Speech by SEC Staff:
21st Century Financial Reporting
Bringing Back the Q
Lynn E. Turner
U.S. Securities & Exchange Commission
27th Annual National AICPA Conference on Current SEC Developments
December 7, 1999
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 other members of the Commission's staff.
I want to thank Bob Herz for that magnificent introduction. It reminds me of three executives trying to define the word fame. One said, "Fame is getting invited to the White House to see the President." The second one said, "Fame is being invited to the White House and while you are visiting, the phone rings and he doesn't answer it." The third executive said, "You are both wrong. Fame is being invited to the White House to visit with the President. When his Hot Line rings, he answers it, listens a minute, and then says, 'Here, it's for you!'" Being asked to speak today before this group is like being in the White House and the call's for me. I truly thank the AICPA, Bob, and his committee for this opportunity.
Before we get started, I would like to congratulate Bob for the tremendous job he has done during the past few years as Chairman of the SEC Regulations Committee. He has been a friend, a good listener that I could bounce ideas off of, and a leader committed to excellence. They say rewards come from a job well done, and I have no doubt that Bob will be entitled to many rewards for the service he has performed. Thank you, Bob.
Before I go further, I have to remind you that any remarks you hear during this conference from me or anyone from my Office are only those of the speaker, and do not necessarily reflect the views of the Commission or others on the staff.
Let me start by noting that we are living and practicing our profession in a unique time. Assuming our economy continues to grow for the next few months, we will have lived in the longest period of sustained growth in the history of this great country. Many who have joined the profession in the past ten years have never prepared or audited a set of financial statements in an economic downturn. At the same time, we have seen record highs for market capitalization, both in absolute terms and relative to the country's gross domestic product. Indeed, the market capitalization of individual companies has soared into the tens and even hundreds of billions of dollars. Unfortunately, what goes up often can come down. And the adage that "the higher they go, the further they fall" may hold true.
I was reading some interesting New York Times articles last night on the stock markets. One article stated that "Playing the stock market has become a major American pastime." Other articles talked of the current market situation with instant creation of wealth. The creation of a new era, new technology and increasing leverage of debt all were discussed. Finally, one article noted a doubling of the number of brokerage accounts in the past two years and stated, "It is quite true that the people who know the least about the stock market have made the most money out of it in the last few months. Fools who rushed in where wise men feared to tread ran up high gains." Interesting indeed. Makes you think rather quickly of day trading, doesn't it?
But let me make it a little bit more interesting. All of the articles I was reading were written in 1929. The new technology that the articles spoke of was radio. The new brokerage accounts were, in part, being opened on cruise ships.
One can't help but thinking of Yogi Berra's comment, "It's déjà vu all over again." Both in the 1920s and today, we have had unprecedented growth in the markets. Both those investors who provided capital and those companies who attracted it benefited. Major changes in technology and in the country's industrial base were occurring. Then, as today, those changes provided an impetus to the growth in the markets. Annual market returns for the past four years have been unprecedented not just double digit returns, but returns that exceeded 20% or even 30%. Much of this impressive growth is occurring in the high-tech and information sector. The current market capitalization is greater than 1.6 times the gross domestic product of the entire country. Unfortunately, high prices sometimes precede large losses in financial fraud cases. Recently, the loss in a single case exceeded the total dollar amount of the decline in the stock markets on October 29th, 1929. As Alan Greenspan has asked on several occasions is our optimism warranted? I ask, is this possibly the mother of all bubbles? Is Yogi Berra ready to say it again?
I won't comment further on market exuberance, but I do want to talk about one item that I hope, and we all must ensure, is not repeating itself today. That is the lack of quality of financial reporting and auditing that existed in the 1920s, that led, in part, to the creation of the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as the Commission itself. Financial reporting in the twenties included a lack of transparency with respect to reported revenues, inappropriate asset values, questionable accounting practices, and a lack of comparability amongst listed companies.
The underpinning of the information I have just covered is simply this: The capital markets, and the investors who drive them, need high quality financial reporting more than ever before. The electronic age and its impact on how markets react, how markets and companies trade, how currency and cash flows move between markets and investments, all make it critical that there is transparency as clear as a piece of Stueben glass.
