Speech by SEC Commissioner:
Improving Corporate Disclosure - Improving Shareholder Value
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
23rd Annual Ray Garrett Jr. Corporate and Securities Law Institute
Northwestern University School of Law
April 10, 2003
Good afternoon. I have the unenviable position of speaking to you after lunch. So please bear with me, and, if necessary, help yourselves to a second cup of coffee. I think the topic - how companies can improve their disclosures to investors - is an important one.
As you know, the late Ray Garrett, for whom this conference is named, served as Chairman of the Commission during the early 1970's - and presided over widespread changes in the securities markets, from the abolition of fixed brokerage commissions, to increased government control over the stock exchanges. Some of you may not know that Chairman Garrett also served on the staff during the 1950's, acting as Director of the Division of Corporate Regulation - which today is known as the Division of Corporation Finance. As such, he was the chief regulator of corporate filings with the Commission.
That experience, along with his service to the Commission in the years immediately following Watergate, suggests that improved corporate disclosure is a topic that Chairman Garrett would have understood better than most. I am pleased to pay tribute to his memory here today by addressing it - albeit not from a lawyer's perspective, as he would have, but from my own, that of an economist. Before I go any further, however, I need to make the standard disclaimer: The views I express here today are my own and not those of the Securities and Exchange Commission or its staff.
As I mentioned, I am an economist, but I have been asked to speak today to a large group composed primarily of lawyers at a preeminent law school in tribute to a great lawyer. A daunting task! As an economist, I generally see things from a different perspective than lawyers. When economists confront an issue, they think, "What reward can we give people to do the right thing?" This is like your mother saying, "If you finish your homework before dinner, you can have ice cream for dessert." On the other hand, lawyers think of all the horrible ways that they or their clients might be punished if they do the wrong thing. Lawyers' principal concern seems to be to avoid liability for their clients. As a result, lawyers worry a lot about potentially bad results from anything that their clients - in this case, corporate managers - say or do. In a world fraught with liability risk, lawyers' concerns are not entirely unwarranted, but they can be overdone. I'm here today to offer a different and, I think, better way of approaching corporate disclosures - the economist's view. I want you to think about all the good things that can result for the company, its managers and its shareholders if the corporation makes more full and fair corporate disclosures. It's like everyone getting ice cream for dessert.
In general, management should think more about the market, and less about hypothetical lawsuits. The focus should be on disclosing information to the market that management thinks is important for shareholders or potential shareholders to know. And that information should be an honest assessment of the direction and risks that companies face.
Simply put, management needs to tell a story. Of course, management should be careful to make its story strictly non-fiction! And the goal should not be to put investors to sleep, but rather to make the information it is conveying to investors compelling and understandable. The moral of the story for investors will be that management understands its business, is honestly conveying all the essential information about it, and is therefore trustworthy. The moral of the story for management is that, as a result of disclosing all the information that it thinks important to shareholders, in a clear, compelling way, investors will have renewed confidence in the company, and the company will have improved shareholder value.
Management can most effectively tell its story through the Management Discussion and Analysis, the MD&A. Management can also tell its story by using clear financial statements and analyses. Financials will be more understandable and compelling if they focus on accounting for the substance of transactions. Let me turn first to the matter of improving financial disclosures.
As you may know, the Sarbanes-Oxley Act passed last summer required the Commission to conduct a study, by July of this year, on the adoption by the U.S. financial reporting system of a principles-based accounting system. Although the exact meaning of the term "principles-based accounting" is not clear, it is generally agreed that such accounting requires a company and its auditors to consider whether its accounting is in accord with the principles governing a particular transaction, not merely whether or not it fits within a specific rule. In other words, auditors must account for the substance of a transaction, rather than its form.
As attorneys, you may not have spent a great deal of time thinking about principles-based accounting. It has many benefits. First and foremost, principles-based accounting would emphasize the spirit of the accounting standards, not just their letter. In addition, principles would apply more broadly, thereby allowing fewer exceptions. There would be less confusion arising from the numerous exceptions that exist under generally accepted accounting principles (GAAP). Principles-based accounting emphasizes the professional judgment of managers and the company's auditors, rather than the need for interpretative guidance. So, again, there would be less confusion stemming from an array of interpretive comments. Of course, management and auditors would need to be aware of their central role in a principles-based regime, and act with the utmost care and integrity.
