Report From A General In The SEC's War On Fraud

For two years, as chief accountant at the Securities & Exchange Commission, Donald T. Nicolaisen has had a ringside seat at the games executives and auditors play with financial reports. He took the job in September, 2003, when the big accounting scandals were being laid bare. A former senior partner at PricewaterhouseCoopers LLP, he doubled his staff as he oversaw controversial new SEC rules. Nicolaisen, 61, plans to leave the agency in October. Recently he talked with Senior Writer David Henry and Correspondent Amy Borrus. Here are a few edited highlights:

What has surprised you most in the two years you've been chief accountant?

I had grown up in the accounting and auditing profession and was proud of it. But when I came here, I saw over and over again how investors and the general public had lost confidence [in the business community, including accountants and auditors] -- it was dramatic. Also, I've been impressed by the sincerity, focus, and intellectual capacity that exists [at the SEC]. I've felt many times that I could accomplish important things with greater dispatch here than when I was in the private sector.

How reliable are financial reports today?

In each of the years I've been here, 7% to 10% of companies have had to restate earnings. That is unacceptable. Accounting has become rules-based and overly complex. Even sophisticated accountants have trouble transitioning from one industry to another. You see in restatements everything from deliberate misrepresentation to pure accidents. For example, the volume of restatements because of lease transactions was a surprise. For whatever reason, some companies and auditors concluded that they didn't need to follow all of the rules. You think you've seen it all, and you never have.

Has the monster wave of scandals run its course?

I believe we're at the end of the massive frauds we saw with Enron and WorldCom. Problems remain, but they're not of the same magnitude. Audit committees are asking more questions. Auditors are asking more questions, and analysts are asking more questions. There's less inclination to believe something that seems too good to be true.

What accounting games do you watch for now?

I pay attention to companies that I wouldn't expect to outperform the market by a wide margin for an extended period of time. I won't name names, but it is extremely difficult to consistently beat the averages and produce outsize returns. I'm also concerned about highly complex, structured transactions that lack economic substance. You still see them in every area of financial reporting, including taxes. We've also heard some very creative presentations from bankers and individual companies attempting to justify the accounting.

Is the culture of auditing firms any better than it was?

Yes. It has changed dramatically. Nevertheless, having some public representatives, rather than only insiders, involved in the governance structure of the accounting firms would do a lot of good.

Will the Big Four accounting firms ever become the Big Five or Six again?

To do it via growth is very hard. The revenues of all the other firms combined are still less than those of KPMG, the smallest of the Big Four. Four is not as desirable as six but can be adequate.

Should smaller companies get relief from the need to assess their internal financial controls?

The internal-control requirements are making larger companies and auditors dig deeper and produce better information. Small companies need strong controls, too, but we need a different framework -- one tailored to their particular structure. Under the current framework the cost may be enormous. These companies make up only 1% or 2% of market capitalization. I have always encouraged entrepreneurship and growth in the small-business arena, so this must be resolved.

You have been adamant that accounting standards are too complex, yet the latest guidelines are dense. Are straightforward standards a dream?

I don't think so. We can't continue to make financial reporting ever more complex. I would really like to see an international, high-level -- almost Presidential-level -- panel committed to considering these issues. At the moment we are talking past one another.

What do you want to do next?

I'd like to take on one more tough challenge where I can make a difference at a major entity that needs somebody with my background, energy level, and interest. I'm very interested in business and meeting investor expectations. Also, I would like to serve on a couple of boards. Having worked hard on corporate-governance issues, I'd like to witness firsthand how they are working. I suspect I'll stay in the New York area, where I spent the bulk of my career in financial services.

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