Speech by SEC Commissioner:
Obstacles to Good Financial Reporting
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
American Enterprise Institute
September 3, 2003
Good morning, and thank you for inviting me to participate in this important program. I am glad that the financial reporting debate is big enough to leave room for more than one Glassman on the program. Before beginning, I should point out that the views I express are my own and not necessarily those of the Securities and Exchange Commission or its staff.
I must admit that, although we are here to discuss financial reporting issues, in some ways I feel like the Commissioner of the Food and Drug Administration must have felt a decade ago, as he pondered whether to require companies to disclose the nutritional information we see on the side of every food package. For as long as I can remember, FDA regulations have required food companies to disclose the ingredients of their products. That was useful information for consumers when the ingredients were things like eggs, milk, flour and sugar. As foods became more (shall I say) "sophisticated," that information became less useful in trying to plan your diet. I frankly do not know whether fructooligosaccharide will help me live a long, active life, or whether it will kill me. So the FDA came up with a new paradigm to give consumers the critical information they need to know - which for most of us is how many grams of fat, protein and carbohydrates there are.
We have reached a similar crossroads with respect to corporate reporting. Company filings today contain more information than they have at any time in history. But when we talk about things like fair value or intangible assets, it is not entirely clear that we are getting good quality information about the ingredients, much less whether or not they are "healthy" for investors.
Over the past 18 months, the Commission has addressed many of the systemic issues that were exposed by the corporate scandals. Much of our work has focused on improving corporate governance and improving the professional conduct of auditors, analysts, lawyers, and corporate officers and directors. We have also tried to increase transparency of disclosure in some specific areas such as off-balance sheet transactions and the use of non-GAAP financial information.
More recently, in our report on objectives-oriented accounting standards, we have focused attention on the corporate reporting framework. We have been asking some fundamental questions about what we require public companies to report, and whether the framework is adequate to ensure that investors get information that allows them to answer their key question - whether the product is good for them. This is not a coincidence. While there have been several notable failures by gatekeepers whose job was to prevent large-scale fraud, we cannot ignore the role reporting standards themselves played in enabling corporate mischief.
You will be spending a good portion of your day assessing how well - or not well - Generally Accepted Accounting Principles or "GAAP" are suited to providing quality financial information to the market. I will focus more generally on the financial reporting framework, and some issues we need to address to keep it relevant for businesses that do not lend themselves to easy measurement. Of equal importance is whether the metrics or indicators we use to value companies have become less useful, or even obsolete, as we have moved from a manufacturing to a service economy. I will then leave the ball in your court - and fully expect that by the end of the day you will have resolved all of these issues and will have a blueprint for quality financial reporting in the U.S.
II. The Changing Role of Generally Accepted Accounting Principles
A useful place to start the discussion is by asking the question, "Why do we care about financial reporting?" Put simply, we care because capital is the engine of our economy, and information is the oil that keeps the engine running smoothly. It is on this premise that the entire disclosure framework of our securities laws rests. The assumption - and I think it is a good one - is that providing information on which sound investment decisions can be made is the best way to allocate the scarce resource known as investment capital. In an efficient market, capital will seek its highest use. It is, therefore, not an overstatement to say that without good information our markets could not function effectively.
As the economy has evolved, so have our needs for different kinds of information, and different ways to use that information to measure a company's value. If you are talking about a small sole-proprietorship with primarily hard assets, you have a fairly straightforward valuation exercise. On the other hand, a drug company whose main asset is in-process research and development presents a real challenge. Going back to my food analogy, one is made of milk and flour, the other with fructooligosaccharide.
The foundation of financial reporting is the historical performance and financial position of a company as recorded using GAAP. GAAP, however, only provides a starting point for a conversation in the marketplace about the value of a company. As the Commission noted last year in its proposal regarding critical accounting estimates, GAAP represents an imperfect compromise in conveying information about a business. One thing many investors don't realize is that GAAP reports don't express a company's performance with pinpoint precision. Some GAAP measures employ assumptions that involve a fair amount of subjectivity. Other items that are not quantifiable with a fair degree of certainty may not be reflected in GAAP earnings at all, even though they can have important present and future economic consequences for shareholders. Earnings per share is frequently cited as a key performance indicator - or the key performance indicator - but for most companies it represents at best only one point within a range of results that reasonable people could arrive at using the agreed-upon rules.
Another issue is that past performance is not necessarily indicative of future results. Because valuation looks to the future as well as the past and present, the Commission has attempted to get companies to provide more forward-looking information. As the Commission noted when it adopted the Management's Discussion and Analysis ("MD&A") disclosure requirement: "The Commission has long recognized the need for a narrative explanation of the financial statements, because a numerical presentation and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance."1 Accordingly, the MD&A must provide forward looking information "where there are known trends, uncertainties or other factors enumerated in the rules that will result in, or that are reasonably likely to result in, a material impact on the company's liquidity, capital resources revenues and results of operations, including income from continuing operations."2
The goal of all of these disclosure requirements is to reduce uncertainty and narrow as much as possible the reasonable range of values for the company that might be inferred from its reported results. Despite these efforts, as businesses have become more complex, they have also become more difficult to categorize for reporting purposes. The fact that both managers and investors have increasingly based their decisions on non-GAAP measures of performance is a good indication that GAAP measures alone do not adequately serve the market's needs.
