A Timely Conference:
Paul Volcker praises the Kellogg School for its commitment to teaching and research in accounting, highlighting its importance amidst the current crisis. The timely scheduling of the conference is noted, considering the recent events that have brought attention to the need for accounting and auditing reform.

The Demise of Arthur Anderson:
Volcker emphasizes the significance of Arthur Anderson’s fall, once a symbol of rigor and discipline in auditing, as a symptom of a systemic problem. The state of accounting and auditing systems is deeply troubled, with concerns extending beyond auditing itself.

Consequences of the Financial Boom:
Volcker highlights the broader erosion of standards in business and market conduct during the financial boom of the 1990s. Creative destruction, productivity, and innovation were accompanied by excessive optimism, leading to an explosive expansion in financial values. Companies were bought and sold at inflated values, often justified by intangible assets or goodwill.

Financial Engineering and Circumventing Conventions:
The focus on financial engineering and complex financial instruments led to circumventing accounting conventions and IRS regulations. Balance sheets and income statements were loaded with hard-to-understand numbers, or risks were taken off the balance sheet entirely. Rising stock market valuations were interpreted as evidence of special wisdom, justifying excessive executive compensation packages.

Pressures on Auditors:
Auditors faced immense pressure to keep reported revenues and earnings growing, leading to the temptation to stretch accounting rules. Accounting firms were caught up in the spirit of the time, seeking to generate revenues and expand their range of services, particularly in consulting.

The Role of Auditors:
Volcker compares auditors to umpires, mandated to keep financial reporting within the established rules. Auditors face challenges in maintaining objectivity and independence when dealing with teams of lawyers and investment bankers focused on maximizing reported profits.

Doubts in Financial Reporting:
Doubts about the reliability of financial reporting are impacting investor decisions and stock market valuations. The time has come to act and support reforms in financial reporting to ensure a fair game and protect the interests of the investing community.

Past Reforms and Lobbying Power:
Volcker expresses concern that past reforms have not gone far enough and that accounting firms have successfully resisted meaningful change through their lobbying power. He emphasizes the importance of avoiding a repeat of this pattern, as the long-term interests of the auditing profession are at stake.

The Challenge of Reform:
Rebuilding faith in financial reporting will take time and requires addressing intellectual, business, and political challenges. Reform involves improving accounting principles and standards, ensuring proper implementation of those standards, and establishing strong institutional structures for oversight and discipline.

The Need for International Accounting Standards:
Volcker advocates for a single set of international accounting standards to minimize compliance costs for companies and ensure consistent information for investors. The United States should promote high-quality standards worldwide and encourage foreign companies seeking access to its market to follow those standards.

Key Observations on the Current State of Auditing and Accounting Standards:
There is a growing need to review and improve national and international accounting standards to ensure consistency and quality. The complexity of financial instruments like derivatives and options has led to challenges in setting effective standards. Self-defined pro forma earnings, fair value accounting, share-based payments, and special-purpose vehicles are areas of intense controversy and resistance to change. Changes in accounting standards have been slow, and suspicions of political compromise have damaged confidence in the process.

International Collaboration and the Role of Standard-Setting Boards:
The Restructured International Accounting Standards Committee Foundation is responsible for appointing and financing the Expert Rulemaking International Accounting Standards Board. There is a need for close collaboration among international and national standard-setters to ensure high-quality standards that are adapted to modern business and financial realities. The European Union has expressed its intention to adopt international accounting standards after 2005, highlighting the global trend toward standardized accounting practices.

Principle-Based Approach and the Importance of Auditor Judgment:
The principle-based approach to accounting standards emphasizes basic principles rather than detailed rules, relying on auditor judgment for specific applications. The Enron debacle has highlighted the potential value of the principle-based approach, emphasizing the need for disciplined, independent, and dispassionate auditor judgment. Auditors bear a significant responsibility to attest to the fairness and accuracy of a client’s financial report, and activities that jeopardize this responsibility are inappropriate.

Auditing Reform and the Need for Effective Oversight:
Recent developments have raised concerns about auditing discipline and the role of consulting work in accounting firms, leading to a focus on auditing reform. Proposed legislation aims to establish an independent oversight body to oversee auditing standards, conduct investigations, and impose penalties. Criteria for effective oversight include independence, authority to modify standards, ability to oversee consulting services, and adequate funding for the SEC. Strong support exists for a robust oversight body with real independence and authority to implement meaningful reform.

Corporate Governance and the Role of Audit Committees and Non-Executive Chairmen:
There is a consensus on the need for strong and technically competent audit committees made up of independent members of boards of directors. The concept of splitting the responsibilities of the CEO from a non-executive chairman of the board is gaining support as a means of providing more effective oversight and a check on CEO authority. Independent auditing committees and non-executive chairmen can help counterbalance pressures to manipulate reported results for short-term gain.

Concerns Regarding Stock Options and Executive Compensation:
Stock options have been used to align management interests with stockholders, but they have often been distorted to benefit management at the expense of stockholders. One-way options, in particular, have been criticized for rewarding subpar performance and being insensitive to long-term company success. Excessive stock option grants cannot be justified, especially when companies face bankruptcy.

Accountability and Independence in Corporate Governance:
Boards of directors are often closely aligned with CEOs, making them dependent on management for information. Their independence and experience are crucial for strategic issues, but their attitudes and aptitudes may not align with those of a skeptical auditor acting in the interest of investors.

Need for Accounting and Auditing Reforms:
Changes in corporate governance alone cannot substitute for needed reforms in accounting and auditing. The auditing profession needs a clear congressional restatement of its primary responsibility to the investing public, not to management.

