From: Richard S. Furlin
Dear Mr. Grundfest,
I recently watched your committee’s meeting via the internet, and thought I would write since you specifically called for outside ideas. I have a very “doable”, cost effective solution that will dramatically improve financial reporting. Better yet, the history of the credit rating industry shows it will work. I’ll explain that in a moment.
First, let me give you my background. I’m the former Sr. Director of Analytic Content for Standard & Poor’s, which put me in charge of developing products for their equity analysts (I’m also a CFA candidate, MBA from Babson). My expertise is product management (as Mr. Herz called for) and I have 10-years experience understanding exactly how both institutional and retail investors access and use financial information. This is an idea I originally developed there, and received a very favorable response from David Blitzer, who heads of the S&P 500 Committee, as well as Neal Wolkoff, President of the American Stock Exchange.
Earnings Quality Rating
According to Integrity Research Associates, there are 20 companies (including my own start up) that currently sell, on a subscription basis, earnings quality/forensic accounting research. It’s the fastest growing area of equity research on Wall Street. What they do is examine how conservative/aggressive management is in their choice and application of accounting polices. Basically, they assess the legal grey areas of accounting and summarize it with a letter grade (A, B, C, D..etc.), or benchmark.
My contention, however, is that this Earnings Quality Analysis, must be democratized just like the credit rating agencies. It should be an SEC requirement. It would change the business model from subscription (available only to wealthy investors), to issuer paid (available to everyone) just like accounting statements. Earnings Rating Agencies would be hired by a company’s Independent Audit Committee to ensure independence and the grades would be freely distributed via the internet to all investors.
Note: This is exactly how the credit rating industry evolved. It was a subscription business until in 1934 regulators stated only higher quality bonds could count as bank reserves. Yes, there have been some troubles with credit ratings lately, but as you said “we can’t let perfect be the enemy of the good.”
While the concept of Earnings Ratings is simple, the benefits would be enormous.
• Simple benchmarks will Result in More Conservative Accounting. Credit ratings force management to be conservative with cash flow. If they overspend, they risk a rating downgrade, which affects interest rates, loan convenient, management compensation agreements, and institutional investor’s investment policy criteria. This can only occur if there is a widely distributed simple grade.
The same can be achieved with accounting. According to CFO.com, 47% of America’s CFO’s still feel pressure from management on accounting issues such as extending depreciable lives. Suppose we give CFO’s cover? Management could still choose to push accounting limits, but now they would risk an Earning Rating downgrade. Would they risk that if pension funds could only invest in “A” rated companies?
In his book Take on the Street, Arthur Levitt said, “to stop the numbers game, Warren Buffet believes, and I agree, that corporate boards should require auditors to rate the aggressiveness of accounting policies”. However, I contend it must be independent. Having a third party gives investors the protection of someone else looking at this books and this is the only way that could be funded.
• Reward Conservative/Transparent Accounting Today companies that chose aggressive accounting policies are rewarded with higher earnings and thus a higher market capitalization. This actually puts conservative companies at a considerable disadvantage when they should be getting credit. Bragging about their AAA accounting rating would do that.
• The perfect amount of information for individuals. I can assure you from my experience at S&P that individuals will not read a summary anymore than they’ll read a 10K. A simple bottom line score issued by an expert is all they want. Furthermore, this grade is easier to distribute to Yahoo Finance, and will effectively remind investors every day that the SEC is doing something new to enforce proper accounting. (It’s important to consider marketing issues as well as accounting).
• Fund the Creation of Extensive Research Earnings Quality research typically produces 20-30 page reports and have the appropriate level of information for institutional investors.
• It’s scaleable - The cost of earnings rating analysis would depend on the size of the company. My company can produce it for smaller companies for as little as $25,000.
There are many other benefits that I would save for a further discussion if you choose. Remember, Earnings Quality analysis is happening today, but by changing the SEC’s requirement we can make it more effective. It would be particularly ideal to experiment with smaller public companies and are not covered by SOX and struggling to get Wall Street analyst coverage.
Richard S. Furlin