Graduate School of Business
1101 E. 58th Street
Chicago IL 60637

Roman L. Weil
V. Duane Rath
Professor of Accounting
(773) 702-7261
FAX: (206) 202-2114

11 December 2002

Re: S7-40-02 Comment on Proposed Regulations for Implementing the Sarbanes-Oxley Act [SOX] of 2002.

I write about the financial expert and financial literacy, only. This letter has two purposes:

  1. To persuade you to allow the Financial Expert to have become a financial expert with more varied career paths than the proposed regulations contemplate, and

  2. to persuade you to write the regulations so that Boards and the Stock Exchanges do not divert their attention from requiring Financial Literacy for three independent audit committee members.

Here are my biases: To do something [think an audit] requires a certain level of knowledge and experience; to teach that same something requires a deeper understanding; to write about it requires an even deeper understanding. Those who write about processes understand them better than people who merely do them.

1. Financial Expert. You're writing regulations to achieve a result. You should have more interest in the output from the process, that is, a desired result, than the input to the process, which you have proposed to be, in part, the career paths of the people who are now financial experts and who can cause the wished-for result to happen.

I do not quarrel with your interpretation of SOX's attributes of the right people in the sense of things they know and can do. I do quarrel with your proposed interpretation of how these people must have spent a professional life to acquire those attributes.

The audit committee provides oversight of both process [internal controls and relations with external auditors, for example] and outcome [the financial statements; note, oversight not preparation or a second vetting]. You propose that only those who have prepared statements [CFOs and the like] or those who have audited them understand well enough to be designated Financial Experts under SOX.

You might consider that other professional paths lead to intimate knowledge of both process and outcome.

  • Professor A. I think immediately of one of the world's [note I didn't say academic world's] experts, perhaps pre-eminent expert, on the Foreign Corrupt Practices Act and other issues requiring intimate understanding of the process of auditing. Professor A has examined the strengths and weaknesses of the processes that have internal controls to fail or to succeed. He has been the top administrator in an organization where employees' self-serving interests do not always co-incide with the interests of the owners. Why exclude such a person from being the Financial Expert, just because he's been an academic all his professional life? The textbooks he's written tell you he understands accounting issues; his research tells you he knows the process of controlling for fraud--the costs, benefits, and techniques. He is a financial expert. Why cannot he qualify by career path to be a potential Financial Expert under SOX?

  • Professor B. Consider another career academic, a professor of accounting and control who is the world's acknowledged expert in cost accounting and related managerial controls systems, from activity based costing, which requires knowledge and insight into the processes that cause cost incurrences, to the balanced scorecard, which requires knowledge of all drivers of firm performance, including executive compensation plans. He not only writes about this subject but is also a leading consultant, helping companies around the world to implement dramatically better cost and performance management and control systems. I assert that this professor knows more about the workings of accounting systems and the costs and benefits of, for example, stock options, than most auditors, who have intimate knowledge of far fewer companies than the Professor has from his detailed investigations to do his published research.

  • Professor C, Former FASB member, and former Professor D, current FASB member. I know two career academics, who've taken time out of their careers to serve on the FASB. Both are financial experts who ought to qualify to be Financial Experts under SOX. They've done research on management controls, they've helped write articles on the audit and control process, they've written about the effects of accounting standards, they've written accounting standards, they've butted heads with CFOs who want looser standards and exceptions thereto for their own companies. But they've never been CFOs [or the equivalent] nor auditors. Why should their career paths cause SOX to exclude them from service as Financial Experts?

  • Professor E has supervised the process of ferreting out fraud and incompetence in a credit union, has worked with one of the Final Four audit firm's offices in a consulting capacity, looking for weaknesses in audit top files and weaknesses in the audit control process, has been hired by Final Four firms to instruct partners, has testified as expert both for and against Final Four firms in cases alleging audit failure, has advised the FASB on financial accounting issues, has advised the Chief Accountant of the SEC on accounting issues, has testified both for and against management of firms charged by the SEC for accounting abuses, has written about accounting principles, financial statement analysis, management information systems, and management controls. He is a CPA who has never been a CFO [or the equivalent] nor has he audited any firm. Let a Board vet this academic; don't preclude him because of his career path.

