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U.S. Securities and Exchange Commission

Speech by SEC Staff:
"The State of Financial Reporting Today: An Unfinished Chapter"

Remarks by

Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

20th Annual SEC and Financial Reporting Institute Conference Sponsored by the Leventhal School of Accounting, Marshall School of Business Administration, University of Southern California

May 31, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Turner and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

I want to thank Bill Holder and the University of Southern California for that kind introduction and for the opportunity to speak at this prestigious conference. I believe those of you in attendance will find that the University of Southern California "SEC Financial Reporting Institute" has once again organized a distinguished group of speakers, including Ed Jenkins, who are covering some very timely topics. I look forward to hearing these presentations. As with all the speakers from the SEC, I am obligated to tell you that the views I express this morning are my own, and do not necessarily represent the views of the Commission, the Commissioners, or my colleagues on the staff.

Interestingly enough, some of topics to be discussed at this conference are being written about or discussed on a regular basis by the news media. Who would have thought when Pacioli came up with the idea of double entry bookkeeping in the 15th century, that accounting might be of as much interest to all of us as the pizza?

The American Investor

Yet Share Ownership 2000, using data from a 1998 survey under the auspices of the Federal Reserve Board, reports that there were 84 million direct and indirect (through mutual fund, self-directed retirement accounts or pension plans) shareholders in 1998, representing 43.6 percent of the country's adult population. That is a 21 percent increase from the number of 69.3 million just three years earlier and a 61 percent increase from 52.3 million in 1989.

These stockholders come from all walks of life, young and old, rich and not so rich. Over one in five stockholders is under the age of 35, and one in eight is over the age of 65. And interestingly, half of those stockholders have income of less than $57,000 and only 18 percent have family incomes that exceed $100,000. Indeed, the average stockholder today is the average American who lives next door, is your aunt or uncle, a close friend or family member.

In addition to individual investors there are the institutional investors, especially pension and mutual funds, which we are likely to trust with our savings for retirement. These institutions now hold $9.7 trillion or 50.8% of U.S. equities and $1.8 trillion in foreign equities, or 10.6 % of their total equity holdings.

What did all of these investors mean to our capital markets last year? Well, trading volume set new records with over 1.56 billion shares being traded on the New York Stock Exchange ("NYSE") on December 15th. This compares to 16.4 million shares that traded on the infamous day of the stock market crash, October 29, 1929. Yet individual investors tend to trade infrequently while so-called "block" trades, trades of 10,000 shares or more, accounted for 135.8 million shares or 51.7% of the NYSE volume. As such, the market pricing does reflect a blockage factor.

So what does this information tell us? It tells us that average Americans today, more than ever before, are willing to place their hard earned savings and their trust in the U.S. capital markets. They are willing to do so because those markets provide them with greater returns and liquidity than any other markets in the world and because they have confidence in the integrity of those markets. That confidence is derived from a financial reporting and disclosure system that has no peer. A system built by those who have served the public proudly at organizations such as the Financial Accounting Standards Board ("FASB") and its predecessors, the stock exchanges, the auditing firms and the Securities and Exchange Commission ("SEC" or "Commission"). People with names like J.P. Morgan, William O. Douglas, Joseph Kennedy, and in our profession, names like Spacek, Haskins, Touche, Andersen, and Montgomery.

Has Quality Improved?

Earlier this week as I was preparing my remarks for this morning, I received a phone call from a reporter. He asked a number of questions about various topics being reported on in the press and that might be of interest to those 84 million Americans investing in the markets. But he came to a point and paused. He asked, "Lynn, do you really think the quality of financial reporting today is as good or better than it was in, say, 1990?" It was a good question that all of us in this room should be asking. It occurred to me, though, it really should be a three-part question:

    1. Is the quality of the product we produce for our customers, the investing public, higher today than what it was ten or twenty years ago or whenever you joined our proud profession;

    2. Has that quality continuously improved as much as it could have, and

    3. What grade would investors give us on the quality of our product?

Important, Successful Accomplishments

Let's first take stock of our accomplishments and respond to the questions of whether the quality of financial reporting has improved.

