apparent increase in misbehavior, as indicated by restatements of financial statements, seems to have been due to a change in SEC policy by former chairman Arthur Levitt, who expressed concern about accounting manipulations. 57

Several other factors, though, probably motivated actual increases in aggressive accounting. One was to give the appearance of superior performance, particularly when the managers were unable to match or exceed past reported performance. Another was to cover up economic losses, perhaps to buy time until hoped-for gains on other projects were realized or until the managers could exercise their options and sell their stock. A third was related to stock options, which became popular following the 1993 tax law disallowance of executive compensation over $ 1 million as a deductible expense unless it is "performance based." 58 Corporate managers might have attempted to increase or maintain the market price of their stock by inflating reported net income.

Another factor probably was greater knowledge about financial "engineering." CFOs and consultants who were familiar with derivatives and the like could find ways to inflate reported net income without having to violate strictly interpreted GAAP rules. In addition, I suggest that the codification of GAAP, which had accelerated since the creation of the well-financed and professionally staffed FASB, made financial statement manipulations easier to accomplish. As GAAP became more rules-based (some reasons for which are suggested later), it became increasingly feasible [*1340] for opportunistic managers to meet bright-line requirements in order to inflate reported net income. They then could insist that their auditors attest that their statements were in compliance with GAAP, even though the statements were, in fact, misleading to investors and other financial statement users. This development has had the unintended consequence of being contrary to the expressed reason for the codification of GAAP rules--instead of reducing opportunistic managers' opportunities to present misleading financial reports, they have made such misrepresentation more feasible.

E. Why Did Andersen (and Other IPAs) Allow or Help Managers to Abuse GAAP?

One reason that IPAs might go along with or participate in managers' manipulation of GAAP may be that the rules-based approach to GAAP meant that the managers weren't actually violating GAAP. Thus, the managers could credibly threaten: "if you won't do it, we will find another firm who will, because we have not actually violated the GAAP rules." The auditors also could justify their weakness with the observation: "anyway, everyone is doing it." A related positive inducement might be the auditors' concern for losing lucrative consulting contracts. In 2000, Andersen received $ 27 million in consulting fees and $ 25 million in audit fees from Enron. 59 During the late 1990s, Andersen's and other audit firms' fees from consulting increased dramatically, to the point where they often were several times their fees from auditing. 60 Based on these observations, section 201 of the Sarbanes-Oxley Act of 2002 prohibits audit firms from providing virtually any non-audit service to a corporation it audits, with the exception of tax-related services. 61

It is not clear, though, why IPAs who feared losing consulting fees would not be suborned even more readily with high audit fees. Income from audits is likely to be more highly valued than income from consulting, particularly by [*1341] the partner in charge of the audit who only gets indirect credit for generating collateral revenue from consulting contracts for his or her firm. Consulting fees also tend to be sporadic, while audit fees usually continue year after year. Antle and Gitenstein analyzed the financial records of the Big Five accounting firms and found that, while the per-hour rate for consulting is higher than the rate for auditing, the present value to IPAs of audit fees is considerably greater, because the net cash flow from audits is steadier and continues for a longer time. 62

This possible conflict of interest has been extensively studied many times over many years. A history of these studies is reviewed by the Public Oversight Board's Panel on Audit Effectiveness. 63 They report that in 1966 a committee of the AICPA studied the issue and "found no evidence that non-audit services impair independence in fact, but found that some users believed that such services created an appearance of lack of independence." 64 A 1974 study by the AICPA's Cohen Commission raised similar concerns, but reported no instances of actual conflicts that impaired audits. 65 The U.S. Senate then examined the issue. An extensive staff report, The Accounting Establishment, published in 1977, generally concluded that audit firms' provision of management information services created a conflict of interest. 66 However, a review of that report revealed that, in fact, no evidence of such conflicts was presented. 67 The Public Oversight Board (established in response to the Senate staff report) studied the issue again in 1979. They concluded: "From the voluminous record before the Board, it is apparent that documented evidence of MAS [management advisory service] abuses or impairment of independence through the use of MAS is virtually nonexistent." 68 The Panel on Audit Effectiveness conducted its own analysis of audit practices and concluded: "The Panel is not aware of any instances of non-audit services having caused or contributed to an audit failure or the actual loss of auditor independence." 69 Nevertheless, in February 2001 the SEC ruled that CPAs [*1342] may not provide nine kinds of management advisory services to their SEC-audit clients. 70 The SEC also required registrants to disclose the amount of its payments to audit firms under three captions: "audit" (only those fees for services necessary to audit and review SEC reports), "financial information design and implementation" (of which almost nothing is reported), and "all other." 71