III. Obstacles to Good Financial Reporting
The task of getting useful information from companies to investors is not an easy one. First, standard-setters promulgate accounting literature to govern reporting; then, a company must interpret the literature and report its financials accordingly. The market then has to analyze and interpret the reported information. And, ultimately, investors have to make judgments based on the reports. It is a road that has many obstacles. It is worth looking at some of these obstacles before we try to come up with solutions.
A. The Process for Setting Accounting Standards
The beginning of the reporting process involves adopting the standards companies will use to construct their reports. There are several problems that can arise at this stage.
The standard-setting process itself can be subject to political pressure and other external influences, with the end result being standards that may not reflect the economics of a transaction in a neutral, unbiased manner. If that is the case, then we have essentially lost the game before it even started, because the standards themselves contribute to a lack of transparency. This concern led Congress to provide the standard-setters (i.e., the Financial Accounting Standards Board) a greater degree of independence by providing them with an independent source of funding.
Another problem is that standards that incorporate too many detailed rules and requirements can be too complex, and also can fail to capture a transaction's economics. The pace of business innovation has outstripped innovation in accounting standards. In too many instances, detailed accounting rules have been misused as a roadmap to structure transactions to reduce transparency. In a rules-based world, the standards will almost always be one step behind, which is one of the reasons the Commission's staff recently suggested that it is time to evaluate whether a more objectives-oriented system would better achieve our goals.
B. Company Reporting
After standards are adopted, companies must make decisions regarding how to apply them to report their financial condition and performance. Here, too, there are conflicts and counter-incentives that can infect the process. Ideally, we hope that managers will strive to convey in clear terms the true economic impact of their activities, and not simply choose the accounting treatment that has the most favorable impact on reported GAAP earnings. Beyond that is a more fundamental hope that managers will make business decisions based on the economics, not the accounting. The fact that a transaction increases GAAP earnings does not necessarily mean that it is in the best interests of shareholders. If a transaction provides a short-term GAAP booster shot at the expense of long-term value, it causes both a possibly misleading picture of the company's financial health and a misallocation of capital.
In the reporting process, bad choices can take many forms. You can have the intentional, deceitful disclosure of misleading information - which, undoubtedly, is a very bad choice. But you can also have bad choices that do not rise to the level of fraud, but which nonetheless serve to mislead investors. Our recent enforcement action against Edison Schools illustrates that even choices that are technically permissible under GAAP can be misleading to investors.3
Bad choices are possible, in part, because accounting standards sometimes make compliance with a preferable standard optional, and rely on the company to choose the better path. The use of non-GAAP information, while appropriate under certain circumstances, can also serve to confuse rather than clarify a company's performance. So the Commission recently clarified the conditions under which a company can report non-GAAP information. Companies also make a bad choice when they manage earnings by inappropriately manipulating subjective judgments to affect the timing of recognition or disclosure.
Bad choices by reporting companies result in more opaque disclosure, thereby increasing the cost of capital. If the cost of capital increases as the quality of disclosure decreases, then why don't companies provide the most transparent financial reporting possible? More specifically, if there is a strong market incentive to publish quality financial data, then how could Enron - with its convoluted capital structure and impenetrable disclosures - become on of our nation's largest companies in terms of market capitalization?
Unfortunately, counter-incentives can encourage companies to choose an accounting treatment that makes them look the best as opposed to the one that most accurately reflects their financial condition. One such pressure is the shift in focus by investors from long-term to short-term performance. In my view, the recent emphasis on quarterly earnings-per-share is a big mistake for investors, not only because it ignores the fundamentals that make for a good long-term investment. It also puts pressure on companies to engage in financial engineering to maximize short-term reported returns, even if it means sacrificing long-term value. As equity prices increase, so does the pressure to manage earnings to meet expectations. However, like any Ponzi scheme, it can't last forever.
A similar counter-incentive can arise from within a company. If you were wondering whether I was going to work the topic of executive compensation into today's presentation, you can stop wondering now. One of the clear lessons coming out of this whole discussion about financial reporting - and the corporate frauds - is that if boards want to provide proper incentives for management, it is critical that they start by creating good criteria for performance-based compensation. The increased use of compensation that provides managers disproportionate wealth based on short-term results undoubtedly contributed to some bad choices. More reflection and creativity is needed to ensure that performance objectives encourage decisions that are economically in the long-term best interest of shareholders. Depending on the nature of the business, GAAP earnings-per-share is not necessarily the target you should be shooting for.
Another counter-incentive is the potential for a race to the bottom in reporting as companies compete for capital. Once a single company has success attracting capital despite opaque disclosure or even deception, there is pressure on others to adopt similar practices or end up competing on a distorted playing field. If the initial actor is not called to task - by the market or the financial reporting gatekeepers - the pressure mounts on others to make similarly bad accounting and disclosure choices. That phenomenon does not excuse the companies that follow suit, but it may explain why practices like round-trip transactions were not isolated to a single company within an industry.