  • What about several former Chairmen of the SEC itself, lawyers all, never CFOs [or the equivalent] nor auditors but who have ferreted out fraud in their private capacity and have designed control systems for companies formerly rife with fraud? I can think of at least two who are not CPAs, but likely better audit committee financial experts than many who'd qualify under the proposed regulations.

Specify the attributes the Financial Expert must have in his or her head; don't specify how they got there.

Let the boards decide who has the necessary attributes--knowledge of concepts and processes--and who doesn't. My experience teaches me that Boards have difficulty firing one of their own, or demoting them, or even suggesting they are no longer up to the tasks. Boards will be more careless about letting a current audit committee member remain on the committee than they will be in vetting new hires to the audit committee. Consider imposing differential standards for the Financial Expert: For example: "If you have been on the board for two years or more, as of January 1, 2003, then to be designated a Financial Expert, you must be a CFO [or the equivalent] or an auditor [of a comparable business]." If the Board is to bring on a new person as Financial Expert, then let the Board vet for attributes, independent of career path.

2. Financial Literacy. In the months since the passage of SOX and the weeks since the proposed regulations issued, I've been listening to and talking with CEOs, CFOs, Boards, and their lawyers. Almost all have been focusing on the Financial Expert and where to find one and the consequences of not having one. They pay no attention to the financial literacy requirement as proposed by the NYSE, NASD, AMEX, and PCX for at least three independent auditor committee members. My own research of the past year or so persuades me that corporate boards are financially illiterate even by modest standards. Even though SOX doesn't mandate financial literacy for audit committee members the way the Exchanges propose, I hope you will write the regulations so as not to discourage the Exchanges from imposing the requirements of financial literacy on three independent audit committee members. I now use a working definition of Financial Literacy, having discarded one that current CEOs, CFOs, and Board Chairmen have told me is too tough. I first proposed that a Financially Literate audit committee member will understand, in his or her own head, the material transactions of a firm and the accounting issues with respect to those issues. I get push back on this: "That's too much to expect." I think it's not too much to expect. Now, I propose a more modest sounding definition that I think will be hard for opponents to say is too demanding and I commend this to you. As you know, you ask registrants to tell report readers about the Critical Accounting Judgments or Policies driving the particular firm's accounting numbers. Let's define Financial Literacy for the Audit Committee member Board as the ability to understand, in his or her own head, the transactions underlying the critical accounting judgments and the accounting issues for these transactions. By 'understand, in his or her own head,' I mean to exclude the oft-heard excuse, "Well, I don't fully comprehend that, but we have retained outside experts who do and trust them when they tell us everything is OK." For example, the audit committee member of some financial institutions needs to understand the transactions derivatives attempt to hedge, how to tell a hedging derivative from a speculative one and the accounting controversies for the various sorts of derivatives. To take another example, I'd say a financially literate member of the audit committee of an insurance company should understand the process of estimating liabilities for claims, claims expense, and incurred but not reported claims. I don't require the knowledge of an actuary, but the processes the actuary uses to generate the estimates, the flexibility or range of those estimates, and how management gets to prod the actuary to produce a desired number within the range. I want the audit committee member to understand the compensation arrangements of the actuary and who sets the bonus and how free is that actuary not to produce the number desired by the CFO or the CEO. And, I want the insurance company audit committee member to have a firm grasp of the notion that all balance sheet items with the word Reserve in the caption are things with credit balances, not debit balances. I am disheartened by the number of board members who think Reserves are things with debit balances, so confuse Reserves with liquid assets available to pay for various outcomes. Any audit committee member should understand the issues of revenue recognition when uncertainties exist about after-sale returns, warranties, and technical support. This requires understanding of the nature of uncertainty, its resolution, and measurement, because it's not uncertainty that impedes revenue recognition, but inability to measured it and compensate for it. Please don't let Boards take their eyes off the Exchanges' proposals of financial literacy for all Audit Committee members in their intense search for a single Financial Expert.

If you want to hear more on these subjects, just ask.

Count me an ally in the search for more efficient markets,

Roman L. Weil