Importance of International Accounting Standards:
The stage is set for an international effort to bring accounting standards up to date, with a focus on principles rather than specific rules. This can help restore market confidence and reduce the litigiousness associated with bright-line rules.

Two-way Stock Options for Executives:
One-way options do not effectively align incentives and can lead to executives cashing in when the stock reaches a high point. Two-way options, where executives hold stock over time and experience both gains and losses, are a better approach.

Government’s Case Against Anderson:
Volcker was involved in efforts to reform Anderson but acknowledges that the government’s decision to indict the firm was beyond his competence to comment on.

International Standards Board Collaboration:
The International Standards Board works with national standards setters like FASB, GASB, and the Federal Accounting Standards Advisory Board to achieve consistency and acceptability of standards. This process can be slow, but it aims to produce better and more generally acceptable results than individual efforts.

Volcker’s Hope for Progress:
Volcker expresses optimism that progress can be made in international accounting standards, even if it may not be a black-and-white issue. He believes that achieving even three-quarters of the standards internationally would be a significant improvement.

Academics and Independent Board Directors:
There is a growing call for more outside and independent board directors to enhance corporate governance. Academics can bring valuable insights and independence to boards but may lack practical business experience.

Challenges of Auditing Committees:
Current auditing committees often consist of chief executive officers (CEOs) from other companies. CEOs may hesitate to serve on auditing committees due to time constraints and the risk of jeopardizing their positions. The workload and complexity of financial reports make it difficult for part-time committee members to fully understand them.

Proposal for Separate Audit Committees:
Volcker suggests creating separate audit committees elected independently from the regular board of directors. These committees would be responsible solely for hiring, compensating, and overseeing the auditor. The clear delineation of responsibilities would enhance accountability and effectiveness.

Academics and Retired Professionals as Suitable Candidates:
Academics and retirees could serve on these separate audit committees due to their time availability and willingness to delve into complex financial matters. The absence of active CEOs in these committees may not necessarily be detrimental, as it allows for more dedicated attention to auditing tasks.

Momentum for Expensing Stock Options:
The debate on expensing stock options has gained significant traction in recent years. Professional opinion largely favors expensing stock options to improve financial transparency. Business lobbying efforts continue to oppose expensing, but some executives privately acknowledge its potential benefits. The International Accounting Standards Board had previously included expensing stock options on their agenda, triggering congressional concerns.

Stock Options:
Paul Volcker criticizes the overuse of stock options, especially by large companies. He questions the justification for stock options in light of cases like Enron, where executives profited significantly just before the company’s bankruptcy. Volcker suggests that stock options are more beneficial during bull markets and are often repriced during market downturns, perpetuating the cycle.

Business Schools:
Volcker believes business schools have focused on more glamorous aspects of accounting and auditing in recent years, neglecting the basics. He highlights the decline of accounting programs and the shift away from traditional accounting courses in business schools. He suggests that this trend has contributed to the current accounting and auditing issues.

Accounting Standards:
Volcker emphasizes the complexity of accounting standards in today’s world, especially for large financial institutions and industrial firms with extensive financial activities. He acknowledges the difficulty in setting accounting standards for these complex entities. Volcker calls for a substantial intellectual input to address the challenges of accounting standards in a complex and dynamic global economy.

Financial Engineering and Accounting Rules:
Paul Volcker criticizes the financial engineering profession for finding ways to circumvent accounting rules and IRS regulations. He emphasizes the difficulty in understanding financial risks and exposures solely based on annual reports.

Business Schools’ Responsibility:
Business schools have a responsibility to address the issue of financial engineering and its negative impact on accounting practices. Volcker suggests that business education leaders should speak out against these practices, especially during the current financial crisis.

Principled Approach and Personal Responsibility:
Volcker suggests adding a principled approach to the US GAAP rules to ensure that companies follow the intent of the rules rather than just the letter. He highlights the need for greater personal responsibility for financial statement signatories, auditors, and audit committees.

Responsibility to the Public:
Volcker emphasizes that business executives and auditors have a responsibility to the public, which transcends finding loopholes in accounting rules. He criticizes the practice of circumventing accounting rules, as it undermines the public’s trust in financial statements.

International Accounting Standards Board:
Volcker mentions the chairman of the International Accounting Standards Board, a respected figure in the accounting field. He highlights the importance of international cooperation in setting accounting standards.

Auditing Principles:
The UK accounting board’s principle approach to auditing is viewed positively by some experts, but the United States may need to supplement it.

Auditing as a Pass/Fail System:
A black-and-white system of pass or fail for accounting decisions is not feasible. A system that forces discussions on borderline decisions is more realistic and beneficial.

Explaining Accounting Decisions:
Auditors should clearly explain the rationale behind their accounting choices and the implications of those choices. Annual reports may become more complex but will reflect the reality of judgment-based decisions in accounting.

Harvey Pitt’s Oversight Approach:
Pitt’s approach has progressed in accepting the need for a strong oversight committee. Concerns remain regarding the extent of his authority to delegate residual authority to an oversight board. Legislation may be necessary to address these concerns and ensure an effective oversight board.

Importance of Legislation:
Strong, independent legislation is necessary to establish a truly effective oversight board. Such legislation should include independent financing, industry non-dominance, disciplinary powers, and public accountability. The absence of such oversight has been a long-standing issue in the auditing profession.

Historical Comparison:
The proposed oversight board is similar to the one established in the securities industry in 1933. The expression of public congressional concern and action is crucial at this stage.