Frankel and his co-authors used these data to study the relationship between audit and non-audit fees, which include an unknown proportion of tax services, not banned by Sarbanes-Oxley. They found a positive relationship between non-audit fees and their measures of earnings manipulation: companies just meeting analysts' predictions and having higher levels of discretionary accruals. 72 DeFond and his co-authors use these fee data, but measure auditor independence by their propensity to issue going concern audit opinions at financially distressed firms. 73 They find no association between this measure and either total fees or audit fees. 74 They describe and cite four working papers by other researchers who also do not find a relationship between non-audit service fees and impairment of auditor independence. 75 In fact, two of these papers report findings contrary to those reported by Frankel and his co-authors. 76 Perhaps of greatest importance, DeFond and his co-authors report that a study of 1071 legal and regulatory actions taken against the Big Five audit firms and their predecessor firms from 1960 through 1995 by Palmrose "finds no instances of lawsuits against auditors that allege non-audit services impair independence." 77

[*1343] Nevertheless, it is conceivable that IPAs' fear of losing the fees paid by clients, whether for audits or consulting services, or the temptation offered by the prospect of higher fees, might cause them either to agree to or overlook managers' deceptive accounting practices or actively propose and design such practices. Assuming that this occurred, the question now is why audit firms risked losing their reputations, which (as noted earlier) would make their services to other clients much less valuable. For a firm with many clients (such as Andersen), the present value of the expected cost of reputational loss should greatly exceed the benefits from higher fees, as it did for Andersen. Why, then, did Andersen do what it did?

One explanation is that it (and other audit firms) had less reason to expect to have to defend themselves in lawsuits, because of legal changes in the mid-1990s. The Private Securities Litigation Reform Act of 1995 (PSLRA) 78 generally made it more difficult for class action plaintiffs to sue IPA firms for accounting abuses, and the Securities Litigation Uniform Standards Act of 1998 (SLUSA) 79 abolished state court class actions alleging securities fraud. John Coffee points to this legislation and two court cases that made bringing lawsuits against IPAs more costly to plaintiffs as possible explanations for the presumed weakening of auditing performance. 80 Although he supports "proportionate liability for auditors on fairness grounds and sees no problem with PSLRA's heightened pleading standards," he concludes: "Their collective impact was to appreciably reduce the risk of liability." 81

However, the PSLRA did not exempt IPAs from liability; all it did was to cut back their joint-and-several liability for accounting misdeeds when there are several defendants before the court. 82 The PSLRA also raised pleading [*1344] standards 83 and restricted the extension of the RICO statute so that treble damages could no longer be sought. 84 The rationale for these reforms was to prevent plaintiffs from digging into the deepest pockets among a group of defendants, regardless of the individual defendant's degree of culpability, and from bringing extortionate lawsuits against IPAs in the hope of a settlement. The SLUSA only abolished state court class actions alleging securities fraud; federal class actions can still be brought against accountants. Furthermore, the legal changes have not kept plaintiffs from suing the audit firms associated with corporations that restated their financial statements.

F. Two Explanations for Auditor Failure

I suggest two major reasons for Andersen's and probably other audit firms' failure (at best) to prevent corporate managers from presenting misleading financial statements. One is the rules-based application of GAAP fostered by the FASB and the SEC. The other is the absence of punishment by the SEC of individual IPAs who were guilty of gross negligence, incompetence, or malfeasance. Both factors are compounded by and in large measure are due to the U.S. tort system, wherein IPAs fear being sued when their clients' fortunes decline substantially or precipitously.

GAAP has increasingly become rules-rather than principles-based. In large part, this may be due to the auditing profession's belief that IPAs can successfully avoid being sued if they can show that their clients and they followed the rules. The existence of a rules-making government agency, the SEC, also has influenced the U.S. approach to GAAP. Although the SEC initially forbore from writing detailed accounting rules, it found it could not administer the securities acts efficiently in the absence of rules. Regulation S-X was enacted in 1940 and expanded as corporations and IPAs sought protection from both lawsuits and criticism, and as opportunistic promoters and managers developed ways to "beat the system." Indeed, as the SEC emphasized the importance of financial statement information for investment decisions, manipulation of accounting numbers became more profitable. When some scandal uncovered financial accounting that appeared misleading or inadequate, public, press, and political criticism led to more rules. The FASB, in turn, was established to write such rules, and it did so assiduously. Its propensity to develop rules with extensive and detailed illustrations, [*1345] interpretations, and instructions resulted, I believe, from its having both a large budget and a professional full-time staff. GAAP then developed into a set of specific rules, not unlike the tax code, which must be followed to the letter, but not necessarily (or at all) according to its intent.

