U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Towards Higher Values in Financial Reporting

Remarks by

Lynn E. Turner

Chief Accountant, U.S. Securities and Exchange Commission

At the Financial Executives Institute 1998 Annual Conference

October 22, 1998

"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 or of the other members of the Commission's staff."


I am extremely pleased to be able, not only as a representative of the securities and exchange Commission but also as a member of the FEI, to participate in this conference. I want to thank the FEI, including Susan Koski Grafer and Norman Roy for extending me an invitation to speak. Before I begin, however, I must remind you that the comments you will hear today are my own, and do not necessarily represent the views of the Commission or others on the staff.

As the Chief Financial Officer of a major semiconductor company for the past couple of years, I have come to better understand the challenges many of you face on a daily basis. The task of working closely with the CEO and senior management team to run a business effectively and efficiently is a daunting task in and of itself. There are strategies to be developed, budgets and plans to be monitored, risks to be addressed, financing to be completed, employees to be recruited and retained, customers both inside and outside the company to respond to, and, of course, requests from your investors and Board of Directors.

Yet at the same time, as a Financial Executive, you also have the unique role of being the primary person responsible for the preparation of the financial statements and disclosures that are provided to the investing public. These financial statements and disclosures form the very foundation upon which our securities markets are built. If the public ever loses confidence in the numbers that create that foundation, I am concerned that we could face problems similar to those currently being faced in the capital markets in Asia and Russia. Such problems could lead to significant increases in the cost of capital for each of your companies and a lowering of the competitive nature of our own capital markets.

Fortunately we do have, thanks to many of you here today, high quality financial reporting by the majority of corporate America. In my opinion, this is due to:

1)The tone at the top' of many of our companies that is consistent with the recommendations of the Treadway Commission and the Committee of Sponsoring Organizations (COSO) of which the FEI has been an important contributor;

2)The quality of effort and long hours put in by many financial executives and their staffs;

3)High quality accounting standards issued by the FASB, AICPA, and other standard setters; and

4)The well developed external audit process in the U.S.

Yet, I have seen developments in financial reporting in the past few years that concern me. In speaking to many members of the business community, including several CFOs, both before and after I arrived at the SEC, I have heard a frustration expressed. The frustration is with those in the financial community that push the envelope too far in the areas of financial accounting and financial analysis.

As a result, the SEC staff began meeting with many representatives of the financial community shortly after I arrived at the SEC. The groups we met with included CFOs, financial analysts, academics, members of the FASB, the emerging issues task force, the AICPA's auditing standards board, the public oversight board, members of the legal profession, and a representative of the business roundtable.

From these meetings, the Commission staff gained valuable insights into a number of issues facing those of us involved with financial reporting. Let me share with you some of the issues and concerns that were expressed to the SEC staff.

Financial Analysts and Investment Bankers

People expressed a frustration over the tremendous pressure placed on CFOs, their staff and auditors to make "the numbers" each quarter. There is a high level of investor anxiety when a company misses the analysts' consensus estimate of earnings by a penny, and even though there have not been any significant changes in the fundamentals and cash flow of the business, the company can lose a significant portion of its market capitalization.

Frustration also exists among investors with companies that constantly lower their earnings estimates below what they honestly expect to achieve, just to be able to get a "bump" up in their stock price each quarter when they surpass the market's deceptively low expectations.

Some of the manipulation with quarterly results also involves selective disclosure to analysts. Chairman Levitt has expressed his concern about the practice, and some believe we need to step up our enforcement activity in this area.

People cited an example of an investment banker who put pressure on a CFO to engage in questionable accounting to make the numbers look better. Sometimes the banker tries to convince the CFO that other companies are using the same questionable accounting and, therefore it is okay, notwithstanding concerns expressed by the CFO and independent auditors of those other companies, or a lack of examples that are directly on point.

Laxity in Audit Committees

Most boards of directors of public companies have audit committees today. Yet, we have seen the quality of the committee members, their charters, and their operating procedures vary greatly. In some of the more visible cases alleging financial fraud that have been cited in the media this year, the companies, audit committees have been called on the carpet and their role in their governance of the corporations seriously challenged. People have encouraged me to consider recommending that the Commission take action, when financial fraud is proven, not only against the CFOs and auditors, but also members of the audit committee.