To achieve the type of transparent reporting needed by our markets in these quickly changing and challenging times, we all need to recognize that our markets, and investors who use them, need all of us here today to pull together as a team to meet a higher, more important goal. That goal is to build and maintain a system that gives investors transparent, comparable, high quality financial information consistently to build a system that instills investor confidence in what each and every one of us does to show that, as a team, we are capable of producing more than mediocre results.
In the past, everyone focused on the "other guy" when addressing issues that confront all of us. Regulators tend to highlight failures in the system and downplay the good things the profession has accomplished. Members of the profession highlight only the good audits that are done and quickly brush over problems causing harm to investors. Preparers seem to forget their responsibility for the sign that says the buck starts and ends here, and the fact that they need to ensure the financial statements they produce measure up to the same quality standards they set for themselves in fulfilling the needs of their commercial customers. Audit committees sometimes seem to lose the vision of themselves as representatives of the public stockholders. And analysts seem to destroy companies and investments in them, without rhyme or reason.
Yet today we are living at a time when we have unprecedented reasons and opportunities to make significant and meaningful improvements to each and every aspect of what comprises our system of financial reporting. As a result, what I am asking for, as we face the morning of a new millennium, is for people to consider that possibly, just possibly, if we can start to work more as a team, and less as adversaries, that we could reach a higher level. That we could better serve our ultimate customer and provide them the value-added product they so rightly deserve. We owe that to the investing public because it is they who give corporate America the capital that expands our economy. It is they who have given the auditors a unique franchise that exists for no one else, and it is they who rely on us the other market participants to create a system that works.
And what is it we need to work on? Let me explain my thoughts on some key components of quality financial reporting.
Quality in Preparation of Financial Statements and Disclosures
Chief financial officers have the primary responsibility for preparing financial statements and disclosures that convey the company's performance and financial position to investors. Their work is the cornerstone of the entire financial reporting process. They need to show personal responsibility. And most do. We need to recognize and applaud those who strive for transparency and high quality as they prepare financial statements.
But at the same time, we have seen emerging and troubling trends. Surveys in business periodicals too often question the integrity of those preparing the financial statements. Lax internal accounting controls that result in money laundering scandals are reported in the press. Major restatements of the financial statements occur not just once, but on repeated occasions, sometimes with different auditing firms.
And many of us have experienced the situation where the preparer of financial statements tells the auditor, "Show me where in the literature it says I can't do this." No wonder we need financial reporting standards in sufficient detail to answer questions like that.
Let me lay down some challenges for financial executives to achieve in order to improve the quality of financial reporting.
First, CFOs need to ask themselves and their company these questions: Is our financial reporting of a sufficient quality to meet the needs of our investors? Do the financial reports and disclosures provide a clear picture of the business? Have the numbers been presented in an unbiased fashion that results in a consistent, comparable picture? In addition, as noted in the November edition of Financial Executive magazine, and I quote "...CFOs shouldn't encourage appeals to the regulators if the local answer isn't attractive."
Second, financial executives should undertake to follow the recommendations and leadership of the Financial Executives Institute with respect to management reports on internal controls. Maintaining an effective and reasonable system of internal controls is a key responsibility of financial management. I would encourage both the FEI and Institute of Management Accountants to renew the call for management reports. I commend the FEI, its members, and leadership for recent recommendations they have made to the SEC staff on this topic. To some degree, the ball has been put in our court. We are certainly going to carefully consider the input we have received and determine how we might best implement those recommendations. My first choice on this issue is, without a doubt, for the CFOs to take the lead themselves in their own annual reports.
Third, I would ask the financial executives to consider the impact that changes in our economy are having on financial reporting. Both the Financial Accounting Standards Board ("FASB"), through its business reporting model, and the Garten Committee are looking at this issue. There is no doubt in my mind that we can improve annual reports by considering how and what creates value in businesses. PricewaterhouseCoopers recently has published a monograph entitled ValueReporting Forecast:2000 that poses relevant ideas and a vision for financial reporting in the new millennium. I would recommend that financial executives consider how value creation in a business, which many of us deal with daily, should translate into disclosures in public filings. While research shows that earnings remain the most relevant information today, it also shows other measurements are becoming increasingly important.