GAAP and GAAS, however stated or interpreted, are of little value to investors if corporations can violate them with impunity. IPAs are the gatekeepers. They attest that a company's financial statements are presented in accordance with generally accepted accounting principles, as determined from an audit conducted in accordance with generally accepted auditing standards. As I note above, audit firms have strong incentives to refuse attestations that might result in damage to their reputations. However, individual partners-in-charge of the audits might benefit substantially from taking such risks. Their compensation usually is based on the audit fees they generate. Loss of a partner's major client is likely to be very costly to that partner. Although the firms should (and I believe most firms do) have strong incentives to monitor the behavior of their partners, the partners probably realize that if their firms are cited by the SEC or sued by private litigants, they will be defended rather than disciplined. Should the firms fire or otherwise punish a partner for having supervised and approved an incompetent or inadequate audit or for having agreed too readily to a client's demands, the firm would be admitting its collective guilt to regulators and present, or potential, plaintiffs. However, if individual CPAs realized that they might lose their CPA certificates, and hence their professional and personal reputations, if they are too accepting of clients' demands for inadequate audits or attestations of misleading financial statements, they might more readily stand up to such pressures.

External discipline of CPAs can be imposed by three entities: the AICPA, state boards of accounting, and the SEC. The AICPA can only discipline CPAs who are members. Even then, members are rarely censured. One reason is that organizations such as the AICPA do not have the resources to investigate their members' professional misconduct and would be subject to lawsuits if they acted without due process and without good cause. Indeed, the Washington Post found that over an eleven-year period, the AICPA took disciplinary action against fewer than twenty percent of accountants who had already been sanctioned by the SEC. 85 State boards of accounting, which grant CPAs their licenses, can and do revoke those licenses. Such actions, however, are taken almost exclusively against CPAs who are charged with and admit [*1346] failure to fulfill important obligations to clients, have been found guilty of fiduciary or criminal offenses, or do not maintain their required Continuing Professional Education. 86

The SEC, though, has the staff, authority, and responsibility to investigate and discipline IPAs who attest to statements filed with it. It can impose its own sanctions, particularly denying IPAs the right to attest to statements required by the SEC, or recommend criminal or civil prosecution by the Department of Justice. But it has done this rarely. Researchers recently studied the SEC's Accounting and Auditing Enforcement Releases (AAERs), which criticize audits of registrant corporations, issued between July 1, 1997, and December 31, 1999. 87 They randomly selected 204 of the nearly 300 AAERs alleging fraudulent financial statements and did not report any SEC actions against the individual IPAs or their firms attesting to those statements. 88

A General Accounting Office (GAO) study of 689 restatements finds that in the period from January 2001 through February 2002, thirty-nine CPAs were suspended or denied the privilege of appearing or practicing before the SEC, twenty-three for three years or less. 89 In addition, one non-Big Five accounting firm was permanently barred, one Big Five and one non-Big Five firm were given cease and desist orders, and three Big Five firms were censured. 90

The GAO also presents sixteen "case studies" that detail the reasons for, and effects of, actions taken by the SEC as a consequence of these corporations' restating their financial reports. 91 In three cases, the violations of GAAP were discovered by the auditor, and in three the restatements resulted from changed interpretations of GAAP requirements. 92 Ten cases involved important and substantial violations of GAAP (e.g., liabilities not reported, improper recognition of income, expensing costs that should have been capitalized, falsification of expenses, and rampant self-dealing by [*1347] management). 93 In three of these cases, the SEC took action against the auditors. In the Sunbeam matter, the auditor was charged with having his firm (Arthur Andersen) sign unqualified statements, even though he knew about the misstatements. He faces trial. 94 In the case of Waste Management, the firm (Arthur Andersen) issued unqualified statements, even though its auditors had identified and quantified the improper accounting practices. Arthur Andersen was fined $ 7 million. Two of the three auditors were fined $ 50,000 and $ 40,000 and barred from practice before the SEC for five years; the other was barred for one year. The GAO states that they continued to be active partners of Arthur Andersen. 95 In the Enron matter, Arthur Andersen was charged with destroying documents in advance of an SEC investigation, and, in a jury trial, was found guilty. No mention is made of Andersen's partner-in-charge of the audit, who destroyed the documents. 96 The GAO does not indicate any actions taken by the SEC against the audit firms or the CPAs who conducted the audits of the seven other corporations where there were serious errors, misclassifications, and omissions that substantially overstated reported net income and assets, while understating liabilities. 97