I entered the profession in 1976, twenty-five years ago. The FASB was barely three years old, and had only issued 14 standards. The Auditing Standards Board or ASB, was relatively young and had only issued 15 standards. Audit Committees, which were recommended by the SEC beginning in the 1940's, were more a novelty than reality and there was no formal system for reviewing the quality of firms' controls to ensure effective audits. Since 1976, I believe the accounting profession, the business community, and the SEC have taken steps to improve the quality of financial reporting. Perhaps some of the more notable achievements have included:

  • Receiving the final recommendations of the "Cohen Commission" (1977), the "Treadway Commission" (1987), the Special Report by the Public Oversight Board (1993), the Jenkins Committee (1994), the 1996 U.S. General Accounting Office (GAO) Report - "THE ACCOUNTING PROFESSION MAJOR ISSUES: Progress and Concerns," the "Blue Ribbon Panel on Improving the Effectiveness of Audit Committees" (1999), and the most recent Report of the Panel on Audit Effectiveness (O'Malley Panel) (2000). Each of these reports made a significant number of recommendations to the accounting profession, private sector standard setters, and the Commission on ways to enhance the quality and creditability of our product - financial reporting.

  • Improvements in audit committees - brought about initially by new NYSE listing requirements in the late 1970's and followed up with the new rules of the NYSE, NASD, SEC and ASB in 1999 and 2000.

  • Establishment of the Public Oversight Board ("POB"), the AICPA's Division for Firms, the SEC Practice Section and the accompanying quality control and peer review systems in 1977-78. The creation of a written Charter for the POB giving it greater oversight and review powers in 2001 was a subsequent enhancement.

  • New requirements effective in 2000 for timely auditor review of all quarterly financial statements filed with the Commission.

  • Adoption of enhanced requirements for the review of audits of publicly traded companies, financial statements by a second partner, commonly referred to as concurring partner reviews (1999).

  • Establishment of quality controls over audits of financial statements in foreign registrants' filings in the U.S. by foreign affiliates of U.S. auditing firms (1999)

  • Adoption in 2000 of major changes in the rules governing the independence of auditors, to reflect the significant changes in the scope of services provided by accounting firms and the changing workforce.

  • Issuance of SEC staff interpretive guidance on some of the more troublesome financial reporting issues - materiality, loss accruals and asset impairments, and revenue recognition (1999).

  • Appointment of the first three public members to the AICPA's 20 member Disciplinary Committee, the Professional Ethics Executive Committee (2000). As an aside, we believe greater public membership and representation must still be achieved.

  • Restructuring of the International Accounting Standards Committee (IASC) into an independent body of technically competent professionals, with oversight by a board of trustees led by former Chairman of the Federal Reserve Board, Paul Volcker (2001).

  • Creation by the FASB of the first conceptual framework for financial reporting (1985). The Board is to be commended for outlining those criteria, which define the qualitative characteristics of financial reporting.

  • Establishment by the FASB and AICPA of higher quality reporting standards that provide greater transparency for pension and health care costs, marketable securities, financial instruments, cash flows and several industry specific issues.

Because of these accomplishments, I do believe that the transparency and quality of financial reporting today is better than what it was twenty-five, or even ten, years ago. And investors owe a debt of gratitude to those who have led the efforts to make these changes.

However, we must consider whether our accomplishments have achieved the goals and recommendations set forth for the profession in the various reports I mentioned earlier.

In addition, we must ask ourselves, what grade would investors give us?

The Ever Appearing Mole

Let me note that dealing with financial reporting issues is like playing the "mole" game at the arcade. One issue pops up and no sooner have you knocked it down, then another pops up. It takes a constant, vigilant effort on the part of the entire accounting profession and the SEC to stay ahead or even abreast of the issues that confront us.

Changing and Challenging Times

No doubt, the times we live in today are perhaps more challenging than ever. Consider these points:

  • Articles in Business Week and CFO Magazine in 1998 cited surveys of CFO's who admitted they had been pressured to inappropriately manage the numbers, and had chosen to do so in a surprisingly high number of cases.