I realize some have raised the specter that if such numbers are required in filings, they would have to be audited to be credible and that involves additional costs. My personal thoughts are that there are many numbers in a filing, including those in the business section and Management's Discussion and Analysis, that are not audited. They are not audited because of the trust the public has in members of the accounting profession who are in private industry. As long as such credibility is earned, and maintained, I do not see why performance or value measures would require auditing. However, if as in 1929, the public were to lose its confidence, then one would have to respond appropriately.
Finally, I would encourage accountants in industry to initiate discussions with audit committees and auditors on the quality of financial reporting. Rather than just wait for auditors to ask for a meeting with the audit committee, CFOs need to initiate these discussions. We must keep in mind whose job it is to ensure the financials are of sufficient quality, and who has a direct responsibility to the audit committee. I know the Auditing Standards Board has issued an excellent exposure draft on communications with audit committees. Given what the auditors have achieved, why can't financial executives also develop best practices for CFOs on working with the audit committee and external auditors to assure high quality financial reporting. We are in a new time, with a new audit committee model requiring leadership and new ideas from CFOs.
Finally let me challenge CFOs who handle the investor relations and public disclosure functions in a company to treat all investors in a balanced and fair fashion. Selective disclosure of material information or facts to some, but not all, analysts and investors needs to be brought to an end. This creates the type of unlevel playing field that executive managers dislike having to play on. Why then should they treat their investors in an unfair fashion?
In addition, financial executives, and perhaps the SEC, need to take a look at some of the questionable disclosures in press releases today. For example, many such releases show what is labeled as "cash earnings per share." But in reality, this is a bogus description attached to a bottom line number that is increased by adding back one or more large charges. The cash EPS number is not a real representation of cash flows from operations a more real number. Perhaps some of the members of the financial reporting community could demonstrate leadership and find a way to bring back credibility to press releases that, no doubt, need to be viewed with increasing skepticism in today's financial reporting ecosystem.
High Quality Audits
Let me turn now to the next partner in this partnership the auditor. The public accounting profession has a unique role and franchise in our capital markets. I often hear auditors say that they should be treated the same as other professionals in the process. But that just isn't dealing with reality. The independent public accountant is the one, and only, professional a registrant MUST hire to sell securities to the public. That is because it is the auditor not the attorney, not the underwriter to whom the public looks to assure the credibility of the financial statements that are so important to many investment decisions.
What then contributes to a high quality audit? Let me list a few items for your consideration:
1.An objective, independent perspective based on integrity and ethics beyond reproach;
3.Quality professional staff committed to serving the investing public after all, they are the most important client;
4.Continuous training focused on providing the auditor with the skills necessary to complete a successful audit training that begins when a professional joins a firm and continues throughout a professonal's career;
5.Availability of and capability to use up to date technologies;
6.Current knowledge of the business and risks associated with the business of their client;
7.An effective quality assurance program;
8.Auditing standards with sufficiently detailed audit procedures and guidance necessary to produce audits that will assure the public's confidence in the numbers;
9.A process that provides input to clients on how they can improve the quality of their financial reporting processes, procedures and product;
10.A sufficiently robust audit methodology and process; and
11.The appropriate compensation program that rewards or penalizes an audit professional based on the critical success factors for a successful audit.
The O'Malley Panel on Audit Effectiveness currently is working on perhaps the most in-depth review of the audit process in the past hundred years. We hope that the Panel's recommendations will be substantive and allow us to make changes that will result in improvements in how audits are conducted. Hopefully those recommendations will hone in on some of the key factors I have just discussed.
With the globalization of the firms' clients, auditing practices also will need to be considered as part of the recommendations. With U.S. registrants who quite often have a majority of their business and audits conducted outside of the country, a global system, not one limited solely to an individual country, will better protect the needs of investors.