G. The Sarbanes-Oxley Reforms

Sarbanes-Oxley does not deal with the GAAP-related reasons for the restatements and misstatements that gave rise to the Enron and other major debacles. I believe that two factors are principally responsible. 98 The first is the increasing specificity of the rules-based approach to GAAP. As noted earlier, although the detailed rules may have been designed to reduce the scope of corporate managers' choice among alternative acceptable procedures, they have allowed managers, often with the concurrence of their IPAs, to claim that the numbers reported in their financial statements were "fairly presented in accordance with generally accepted accounting principles," even when the substance of GAAP was violated. The second is the movement of the FASB [*1348] and the SEC toward "fair value" accounting, according to which financial assets (and, increasingly by extension, other assets) are restated at their estimated "value," with the changes (usually increases) reported as income. This differs from "market value" accounting, in which financial assets are restated at prices obtained from relevant actual market transactions. The problem is that fair values are subject to manipulation by opportunistic managers, because they are based on discounted expected cash flows or estimates of possible future transactions. The present values of these future cash flows necessarily are uncertain, because there is no objective way to determine the applicable discount rate and the future amounts often change unexpectedly. Hence, fair values can be readily manipulated, or are likely to seem to have been manipulated when, ex post, they turn out to be substantially incorrect.

Sarbanes-Oxley, though, is concerned almost entirely with the regulation of IPAs rather than with reform of GAAP (although it mandates a GAO study of principles-based accounting). 99 Previously, the AICPA and the SEC had authority over the way audits were conducted and IPAs were disciplined. IPAs must audit financial statements in accordance with GAAS, which were promulgated by the Auditing Standards Board of the AICPA in 1948. In 1988, the AICPA established the SEC Practice Section (SECPS). Member firms that audit corporations reporting to the SEC were required to join the SECPS, meet its standards, and undergo periodic peer reviews. The Public Oversight Board oversaw this process until its members resigned in 2001 following criticism by the SEC and others that it did not prevent the Enron debacle. It was superceded in 2003 by the Public Company Accounting Oversight Board (PCAOB). 100 The Board has five "financially literate" full-time members, only two of whom are required to be, or to have been, CPAs. 101

The PCAOB, which reports to the SEC, has been given substantial powers over IPAs and public companies. It registers public accounting firms 102 and inspects them at least every three years or annually if they audit more than 100 "issues," 103 and conducts investigations and disciplinary proceedings. 104 It then may impose appropriate sanctions, presumably against both firms and [*1349] individual IPAs. 105 It also has authority to establish standards related to auditing, quality control, ethics, independence, and the preparation of audit reports. 106

Sarbanes-Oxley specifies that public accounting firms must maintain records for seven years and have a second partner review and approve audits. 107 In addition, the lead audit or coordinating partner and reviewing partner must rotate off the audit every five years. 108 The CEO, Controller, CFO, or Chief Accounting Officer of a client may not have been employed by the accounting firm during the one-year period preceding the audit. 109 It now is unlawful for a registered public accounting firm to provide specified non-audit services to an audit client. These include financial systems design and implementation, appraisal or valuation services, fairness opinions, actuarial services, internal audit outsourcing services, management function or human resources, securities and banking services, and legal services. 110 Tax services, though, may still be provided to audit clients. 111 Nor are public accounting firms prohibited from offering non-audit services to the audit clients of other firms.

The PCAOB will fund itself from fees paid by issuers of securities in proportion to their market capitalization. 112 At its first meeting, the PCAOB members voted themselves annual salaries of $ 452,000, 113 although the Senate has reduced this to $ 400,000 (the amount of the President's salary). 114

An important part of Sarbanes-Oxley is the increased role of the audit committee of public companies. Under the Act, a registered public accounting firm must report to the audit committee, which is directly responsible for the firm's appointment, compensation, oversight, and retention. 115 Further, all members of the audit committee must be independent members of the board of directors, 116 and one of the members should be a "financial expert." 117

[*1350] It is too early to determine whether the benefits that might flow from the new regulatory bureaucracy will exceed the costs. Shareholders will benefit if the IPAs are more diligent in conducting audits and in assuring investors that corporate financial statements are not misleading. Another benefit would be more effective operation of corporations, if incompetent managers who find it more difficult to hide poor performance are removed more quickly. Better audits also might prevent or limit gross misuse or outright theft of shareholders' resources.