  • An article in the June 2001 Harvard Business Review entitled "The Earnings Game: Everybody Plays, Nobody Wins," which states, "The earnings game is now so common-place that it can sometimes seem like a collective agreement to believe the unbelievable.... Companies have a variety of techniques for making earnings appear out of thin air."

  • Restatements have been increasing in the past few years, topping 150 in 2000. And with this increase in the number of restatements has come staggering investor losses totaling tens of billions of dollars, and aggregating by some estimates to be more than $100 billion in the past six to seven years. And while some in the profession argue that 150 restatements in one year and $100 billion in losses over the last several years are not significant in relation to 10,000 to 12,000 actively traded public companies and a total U.S. market capitalization of $16 trillion, I don't think the average U.S. investor is going to buy it.

  • There has been a constant parade of press reports of alleged major financial frauds involving companies with household names. Some of these companies have restated their financial statements for errors totaling hundreds of millions and even tens of billions of dollars. Often in these press reports the auditors say management fraud is the reason the errors were not detected during the audit or, in some cases, during a number of audits. Keep in mind it is not just one auditor who missed the problem, but rather an entire experienced team that includes an engagement partner and a second experienced reviewing partner, both of whom probably have 10 to 30 years of experience, as well as a manager with 6 to 12 years of experience. Quite often there also is a third reviewing partner involved if the company is registering securities.

So ask yourself, what grade do you think the average American investor would give these auditors who missed a $100 million dollar or a $1 billion dollar error in the accounts? Better yet, what grade would your college professor have given you for such a miss?

  • I also have noted with concern the abuses of pro forma earnings announcements, which distract investors from the real GAAP earnings and recently made the front and editorial pages of Business Week.

  • Finally, some analysts' reports and recommendations are reported to be tainted by conflicts, to lack any correlation with overall movements in the market, and to be based more on a desire to market one's products rather than to provide sound investment analysis and advice to investors.

An Ice Cube or An Iceberg?

In light of these developments and statements by others, one of the most frequent questions I am asked is just how widespread are the problems with financial reporting? Is there more than what meets the eye? My experience as an audit partner, a CFO and business executive, and as a regulator tells me the answer to that question is yes. And to use an analogy - I wonder at times just how big is the iceberg below the waterline?

Working Together for Continuous Improvement

So should we chalk up the achievements of the past quarter century and say the improvements made to the quality of financial reporting are sufficient? Given the disturbing trends and cultures just highlighted I think not. Rather, we should continually move forward to strengthen the trust and credibility investors place in the accounting profession. We do not have to look far for ideas because there are recommendations that have been made over the past twenty-five years in the reports I have cited, which have not yet been implemented and would greatly enhance the quality of financial reporting. Let me cite some of those and other ideas.

Improvements for the SEC

Let me start with the recommendations for the SEC. First, the O'Malley Panel recommended we increase our enforcement efforts and we are doing just that. We created the Financial Fraud Task Force headed by Charlie Niemeier, from whom you will hear later on today. And while Charlie has only 25 accountants in Washington D.C. to investigate approximately 250 open cases, they have worked long and hard to bring cases such as those involving W.R. Grace and its auditors, as well as Livent, MicroStrategy, and the more recent Sunbeam case.

Second, the Cohen Commission, the Treadway Commission, GAO, Financial Executives International (FEI), and others have recommended strongly that the SEC adopt a requirement for management reports on internal controls. As the Cohen Commission report stated, "Users of financial information have a legitimate interest in the condition of the controls over the accounting system and management's response to the suggestions of the auditor for correction of weaknesses." I couldn't agree more and have asked the staff to work on a draft of a proposal we can present to the next Chairman for his consideration.