Internal Pressure on Financial Executives

In some cases of financial improprieties, it appears there may have been pressure placed on the CFO by other senior management executives. Certainly, all of the management team is faced with pressures to make the numbers. Some compensation packages that include stock and earnings based incentives can increase this pressure.

In one case we are following, it appears the CEO may have improperly pressured the CFO to "cook the books." If this proves to be true, we will be recommending action against all the cooks including the CEO.

Unfortunately, some members of the accounting profession have succumbed to this pressure. As noted in Chairman Levitt's' recent speech, "the numbers game," we have seen what we consider to be inappropriate earnings management in the form of:

  • Big bath charges: these include improper liability accruals often made under the guise of a restructuring, merger or in the name of conservatism. Some of these charges include improper write offs of assets to avoid future charges to earnings. We have seen instances where changes to business plans, strategies and technologies were made and, instead of properly adjusting asset depreciable lives, the registrant took a large asset writedown at a later date.

  • Creative acquisition accounting: the high level of merger activity has left us with companies charging off almost the entire purchase price of a business, calling it "in process research and development." Some of these companies, however, previously reported very little or no research and development expenditures.

    Some of the merger transactions also have resulted in large liabilities being added to the companies' balance sheets with equal amounts of goodwill being created. Some of these accounting entries clearly appear to lack business or economic sense.

  • Cookie jar reserves: simply put, these are reserves set aside in good times or under the guise of a large one time charge. Later on they are often bled back into earnings when needed.

  • Misuse of materiality: you will find very few instances in GAAP where materiality is defined as a specified amount. Instead, both the legal standards and accounting literature spell out clearly both qualitative and quantitative factors that must be considered when assessing materiality. This is an area in GAAP where professional judgment is required. But it is also an area where the Commission staff has seen numerous instances of nonGAAP entries, in some cases intentionally made, that changed earnings trends or perhaps allowed the company to make the earnings forecast for the quarter. The argument we have heard to justify these entries, both from companies and their auditors, is that the amounts are less than a rule of thumb 5% or 6% of net income, or whatever test they use for materiality.

  • Revenue recognition: as one analyst summed it up, the number of reported instances of companies improperly booking revenues has become an embarrassment to all of the accounting profession. A substantial majority of our accounting-related enforcement cases involve revenue recognition. It seems as if all too often we are seeing instances of revenue recognized improperly when:

    • Delivery of the product to the end user's site has not occurred.

    • Agreements have not yet been accepted and executed by the customer.

    • The seller has to complete remaining obligations, such as installation or training.

    • The customer unilaterally can terminate or cancel the agreement.

    • "Just in time" arrangements exist, with fob delivery terms, and revenue is recognized prior to arrival at the delivery destination.

    • Upfront fees are recognized immediately upon receipt notwithstanding an agreement to provide services, discounts or products during an ensuing membership period.

In the chairman's speech in September, he stated a belief that these abusive earnings management practices are a financial community problem that calls for a financial community response. To date, the response has been tremendous. Business leaders, attorneys, academics, managing partners of the major accounting firms, and the AICPA have all commended the chairman for undertaking this bold initiative.

The financial community also has commenced work on the action plan outlined by the chairman. Let me summarize for you that action plan and the progress to date.

Audit Committees

The NYSE and NASD have formed a blue ribbon committee co-chaired by Ira Millstein, one of the most experienced corporate governance attorneys of our time, and John Whitehead, former co-chairman of Goldman Sachs and undersecretary of state. This 11 person panel, comprised of the chairs of the exchanges, leading CFOs from the FEI, managing partners from the five largest accounting firms, executives of institutional investors, and the business community, is holding its first meeting today. This panel is expected to propose recommendations to the business community, regulators, and the exchanges for strengthening the role and performance of audit committees.

The independence standards board also tentatively has agreed to recommend a robust discussion each year between auditors and audit committees regarding auditors' services, fees, and independence. This new proposal, which both the SEC and public oversight board strongly support, should result in a robust discussion about the auditor's independence. I urge you as CFOs to take an active and leading role in this discussion and topic. As the purchaser of both audit and nonaudit related services from your accounting firms, I believe it is appropriate that you should be making your own assessment of the independence of your auditor.

I firmly believe the role of the audit committee in corporate governance is important. I believe the audit committees must work closely together with the CFOs and auditors, as a team, to ensure the quality of our financial reporting. That is why I now ask the question of each registrant who visits with us, "have you discussed this issue with your audit committee?"