However, most of the financial statement restatements that gave rise to Sarbanes-Oxley revealed losses that had occurred and that should have been reported earlier. At the time the accounting misstatements were revealed, the share price of some (but not all) of the affected corporations declined. A GAO study of 689 restatements from January 1, 1997, through March 26, 2002, found a three-day loss of ten percent of those corporations' capitalization, adjusted for changes in the market, or a total of $ 95.6 billion for the 689 restatement announcements, or $ 139 million on average. 118 But to the extent that the losses or thefts that eventually were revealed would have occurred anyway, the only loss shareholders actually incurred was gains obtained by insiders who sold their shares before the bad news was made public. Furthermore, shareholders can hold diversified portfolios of stocks. Although the amount of market-value loss is great for individual restating corporations, it averaged only 0.11% of total market capitalization. 119

The cost of better audits, though, also must be borne by shareholders. This cost includes the additional fees that are paid to the PCAOB, as well as higher audit and non-audit fees. Audit fees will increase, because of auditors' costs of complying with PCAOB rules and inspections, as well as those of conducting more thorough and more carefully and extensively supervised audits. Non-audit fees will increase, because corporations no longer can obtain economies from purchasing these services jointly with audit services. The GAO study found that ten percent of listed companies restated their financial statements in some fashion in 1997-2002. 120 Considering that these costs must be borne by the shareholders of all publicly traded corporations, while the benefits will be obtained only by the shareholders of companies with significantly improved [*1351] financial statements, it may be that the costs to all shareholders will exceed the benefits.

My guess is that, for shareholders, the cure is likely to be worse than the disease. A less costly and almost as effective cure, I suggest, would have been for the SEC to have used its authority under Rule of Practice 203(e) to discipline severely IPAs who attested to financial statements that significantly violated GAAP or who supervised audits that significantly departed from GAAS. I also suggest that the partner-in-charge of an audit and the confirming partner should be required to sign the attestation so that their personal reputations will be on the line.

Although the Sarbanes-Oxley reforms are likely to be a net cost to shareholders, there are societal benefits that should be included in the equation. Shareholders generally appear to benefit from greater confidence that corporate financial statements are more trustworthy. 121 IPAs also will benefit, as will teachers of accounting, because the demand for their services has increased. As a sometime teacher and researcher of accounting, I really cannot complain.

FOOTNOTES:
n1. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified at 15 U.S.C. 7201 (2000)).

n2. 15 U.S.C. 7211 (2000).

n3. See George J. Benston, The Market for Public Accounting Services: Demand, Supply and Regulation, 2 Acct. J. 2 (1979-80), reprinted in 4 J. Acct. & Pub. Pol'y 33 (1985) for a more complete analysis of the demand for public accounting services.

n4. Previously, in the United Kingdom, external auditors had to be stockholders in the firms they audited. See infra Part I.B for a discussion of why IPAs should be trusted.

n5. Some accounting authorities (particularly the Financial Accounting Standards Board) and financial statement users (particularly financial analysts) would prefer that financial statements reflect current economic values rather than historical costs, which they view as substantially irrelevant. However, when these numbers are not based on verifiable (hence, trustworthy) values derived from market transactions, the numbers presented in financial statements are subject to manipulation by opportunistic managers and, hence, are not only irrelevant but potentially misleading. See George J. Benston et al., Following the Money: The Enron Failure and the State of Corporate Disclosure (2003); George J. Benston, Accounting Doesn't Need Much Fixing (Just Some Reinterpreting), 15 J. Applied Corp. Fin. 8 (2003) [hereinafter Benston, Reinterpreting]; George J. Benston, The Quality of Corporate Financial Statements and Their Auditors, Before and After Enron, Cato Institute Policy Analysis (forthcoming 2003) [hereinafter Benston, Quality].

n6. See Benston, supra note 3, at 15.

n7. See id. at 20.

n8. See id.

n9. See id. at 18.

n10. See id.

n11. See id. at 15.

n12. See id. at 22-26 for a review of the evidence from which this conclusion is drawn.

n13. Id. at 15-16.

n14. Id. at 23-24.

n15. Id. at 26-27.

n16. Id. at 12.

n17. Actually, this facetious remark is historically correct. Before professional organizations were formed, individuals who had strong reputations for probity and financial experience made attestations.

n18. See infra Part I.F.