Third, the Garten Committee, in their recently issued report, recommended that the Commission issue a concept release soliciting ideas and comments on how the historical financial statements and disclosures might be supplemented with information that will add transparency to those factors that increase or decrease the value of a company in the market place. For over a year I have been calling for companies to disclose Key Performances Indicators (KPIs). I have written to the AICPA and asked them to join this project by providing transparent, comparable definitions of KPIs such as revenue per employee (i.e., Do independent contractors count as employees?), sales from new products (i.e., What is a "new" product?), and EBIDTA (i.e., companies calculate EBIDTA more ways than you have fingers on your hands). During recent months, the Office of the Chief Accountant has been working on a draft of the concept release recommended by the Garten Committee.

Improvements for the Accounting Standards Setters

First let me say that I believe we have the preeminent accounting and financial reporting in the world due to the quality of work performed by FASB and its predecessors, and the AICPA's Accounting Standards Executive Committee. They have the type of jobs where they get mountains of criticism and sands of praise, and no doubt have to call their moms periodically to see if someone still loves them. But let me state unequivocally, investors are grateful.

But again, improvements can and should be made. First, it has taken too long for some projects to yield results necessary for high quality transparency for investors. For example, in the mid 1970's the Commission asked the FASB to address the issue of whether certain equity instruments like mandatorily redeemable preferred stock, are a liability or equity? Investors are still waiting today for an answer. In 1982, the FASB undertook a project on consolidation. One of my sons who was born that year has since graduated from high school. In the meantime, investors are still waiting for an answer, especially for structures, such as special purpose entities (SPEs) that have been specifically designed with the aid of the accounting profession to reduce transparency to investors. If we in the public sector and investors are to look first to the private sector we should have the right to expect timely resolution of important issues.

Second, the Cohen Commission recommended in 1977 that the FASB amend APB No. 20 to require a standard note to the financial statements covering accounting changes and requiring, not just recommending in certain instances, disclosure of ALL changes that materially affect interperiod comparability, including "changes in accounting estimates." I believe that disclosure of items affecting comparability would assist investors in better understanding what has impacted the numbers they are analyzing. It also would put sunlight on some of the issues impacting financial reporting that have been relegated to the "dark room."

Third, the O'Malley Panel recommended the FASB work more closely with the ASB to ensure that new standards result in accounting that can be verified and audited. Auditors have challenged whether accounting under such standards as FASB Statement of Financial Accounting Standards (SFAS) No. 121, on impairment of long-lived assets, in fact can be audited. The ASB recently expressed similar reservations regarding the FASB's proposal on accounting for business combinations. I share those concerns. As a result, I hope the FASB will spend more time, and engage in a greater dialogue, with the ASB as it develops new standards and avoid some of the pitfalls of the past.

Finally, I note that in the 1990's the Board issued SFAS No. 121, which is now being rewritten. In addition, SFAS No. 125 had inherent issues that required amendments in Statement No. 140. SFAS No. 133 resulted in SFAS No. 138 before the original standard even became effective.

I do give the FASB credit for the willingness to review a standard it has recently issued. I believe this should be an expected practice for all standards five to ten years or so after they are issued. But I challenge whether there has been sufficient field-testing of the operationality and practicality of some standards when they are in their development stage. I believe the need for some of these prompt amendments highlight this concern. I strongly encourage the Board to take the necessary steps to improve its standard setting efforts in this regard. As the United Kingdom's Accounting Standards Board noted in a recent comment letter, extensive testing greatly contributed to the success of its Financial Reporting Standard No. 11, "Impairment of Fixed Assets and Goodwill."

I also believe that accounting firms need to help the FASB with its work by being more forthright, comprehensive and transparent in their comment letters. On more than one occasion, I have heard the national office of a Big Five firm criticize in private a FASB proposal. Some of those comments I believe were valuable and constructive. Yet, when I read the firm's comment letter, the points that had been discussed with me were not made or were made in such a fashion it would take telepathic vibes to understand them. On one occasion, I even went as far as to call the Board and ask for a meeting with the firms one more time, which Board members willingly did. At that meeting, many significant issues were discussed, which ultimately contributed to a better final product. The issue of objectivity and professionalism in comment letters, which was set forth in the 1993 POB Report, remains today and requires a renewed effort. The profession should not let competitive pressure for clients deter them from improving professional standards and negatively impact what is a good standard setting process.