Audit Effectiveness

The media has reported on a number of alleged spectacular financial fraud cases in 1998. Articles have included headlines such as "pick a number, any number," " abracadabra," and "10 reasons numbers lie." In some of these articles, the question has been raised "where were the auditors?" This is a very serious question, especially given that the magnitude of some of the financial statement errors are reported to have been in the hundreds of millions of dollars.

Personally, I wonder if the audit process has kept pace with the quickly evolving and changing ways we do business. While the auditing firms hire some of the brightest graduates from our universities, I wonder if these new staff, who typically have zero to six years of auditing or business experience, and who perform more than 80% of the audit work, have an adequate understanding and knowledge of both auditing procedures and business operations to dig deep enough into a complex business, its operations, and the resulting numbers.

To address this concern, the public oversight board will be announcing in the next few days, a distinguished panel chosen from the business, accounting, investment, and academic communities. This panel will reexamine how we do audits. This in-depth study is expected to get underway shortly and to be completed within the next 12 months.

Needless to say, the very integrity of the auditing profession rests on the objective review of the numbers you prepare, and an ability to stand tall when the difficult issues and questions arise. We do not need any more articles with the question, "where were the auditors?"

The Accounting and Auditing Standard Setters

The AICPA is already in process of developing a tool kit, for accountants and auditors alike, on revenue recognition. This tool kit will be completed before the end of the year. Subsequent to the development of the tool kit, the auditing standards board will reexamine the standards related to auditing revenue and liabilities, such as those for restructuring changes.

Many of the concerns about earnings management have been highlighted in this year's AICPA audit risk alerts, to be published soon. I recommend that you review that document once it is available. We have provided the AICPA with a letter, which will be available next week on their website, that identifies issues we expect to be looking at closely in the course of our reviews of this year's filings.

Finally, the AICPA has formed a task force to provide better guidance for the valuation of in process research and development. That task force will commence its deliberations next month. In the meantime, the SEC staff has provided guidance on this topic, which also will be part of the letter on the AICPA website.

In addition, we are monitoring closely the FASB's projects, currently underway, which will define more clearly what transactions should be recorded as a liability. The board and its staff met yesterday on this issue and are actively working on a timely decision.

SEC Action Plan

The SEC's action plan is comprised of both rulemaking activities and further staff guidance. We are working on a rule proposal to expand the required disclosures of loss accruals, sometimes erroneously referred to as reserves. This is most likely to come in the form of a recommended change to the current regulation S-X schedule for valuation and qualifying accounts.

We also expect to issue by the end of the year staff accounting bulletins addressing (1) revenue recognition, (2) recognition of loss accruals, such as restructuring charges and asset impairments, and (3) materiality. This additional guidance is expected to focus on general revenue recognition concepts, many of which are embedded in the AICPA statement of position on software revenue recognition; the specificity needed in plans in order to recognize a restructuring charge; a time frame in which those plans must be completed if an accrual is to be made; greater delineation of the types of costs that cannot be accrued for; guidance on proper adjustment of asset lives; and qualitative factors that should be considered when assessing materiality.

In addition, the division of corporation finance has formed an earnings management task force to coordinate and focus our filing reviews on abusive financial reporting practices. The Division of Enforcement also has stepped up their focus on earnings management.

Change in Culture

Finally, and perhaps more importantly, we are calling for a change in our business culture and how all of us interact with the different members of the financial community.

Analysts and investment bankers need to reexamine how they react to narrow misses in quarterly earnings. CEO's need to be sure the focus is on numbers that reflect the underlying economics of the business and stop putting pressure on CFO's to move the numbers around to meet analysts' quarterly earnings forecasts. Likewise, CFO's need to step it up to ensure the quality of our financial reporting provides investors with all the information they need on a timely basis.

Business Ethics

We have all heard people from time to time discuss the topic of business ethics. The universities have courses on it, companies have ethic officials and auditors certainly focus on the topic. Yet, I think the notion of business ethics is misleading. It conveys a sense that those of us who are in or have been in business have a different level of ethics than others. I would like to end by saying I certainly hope that is not the case. I believe we can have only one level of ethics, and that is a standard of the highest level. Nothing less should suffice.

Thank you.