n19. Wiley Daniel Rich, Legal Responsibilities and Rights of Public Accountants 100 (1935).

n20. George J. Benston, Corporate Financial Disclosure in the UK and the USA 104-08 (1976).

n21. See Rich, supra note 19, at 66-67.

n22. 15 U.S.C 77l (2000).

n23. See infra Part I.E for a discussion of changes in IPAs' legal liability in the 1990s.

n24. See Stephen A. Zeff, Forging Accounting Principles in Five Countries: A History and Analysis of Trends 113-19 (1972).

n25. Id. at 118.

n26. Id. at 119.

n27. Id. at 123.

n28. Id. at 124.

n29. 15 U.S.C. 78m(b)(1) (2000).

n30. Administrative Policy on Financial Statements, SEC Accounting Series Release No. 4 (Apr. 25, 1938).

n31. Zeff, supra note 24, at 134.

n32. See id. at 134-67.

n33. See id. at 167-73.

n34. See id. at 173-230.

n35. See FASB Statements, available at http://www.fasb.org/st/ (last visited Aug. 31, 2003).

n36. See, e.g., Summaries of Recently Issued SOPs & Guides, at http://www.aicpa.org/members/div/ acctstd/recent<uscore>issued.asp (Aug. 7, 2003).

n37. FASB Statements, supra note 35.

n38. In a 1997 article critical of the FASB's then-proposed fair-market-value approach to accounting for derivatives, I wrote that if the proposal were adopted (as it was),

the FASB would substantially increase the cost to firms of using derivatives to hedge risk by turning hedge accounting into an arcane body of rules with the complexity of tax accounting. Simply researching and attempting to determine roughly what can and cannot be done could take days, if not weeks. Even then, the SFAS [Statement of Financial Accounting Standards] (should it be adopted)--and the manuals and course materials that no doubt will be developed to interpret it--will fail to provide guidance for new financial instruments that will be developed to cover new or altered risks. This probably will result in inconsistencies, such as those the FASB is now trying to correct, and demand for additional authoritative opinions.

George J. Benston, Accounting for Derivatives: Back to Basics, J. Applied Corp. Fin., Fall 1997, at 46, 51.

n39. In 1964, the AICPA formally adopted Rule 203 of the Code of Professional Ethics that requires a member to express only opinions on financial statements that are in accordance with GAAP, unless the statements would be materially misleading, in which event the CPA must give the reason and justification for the departure. See AICPA, ET Section 203, Accounting Principles, available at http://www.aicpa.org/about/ code/et203.htm (last visited Aug. 31, 2003); see also Zeff, supra note 24, at 182-83.

n40. However, this defense may not necessarily be successful. In United States v. Simon, 425 F.2d 796 (2d Cir. 1969), the court ruled that the "critical test" is whether financial statements as a whole "fairly present" the financial position and results of operations of the company for the period under review. Compliance with GAAP was held to be "persuasive," but not "conclusive," that the facts as certified were not materially false or misleading. Id. at 805-06.

n41. See George J. Benston & Al L. Hartgraves, Enron: What Happened and What We Can Learn from It, 21 J. Acct. & Pub. Pol'y 105 (2002) (summarizing and analyzing the Powers Report and accounts in the press); see also First Interim Report of Neal Batson, Court-Appointed Examiner, In re Enron Corp., No. 01-16034 (AJG) (Bankr. S.D.N.Y., Sep. 21, 2002), available at 2002 WL 3111331; Second Interim Report of Neal Batson, Court-Appointed Examiner, In re Enron Corp., No. 01-16034 (AJG) (Bankr. S.D.N.Y., Jan. 21, 2003), available at http://www.enron.com/corp/por/examiner2.html (last visited Aug. 9, 2003).

n42. See FASB, Classifying Notes Received for Capital Stock, EITF Issue No. 85-1 (1985).

n43. SEC Form and Content of and Requirements for Financial Statements, Balance Sheets, 17 C.F.R. 210.5-02.30 (2003).

n44. First Interim Report, supra note 41, at 2.

n45. Id. at 2-4.

n46. FASB, Related Party Disclosures, Fin. Acct. Standards No. 57 (1982), available at http://www. fasb.org/st (last visited Aug. 31, 2003).

n47. 17 C.F.R. 229.404 (2003).

n48. FASB, Accounting for Contingencies, Fin. Acct. Standards No. 5 (1975), available at http://www.fasb.org/st/ (last visited Aug. 31, 2003). Other violations of GAAP are described in Benston & Hartgraves, supra note 41.