While some auditors apparently facilitated improper corporate reporting, Sarbanes-Oxley and the Commission's rules recognize that auditors and the audit committee have to play an important role in promoting good choices. That role is prominent in provisions creating the PCAOB, requiring heightened auditor independence, and making it illegal to lie to the auditors. Auditors should act as a check on management's lapses in judgment, and the audit committee should ensure the choices made in financial reporting are in the shareholders' best interests.
C. Analysis of Information in the Marketplace
After a company reports its information, the next stop along the road involves the market digesting that information. Analysts on both the buy- and sell-side play an important role in interpreting and disseminating information, and acting in effect as translators.
In considering ways to enhance financial reporting, we need to take into account the ability of investors and analysts to digest complicated information. It appears that investors as a group are not confused, at least over the long-term, by accounting choices that affect reported GAAP earnings, but not the real health of the company. For example, they are able to work their way through such issues as straight-line versus accelerated depreciation; purchase versus pooling accounting; expensing versus capitalizing R&D costs; and recognition versus deferral of unrealized gains on marketable securities.
However, even if analysts and investors ultimately can parse through to the important information, there is an increased cost as more decryption and interpretation becomes necessary. Less transparency often leads to a greater divergence of opinions regarding the valuation of a company's securities, which itself raises the uncertainty and costs surrounding a decision to commit capital.
Here, too, conflicts raise the potential for bad choices by analysts as they interpret corporate disclosures, and make investment decisions or recommendations. Biased research analysts or other intermediaries can distort the impact of information in the marketplace, and encourage a misallocation of capital. To avoid this distortion and protect investors, we must recognize and deal with conflicts of interest that can pressure analysts to make bad choices.
D. Investment Decisions
The final stop on the financial reporting highway - and the final opportunity for bad choices - is the investment decision made by investors, the ultimate consumers of company reports. It is through investment decisions that investors engage in the "conversation" about a company's value that I referred to before.
Bad investment choices can skew a company's market valuation as easily as bad information. Unfortunately, even good information cannot protect investors from the ultimate counter-incentive - greed. We are painfully aware that investors may dispense with critical analysis of financial reports because they want to believe that the numbers are real. Like a child watching Peter Pan, they think they can fly simply because they believe they can, and Neverland becomes a real place. It is worth noting that the Peter Pan syndrome is not limited to small, retail investors, as demonstrated by numerous instances of sophisticated businesses chasing returns without conducting adequate due diligence. And conflicts of interest again reared their ugly head as some banks apparently made lending decisions on a basis other than the customer's credit-worthiness.
IV. Implications for the Future
These obstacles to good financial reporting are challenging under the best of circumstances. They have become even more so as our economy has shifted to companies with intangible assets, the valuation of which is particularly difficult and subjective. So it is an appropriate time to examine whether there are ways to get different and improved metrics and indicators that are better suited to investors' needs.
As we do so, however, there is one point that is worth keeping in mind. The current reporting framework - and in particular the MD&A - gives companies flexibility to provide useful information to investors outside the GAAP framework. In that spirit, we would love to see metrics and indicators that the market deems useful. Unfortunately, MD&A disclosure has not reached its full potential because companies view it as an obligation, rather than an opportunity to discuss their business with investors and potential investors. Last year, the Commission's Division of Corporation Finance reviewed the reports of all of the Fortune 500 companies. The Division's most frequent comments related to the MD&A, and typically cited instances where companies simply recited financial statement information with boilerplate analysis that did not provide any insight into the companies' past performance or business prospects. That, in my opinion, is a tremendous lost opportunity to fill the gaps in GAAP, and is one of the main reasons programs like this one are questioning the relevance of GAAP.
Although we have been trying to limit the counter-incentives inherent in the process, there is no way to eliminate judgment and subjectivity from the reporting process. Any reporting framework - whether based on rules, principles or objectives - will therefore present the potential for bad choices.
In that sense, the reporting framework relies on a culture that demands and rewards good reporting. Aggressive interpretation, technical compliance and gamesmanship have in too many instances replaced conservatism, full disclosure and transparency as the guiding principles for financial reporting. I have no doubt that reporting under the current GAAP framework could be improved significantly by a culture that rewards and values good reporting. Conversely, it may be foolish to believe that we can improve corporate disclosure by changing the reporting framework without improving the underlying culture. I believe we must work on both.
I hope that we are able to move the discussion of this important topic forward during the course of the day. And I hope that we end up with clearer, more transparent and more useful metrics and indicators (and not fructooligosaccharide).
Thank you. I would be happy to take your questions.
1 Securities Act Release No. 6711.
2 Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies, available at www.sec.gov/divisions/corpfin/fortune500rep.htm.
3 In the Matter of Edison Schools, Inc., Exhange Act Rel. No. 45925 (May 14, 2002).