The SEC man who smoothed a difficult path
DONALD Nicolaisen bowed out on November 04 after a little over two years as chief accountant at the US Securities and Exchange Commission (SEC).
He started this powerful job at America's chief financial regulator at a time when auditors had been accused of failing to blow the whistle on massive accounting frauds at companies such as Enron, WorldCom and HealthSouth.
Those scandals badly undermined public confidence in the accounting profession. Mr Nicolaisen, together with the Public Company Accounting Oversight Board (PCAOB), the watchdog for auditors at public companies, has done much to enable the profession to start to restore its reputation.
The regulators have acted as tough but sympathetic supervisors of accountants, and Mr Nicolaisen says there has been a "dramatic" improvement in auditing since the scandals. But he warns of huge challenges ahead for the profession, as it grapples with the increasing use of "fair" or market valuations of companies' assets and liabilities, and auditors' elevated role in checking clients have adequate internal controls to prevent fraud and ensure good financial reporting.
Perhaps Mr Nicolaisen's most significant achievement as SEC chief accountant has been to ensure the smooth implementation of the Sarbanes-Oxley legislation on accounting and corporate governance.
Section 404 of the 2002 act requires management to tell investors about the quality of companies' internal controls, and it represents the biggest reform of financial reporting in the US in 75 years.
By obliging companies to reveal any "material weaknesses" in their controls, section 404 had the potential to unleash panic in the stock market, but Mr Nicolaisen and his SEC colleagues urged investors to engage in calm reflection on the information. Their pleas were largely heeded.
But while investors held their nerve, section 404 imposed huge costs on the big and medium-sized US companies that had to comply for the first time last year. This is partly because the PCAOB went beyond Sarbanes-Oxley and said auditors must give opinions on the effectiveness of companies' internal controls. Two of the SEC commissioners have expressed concern about the requirement.
Mr Nicolaisen, a former partner at PwC, the big accounting firm, has no such misgivings. He points out that about 15 per cent of companies that had to comply with section 404 admitted to material weaknesses in their controls, a much higher number than prior to the Sarbanes-Oxley law. "I believe the PCAOB reached the right decision in requiring the auditor to opine on effectiveness," he says.
PwC predicted last month that audit fees, which often doubled with clients in 2004 because of section 404, could fall by between 25 and 50 per cent this year. Mr Nicolaisen says the picture is mixed, based on information from accounting firms, with forecasts of some increases in fees as well as reductions. "We have also heard on balance that fees will likely be close to where they were a year ago," he adds.
While Mr Nicolaisen made big strides on the implementation of the Sarbanes-Oxley legislation, he made less progress with his goal of reducing complexity in US financial reporting.
The SEC called for the US to switch to "objectives oriented" accounting standards in a July 2003 report, after the scandal of Enron, the energy trader, had exposed shortcomings in its financial reporting rules, but the initiative has struggled to gain momentum.
Mr Nicolaisen says the Financial Accounting Standards Board (FASB), the independent body that writes US accounting rules, has, like the regulators, been in "reactive" mode. It has been busy drawing up rules to deal with specific problems found in the scandals, he adds.
To an extent, Mr Nicolaisen has laid the foundations for future changes that should improve the quality of financial reporting. He released a report in June that sought to end some of the worst off-balance sheet accounting by calling for changes to reporting on leases and pensions. He also championed FASB rules that require companies to treat stock options as expenses, and make deductions from profits.
In the US's aggressive litigation environment, companies and their auditors often rely on their ability to show they comply with particular accounting rules when they are sued by investors. Mr Nicolaisen accepts that it is difficult to wean companies and auditors on to "objectives oriented" accounting standards, which offer less certainty in the courtroom.
However, he argues, reform is essential. Not least, he says, because the complexity of existing accounting rules means that about 10 per cent of companies have to restate their accounts each year as the first results turn out to be wrong. "That is a default rate that would be rejected in almost every area other than accounting," he says.
Mr Nicolaisen has proved a strong advocate of convergence between US and international accounting standards, which would result in a single financial reporting language for multinational companies. He believes the US can learn from best practice overseas.
He also says the SEC could consider as soon as next year whether to ease the financial reporting burden imposed on foreign companies with US share listings. European companies, for example, must currently provide the SEC with financial statements that comply with US as well as international accounting standards, which were adopted across the European Union this year.
In a nod to his interest in reducing complexity in financial reporting, Mr Nicolaisen calls for a discussion of the case for giving auditors some further protection against potentially catastrophic negligence claims. Federal law already says auditors should only be liable for damages to the extent they make mistakes, but accounting firms want caps on their liability that would stop ruinous claims.
Such caps could help auditors embrace "objectives oriented" accounting standards. They would be more willing to exercise the judgement necessary to make a success of the standards if they thought any wrong decisions would not result in ruinous claims.
But Mr Nicolaisen insists on a "trade-off" to any reform of auditors' liability. He says accounting firms must publish annual accounts and provide information about partners' compensation. Now, they only give revenue figures. He says the firms should embark on corporate governance changes, and have boards that, like public companies, have a majority of independent directors.
"What you would want to be sure of is that the audit profession remains diligent, focused and committed to doing the highest quality auditing," says Mr Nicolaisen.
As he left the SEC, the public might be more easily persuaded that most auditors are committed to doing the right thing.
Under syndication arrangement with FE