n49. See First Interim Report, supra note 41, and Second Interim Report, supra note 41, app. M, at 1-21, for descriptions.

n50. Second Interim Report, supra note 41, app. Q, at 1.

n51. The Examiner determined that Enron had not met the legal standard for a "true sale," although based on an interpretation of the rules by the SEC allowing non-consolidation of SPEs, Enron did not violate a strict interpretation of GAAP. First Interim Report, supra note 41; Second Interim Report, supra note 41, app. M, at 34.

n52. Second Interim Report, supra note 41, app. Q, at 1.

n53. See FASB, Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights, EITF Issue No. 96-16 (1996).

n54. See Second Interim Report, supra note 41, for several other examples.

n55. Id.

n56. A search of databases for mentions of restatements due to irregularities or errors found 224 in 1977-1989 (seventeen a year on average), 392 in 1990-1997 (forty-nine a year), and 464 in 1998-2000 (155 a year). FEI Research Foundation, Quantitative Measures of the Quality of Financial Reporting, available at http://www.fei.org/download/QualFinRep-6-13-2k1.ppt (last visited Aug. 9, 2003). See Benston, Quality, supra note 5, for a review of these and other studies.

n57. Arthur Levitt, The Numbers Game, Remarks at the New York University Center for Law and Business (Sep. 28, 1998), available at www.sec.gov/news/speech/speecharchive/1998/spch220.txt (last visited Aug. 9, 2003). In fact, the author of the FEI study ascribes most of the 1998-2000 restatements to SEC objections to software companies that restated their accounting for in-process research and development (fifty-seven of 207 restatements in 1999), to the SEC having registrants account for immaterial errors with restatements rather than with future adjustments, and to corporations reluctantly restating to avoid having their registration statements held up because of accounting issues. FEI Research Foundation, supra note 56.

n58. 26 U.S.C. 162(m) (2000).

n59. Michael Schroeder, Arthur Levitt Says Enron Case Shows Need for More Curbs, Wall St. J., Jan. 11, 2002, at A4.

n60. In 1990, 71% of the revenue from SEC audit clients of the Big Five audit firms was derived from accounting and auditing; in 1999 this percentage declined to 48%. Consulting grew from 12% to 32% over this period, with tax-related services increasing from 17% to 20%. However, in 1999 75% of these clients "received no consulting services from their auditors" (80% in 1990). Public Oversight Board, Panel on Audit Effectiveness: Report and Recommendations 112 (Aug. 31, 2000), available at http://www.pobauditpanel. org/download.html (last visited Aug. 9, 2003). Using more extensively disclosed data, researchers report that in 2001, audit fees comprised between 25 and 33% of the revenue of the Big Five audit firms and 58% of all other audit firms' revenues. Richard M. Frankel et al., The Relation Between Auditors' Fees for Nonaudit Services and Earnings Management, 77 Acct. Rev. 71, 81 tbl.3 (2002).

n61. 15 U.S.C. 78j-1 (2000).

n62. Rick Antle & Mark H. Gitenstein, Analysis of Data Requested by the Independence Standards Board from the Five Largest Accounting Firms 6 (Feb. 17, 2000) (unpublished report presented to the Independence Standards Board), available at http://iicg.som.yale.edu/working<uscore>papers/papers/ISB<uscore>Data.pdf (last visited Aug. 9, 2003).

n63. Public Oversight Board, supra note 60, at 203 app. D.

n64. Id. at 203-04 (emphasis in original).

n65. Id. at 204.

n66. Id.

n67. Benston, supra note 3, at 36-38.

n68. Public Oversight Board, supra note 60, at 205.

n69. Id. at 110.

n70. These include: (i) bookkeeping or other services related to the audit client's accounting records or financial statements; (ii) financial information systems design and implementation; (iii) appraisal or valuation services and fairness opinions; (iv) actuarial services; (v) internal audit services; (vi) management function, such as acting as a director or officer or performing decision-making, supervisory, or ongoing monitoring; (vii) human resources, such as searching for executives, engaging in psychological testing, acting as a negotiator on the audit client's behalf, and recommending hires; (viii) broker-dealer services; and (ix) legal services. 17 C.F.R. 210.2-01.3(c)(4) (2003).

n71. Revision of the Commission's Auditor Independence Requirements, 65 Fed. Reg. 76,008, 76,057 (Dec. 5, 2000) (to be codified at 17 C.F.R. 240.14a-101, Item 9(e)).