Personally, I do not think either strictly principles-based or strictly rules-based accounting is feasible. Ultimately, we should have a hybrid of rules and principles. Such a system would provide overriding principles that incorporate specific guidelines as examples to give the system more context and more teeth. For now, we still have to work with GAAP.
In assessing the value of GAAP, it is important to remember that it does have its good points! GAAP provides basic uniform accounting standards, as well as consistency of accounting standards across all companies. And, although the detailed exceptions and rules sometimes hide them, GAAP itself is indeed based upon certain fundamental principles of accounting.
Unfortunately, GAAP as applied in the U.S. has gone beyond those principles to the point that it has, at times, obscured them completely, creating a morass of exceptions and bright lines. GAAP's complex of rules creates situations where lawyers and accountants may play games with the rules, rather than focusing on the principles underlying them. The more specific the rules, the easier companies may find it to structure transactions specifically to circumvent them. This, of course, is the problem with "bright line" rules: the impulse is to make sure the line isn't crossed instead of making sure the books reflect the true economic condition of the company. The substance of a transaction should dictate the accounting, not vice versa.
It is also important to remember that simply complying with GAAP may leave gaps in disclosure and give investors an incomplete - or even misleading - picture of a company's operations. As the Commission's recent actions in Edison Schools and Dynegy make clear, technical compliance with GAAP alone does not immunize companies from liability if GAAP does not provide a clear picture of a company's operations and transactions.
Similarly, just as compliance with GAAP without more information is not a remedy for all of a company's ills, using pro formas is not necessarily a deadly disease. As long as pro formas are not used in a misleading way, they can be an excellent tool to give investors more information about a company. For example, Regulation G -requiring companies to reconcile non-GAAP accounting measures to comparable GAAP measures - specifically contemplates that companies may effectively and honestly use non-GAAP financials.
One example of how GAAP does not necessarily reflect reality is accounting for pensions. About 20 years ago, FASB issued a new statement on pension fund accounting: While acknowledging that "smoothing" mechanisms did not provide the best information, FASB allowed for the smoothing of a company's returns on pension plan funds. The guidance was a good idea at the time - and indeed was an improvement to previously existing guidance on pension accounting. Smoothing was based on the theory that pension accruals are a long-term matter. As an accounting principle, that makes sense. But, in the current market, "smoothing" has led to the problem of "phantom" earnings. Companies are reporting earnings based on assumptions of, for example, 9% growth in pension funds, while those same funds are actually losing money. To make matters worse, investors have a tough time figuring out the effects of pension fund accounting by looking at a typical company's financial statements. Actual pension fund earnings or losses are not reflected on the face of the financial statements. Investors have to dig into fine print to learn that supposed earnings are really just assumptions about pension plan investments permitted by GAAP.
There are a number of different ways that this problem might be fixed. At a minimum, separating earnings on pension investments from operating earnings would clarify the picture.
Another lesson learned from pension plan accounting under GAAP is that clear disclosure in footnotes or the MD&A is required to bridge the gaps between what GAAP allows and the economic reality of the company's operations. As counselors, you should remind your clients to look to the principles underlying GAAP so that companies report accurately their business operations - not to strive to take advantage of the technicalities in GAAP to distort the bottom line. Managers should also correct some of the imperfections in GAAP by better disclosure outside the GAAP framework - by describing their actions more fully in the company's MD&A.
Let me turn then to the matter of how companies can make better use of the MD&A to inform investors, and also clarify problems possibly caused by GAAP accounting.
As you know, Item 303 of Reg S-K requires a company's management to discuss the company's financial condition and results of operations. This is the MD&A. The MD&A serves the laudable purpose of giving investors important disclosures about a company's operations. It also represents a unique opportunity for companies to explain the company and its operations to investors in a way that is honest and understandable - as I said earlier, just like a good story.
The company's MD&A must be more than a recitation of its recent history. It must describe known trends, uncertainties or other factors that will or are reasonably likely to result in a material impact on company's liquidity, capital resources, revenues and results of operations. Beyond just pointing out known trends, managers can use the MD&A to help investors interpret and understand what a trend may mean for the company going forward. Management should also give its insight into the company's operations. It is exactly this insight that helps management communicate its understanding of the business environment to investors, and exactly this insight that investors want to see.