Similar to the challenge to the accounting firms, I also believe industry needs to do a better job of speaking out on important financial reporting issues. During the past couple of years, I have had several prominent companies in America tell me they strongly support the FASB on a controversial proposal. Their executives clearly were concerned about the quality of financial reporting, the importance of the independence of the private sector standard setter, and the proposals on the table. I applaud them for their interest and willingness to discuss the issues with the staff. But when I asked them to join with others and express their viewpoints and support publicly, they were unwilling to do so because of the risk of opposing other members of the business community. All I can say folks is, that just doesn't count. There are two types of people in this world, leaders and followers. You can't be like the cat wanting to get the fish in the fish tank, but not willing to get its paws wet.

Improving the Effectiveness of Audits

Let me finish by teeing up some considerations for auditors. The O'Malley Panel Report contains over 200 recommendations for improving the effectiveness of audits. Such recommendations are interesting since many come from the Panel's Quasi Peer Reviews, most of which were captained by the same individuals who captained the regular peer review of that firm and previously had issued a "clean" report on the firm's quality controls. To improve the effectiveness of audits, we need to ensure that auditing firms and the ASB fully implement these recommendations on a timely basis. To that extent, I have asked the POB to report publicly on the progress made on the O'Malley Panel's recommendations.

However, I am already concerned about whether investors' interests are adequately being considered by the ASB. An example of this is the ASB's effort to improve audit documentation, which was a subject of criticism in the O'Malley Report and in various peer review reports of firms. Today, I would give that project a "C" for caution.

In 1978, one of my predecessors, Sandy Burton, testified before Congress. He noted:

"In general, the standard setting mechanism has not resulted in an innovative approach to the auditing function, but has tended to enshrine or justify current practices. Recent auditing standards have emphasized protection against litigation and the consideration by AudSEC [the predecessor to the ASB] has been heavily influenced by participation of legal counsel for the major firms. AudSEC has been hesitant to increase auditors' responsibility except under pressure from outside forces.

Standard setting should result from an analysis of how professionals can serve society more efficiently and effectively. It should not simply represent an expression of the least common denominator in current practice. By this test, the current process of standards setting must largely be deemed a failure despite its occasional achievements."

It is my hope and strong desire that the ASB will meet the needs of investors by implementing the O'Malley Panel recommendations. But in the end, the final proof will be "in the pudding" and the final grade will depend on whether society has been more effectively and efficiently served.

I also hope the auditing firms will significantly enhance the quality of the audits their foreign affiliates perform for subsidiaries of U.S. companies as well as foreign companies who list on the U.S. capital markets. The recent report of David Cairns, former Secretary General of the International Accounting Standards Committee, highlights the lack of compliance with IASC standards, in part due to lax audits.

Investors and regulators worldwide depend on independent auditors to perform robust and effective audits, thereby ensuring compliance with home country or IASC GAAP. However, that is not the universal product received today.

And all too often, when a problem does develop and investors lose money, the accounting firms in the U.S. tell the SEC and investors they do not own or control the foreign affiliates. In fact, that may very well be the case - it is just a global co-branding, co-marketing alliance. As the Commission noted in its International Concept Release, this is an issue that requires attention. Too often it has resulted in accounting firms attempting to thwart timely investor and Commission enforcement proceedings by withholding access to audit workpapers. This is a problem other U.S. regulators have faced as well. Ultimately, if the profession continues to delay such processes I believe the staff will need to recommend to the Commission further rules, as discussed in the concept release.


Let me close by again noting that the past quarter century has been productive and successful with improvements in the quality of financial reporting. But as with any business, continuous improvement is necessary to keep up with the fast pace and ever changing challenges we face in our global economy. If the accounting profession is to receive an "A" from investors, our customers, for our efforts, it will not come from the path of least resistance but from a passionate desire to serve society and the public. And that is why we are still called certified PUBLIC accountants.


Modified: 06/05/2001