n72. Frankel et al., supra note 60, at 72-73.

n73. Mark L. DeFond et al., Do Non-Audit Service Fees Impair Auditor Independence?: Evidence from Going Concern Audit Opinions, 40 J. Acct. Res. 1247, 1248-49 (2002).

n74. Id. at 1250.

n75. Id. at 1252-54.

n76. Id. at 1253.

n77. Id. (citing Zoe-Vonna Palmrose, Empirical Research in Auditor Litigation: Considerations and Data 1 (1999)).

n78. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.).

n79. Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227 (codified as amended in scattered sections of 15 U.S.C.).

n80. John C. Coffee, Jr., Understanding Enron: "It's About the Gatekeepers, Stupid," 57 Bus. Law. 1403, 1410 (2002). Coffee cites and discusses two cases: (1) Lampf, Pleva, Lipkind & Petigrow v. Gilbertson, 501 U.S. 350, 359-61 (1991) (creating a federal rule requiring plaintiffs to file within one year of the time they should have known of the violation underlying their action, but in no event more than three years after the violation; previously the state law rule was from five to six years); and (2) Central Bank of Denver, N.A., v. First Interstate of Denver, N.A., 511 U.S. 164 (1994) (eliminating private "aiding and abetting" liability in securities fraud cases). Coffee, supra, at 1409-10.

n81. Coffee, supra note 80, at 1410 & n.34.

n82. 15 U.S.C. 78u-4(f) (2000). In particular, the Act assigns joint-and-several liability only when the jury specifically finds that the defendants knowingly violated the securities laws. Id. 78u-4(f)(2)(A).

n83. Id. 78u-4(a)(2), (b).

n84. Id. 78u-4(e).

n85. David S. Hilzenrath, Auditors Face Scant Discipline, Wash. Post, Dec. 6, 2001, at A1.

n86. Hilzenrath found that "the state of New York, which had the most accountants sanctioned by the SEC, as of June had disciplined [only] 17 of 49 New York accountants ... ." Id.

n87. Mark S. Beasley et al., Fraudulent Financial Reporting 1987-1997: An Analysis of U.S. Public Companies (1999).

n88. Id. at 27-29.

n89. General Accounting Office, Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges 3, 53 (2002).

n90. Id. at 53.

n91. Id., apps. IV-XX, at 113-235.

n92. Id.

n93. Id.

n94. Id. at 201-06.

n95. Id. at 214-24.

n96. Id. at 144-51.

n97. Id. at 113-235. These corporations (and their auditors) are Adelphia Communications Corporation (Deloitte & Touche), MicroStrategy Incorporated (PricewaterhouseCoopers), Orbital Sciences Corporation (KPMG), Rite Aid Corporation (KPMG), Safety-Kleen Corporation (PricewaterhouseCoopers), Sea View Video Technology, Inc. (Carol McAtee, CPA), and Xerox Corporation (KPMG). Id.

n98. The following critique of GAAP is necessarily brief and incomplete. See Benston et al., supra note 5; Benston, Reinterpreting, supra note 5; and Benston, Quality, supra note 5, for more extensive descriptions and analyses.

n99. 15 U.S.C. 7218(d) (2000).

n100. Id. 7211.

n101. Id. 7211(e).

n102. Id. 7212.

n103. Id. 7214(b).

n104. Id. 7215.

n105. Id.

n106. Id. 7213.

n107. Id. 7213(a)(2)(A)(i)-(ii).

n108. Id. 78j-1(j).

n109. Id. 78j-1(l).

n110. Id. 78j-1(g).

n111. Id. 78j-1(h).

n112. Id. 7219(g).

n113. Mike McNamee, Is This Job Worth $ 452,000 a Year?, Bus. Wk., Jan. 27, 2003, at 39.

n114. Bill Carlino, The PCAOB Has Had "Buzzard's Luck," Acct. Today, Feb. 24, 2003, at 6.

n115. 15 U.S.C. 78j-1(m)(2) (2000).

n116. Id. 78j-1(m)(3)(A).

n117. Id. 7265(a)-(b).

n118. General Accounting Office, supra note 89, at 24-26. This loss was usually preceded by a much more substantial decline in share prices. Id. at 25. If the information contained in the restatement was known to and acted upon by some market participants before its release, the ten percent understates the loss.

n119. Id. at 27.

n120. Id. at 16.

n121. See id. at 32-41, which concludes from a study and review of papers that, on balance, "restatements and accounting issues appear to have negatively impacted investors confidence." Id. at 32.