There are some fairly straightforward ways that management can improve its MD&A and disclosures to investors - by explaining financials, using more trend disclosure, clarifying and providing context, and using the MD&A to fill some gaps in GAAP.
The MD&A should explain the company's financials, not just parrot them. Advise your clients to give a narrative explanation of the material elements of a company's financial condition and results. They should include financial disclosures as well as the context within which investors should read those statements, and avoid the immaterial. Management should give investors information about the quality and potential variability of the company's earnings and cash flow, so investors can assess whether past performance is indicative of future performance. All of these matters are important to investors, and, if you help management present them fully and fairly to investors in a straightforward way, investors are more likely to have more faith in management.
A company must use the MD&A to disclose "known trends and uncertainties." Typically, companies simply recite financial information in the MD&A without any analysis. Instead, work with management to give a detailed analysis of important year-to-year changes and trends that are material to operations. Advise your clients to spend more time talking about liquidity, cash flow and capital resources.
Management should also take advantage of the opportunity that the MD&A provides to clarify and provide context to its operations. It is not necessary to dumb down disclosures, but rather to organize them better. One good way of organizing a complex MD&A is by providing a roadmap or executive summary. A roadmap would give investors information and guidance that makes the details easier to put in context and easier to understand. An executive summary is also a desirable addition. And you attorneys in the audience should not be concerned that potential liability will arise from including a summary. So long as the summary is balanced and includes key issues, and the details are included in the body of the MD&A, it will be viewed as an improvement to your client's MD&A.
Another possibility for clearer MD&As would involve taking advantage of technology. Companies should consider a presentation on their website that layers the MD&A with hyperlinks to other more detailed information.
As I've said, an MD&A should be management's understandable and honest story of its finances and operations. As MD&As are usually written now, though, they are too complicated and difficult for investors to follow. Just think of how you would complain if you had to listen for hours to a story about the effect of a mountain of numbers and other disconnected statements, especially where boring information is jumbled together with the interesting and exciting parts of the story! Of course, it is true that business has grown increasingly complex for many companies. A company may feel that it has voluminous disclosures that it must make. But companies should be careful not to create unnecessary information overload for investors or to obfuscate the basic economic drivers of success and failure. When the MD&A is so complicated and long-winded - topping out over 100 pages, for example - the information disclosed becomes essentially useless.
Compounding the problem is the fact that companies tend to use too much boilerplate in their MD&A's. This may stem from the lawyers' fear of straying from what has worked in the past, or from describing the same matter slightly differently in the company's next filing. An MD&A is not a homework assignment where you must fill a certain number of pages! The MD&A is the company's chance to tell a vital and interesting story to its investors to increase their confidence - and by extension their investment - in the company. Advise your clients not to blow it by making it boring, repetitive or, worse yet, incomplete!
And coming back to GAAP, the MD&A can be used to fill gaps in GAAP when there is a material impact such that supplemental disclosure is advisable. Some specific areas come to mind: Revenue recognition, impairments, pension plans and special purpose entities.
Companies should use the MD&A to disclose the revenue recognition practices that involve the most sensitive judgments and material consequences.
The MD&A is also an excellent place for companies to explain better their impairments. The problem is that an investor reading a typical MD&A does not come away with a full understanding of why impairments are being used for certain items, and how they are arrived at. For instance, to make disclosure more meaningful, you might counsel management to disclose the specifics of the impairment, including the facts and circumstances surrounding it, and accounting policies used.
Similarly, as I mentioned earlier, an investor reading the company's financial statements will not find it easy to understand how a company's pension plan affects the company's financial condition. The investor needs a full picture presented in an understandable fashion. The MD&A can be used to set forth how the company accounts for its pension plan, the assumed rate of return or discount rate, and the pension plan's effect on the company's operations, cash flow and liquidity, including the amount of expected pension returns included in earnings and amount of cash outflows used to fund the pension plan.
Special purpose entities, or SPEs, present a particular challenge for a company preparing an MD&A. SPEs can have a legitimate purpose, but they have also been used to conceal assets and liabilities from investors. Prior accounting interpretations did not adequately address the concern that a company might obfuscate its financial condition by using SPEs. The new FASB guidance changes certain rules regarding consolidation that were easy for companies to structure around. This improves the landscape, but the potential for abuse remains. I would urge companies to conform to the Commission requirements regarding off-balance sheet transactions in the MD&A, follow the spirit of new FASB guidance, and use the MD&A to disclose to investors the purpose and effect of the company's use of SPEs.
Investors would also benefit from better disclosure about a company's critical accounting policies. You might counsel your clients to use the MD&A to disclose their most difficult and judgmental estimates, their most important and pervasive accounting policies, and those areas most sensitive to material change from external factors. This will allow investors to understand some of the serious accounting issues that management faces from management's perspective.
At the beginning of my remarks, I mentioned how lawyers approach issues, and, in particular, the issue of corporate disclosure. I don't think I would be going very far out on a limb if I said that lawyers - because of their defensive posture - are part of the problem with the poor state of corporate disclosures. But they can also be a key part of the solution.
What roles can lawyers play? First and foremost, lawyers can identify the requirements and risks and encourage business management to make the actual decisions as to what disclosures are important to investors. As Alan Beller, the Commission's Director of Corporation Finance, and a lawyer himself, has said on several occasions, "Disclosure is too important to be left solely to lawyers." With respect to GAAP, lawyers should recognize it is not the outer limit of accounting disclosure, but rather a starting point. Lawyers should also accept that the best way for companies to stay in the good graces of the Commission and investors is to make complete, accurate and understandable disclosures in the MD&A. Help management to tell a good and fair story - and don't hinder management with boilerplate, wordiness and incomprehensible statements. Even if the story doesn't have a happy ending, telling the story accurately is important for the company's long-term credibility.
The good news is that better disclosure is its own reward. It will reward a company's shareholder value, and, on a macroeconomic level, lead to more efficient markets. Certainly, a company will be punished - both by the Commission and investors - for inaccuracies and misleading statements in its disclosures or for leaving out important parts of the story. We will pursue enforcement actions for false or misleading disclosures. Perhaps more importantly, withholding information from investors appears to raise the cost of doing business because the market values having more and better information about a company and adds a risk premium if it does not have it.
Two studies of larger companies both found that better disclosure translates into lower cost for a company in raising capital. One study showed that companies that made better disclosures allowed analysts to be more accurate in their forecasts of company performance.i Better disclosures also lead to greater agreement among analysts about the company's prospects, risks, and ultimately its value. In addition, and likely as a result, those companies making better disclosures had lower costs of capital. Another study of large companies demonstrated the same result from a different perspective: Companies that perform better - in terms of stock returns- have a pattern of making better disclosures.ii That same study also showed that firms that are issuing equity, and therefore are perhaps particularly concerned about disclosure, also make more and better quality disclosures.
The benefits of good disclosure extend to smaller companies as well. A study of small companies - those not covered by analysts - rated how well those companies made disclosures in their financial statements.iii This study, too, concluded that better disclosure is associated with a lowered cost of capital.
As advisers to management, you have a central role to play, but don't forget that it should be management who decides what to disclose to investors. As advisers, focus on identifying the risks for management. Point out inaccuracies or what is misleading. Focus your clients on complying with the spirit as well as the letter of the rules. And, especially, understand that there are risks to companies of disclosure designed solely to avoid liability and not designed principally to inform investors. Don't strike so much fear into management that they are handcuffed and afraid to make the disclosures they feel are necessary. Remember how an economist would view management's proposed disclosures. Think of the benefits that may flow from the disclosures: how they will help investors to understand better the company's financials and operations, increase shareholder confidence, and improve shareholder value. In the end, let management tell its own story to investors, and let it reap the rewards.
And that brings me to the end of my story. Thank you.
I am happy to take your questions.
||M. Lang and R. Lundholm, "Corporate Disclosure Policy and Analysts Behavior," The Accounting Review, 467 (October 1996). |
||M. Lang and R. Lundholm, "Cross sectional Determinants of Analysts Ratings of Corporate Disclosure," Journal of Accounting Research, 246 (1993).|
||Botasan, "Disclosure Levels and Cost of Equity Capital," The Accounting Review, 323 (1997).|