One last thought on auditors relates to their role in a process that creates less, rather than more, transparency for investors. I am talking about a process involving the structuring of transactions to get around the rules written by our standard setters. I might add that there is nothing inherently wrong with this and each and every one of the major firms has a group that works with the investment bankers in structuring transactions. Unfortunately, in many instances, this results in transactions for which financial reporting becomes less transparent, less clear, and in some cases undecipherable. I must challenge the profession and firms with the following questions regarding their involvement in this process:
1.Is there an appropriate role for independent auditors to assist their clients in structuring transactions that knowingly impact the quality of financial reporting to investors?
2.What obligations does the profession have in this situation to identify these shortcomings and refer them on a timely, if not immediate, basis to standard setters or the interpretative process to address the abuse?
3.When such activities are undertaken to get around the rules, and to get desired results that may not reflect the true economics of the transaction, thereby reducing transparency, what should be the role of the regulator?
Improving Regulation and Oversight
The audit committee is not the only player in financial reporting that has an oversight role. The Public Oversight Board ("POB"), the SEC Practice Section of the AICPA, state regulators and the SEC also have a role.
But it is interesting and challenging to note that our oversight structure was put in place during the 1970s almost twenty-five years ago. At that time, the public accounting firms had mostly national as opposed to international practices. A one-hundred person office was a large office. The auditing practice drove the strategy of the firms because it was the largest revenue, cash flow and profit generating part of the practice.
Today, the larger firms are international in scope, and range in size up to 160,000 people worldwide. Offices are larger too. For example, the Washington DC practice of one firm currently employs approximately 5,800 people. Auditing, while still very profitable, is no longer the largest part of the practice for many firms. Auditors may no longer make up the largest number of people in a firm. Indeed, within the AICPA, practicing auditors especially those of public companies are a clear cut minority of the membership.
The oversight and regulatory structure needs to be updated to ensure the quality of the implementation and then enforcement of accounting and auditing standards. New ideas need to be considered including recommendations such as:
1.A mechanism to initiate more timely investigations into problematic audits with a goal of providing timely recommendations on ways to improve the audit process there needs to be a more direct link between the investigation process and the standard setters;
2.A more efficient process that eliminates some of the redundancies and inefficiencies in the current system;
3.An external monitoring process that is ongoing much like the annual internal inspection programs today. This could be based around an enhanced peer review that focuses on the performance of audits in critical risk areas rather than being so process-oriented. In addition, careful consideration needs to be given to providing the POB the latitude to make reviews of audits on an unannounced basis.
4.A mechanism for assuring continuous improvements in a constantly changing environment; and
5.Significant improvements in worldwide internal controls over auditor independence and the monitoring and testing of compliance with those controls.
I also have heard constructive criticism concerning ways that we can improve our regulatory efforts at the SEC. There is nothing like effective input to make one look hard at how one does things. As a result, we are looking for ways to improve our processes and I welcome your input.
Based on input we have received to date, we recently have implemented new policies and procedures designed to make the pre-filing process more effective and more efficient. These policies are available on our website or through the SEC Regulations Committee of the AICPA. These policies are intended to streamline the process and to provide greater consistency in responses.
A second project we hope to undertake in the near future, as staffing becomes available, is to establish a compendium of the various positions taken by the staff on registrant accounting issues. On several occasions, I have received requests from financial executives to make this information more publicly available and more retrievable. We are looking at how best to do this. I also believe that this will result in more consistent application and interpretation of the accounting literature.
Accounting Standard Setters
Switching to the accounting standard setters, let me first note the very positive and excellent achievements of the International Accounting Standards Committee ("IASC") and its Strategy Working Party in developing a restructured IASC. Based on a framework that has as its goal the development of high quality financial reporting, the IASC tentatively has developed a new structure. This structure will result in an independent Board that is chosen based on technical competence and know-how. We look forward to the successful implementation of the restructuring of the IASC and, ultimately, to the development of high quality financial reporting and disclosure standards. I must commend all of those who have taken an active part in this important undertaking for their tremendous effort in making a high quality international accounting standard setting structure a very real possibility, very soon.
This positive outcome with respect to international standards should serve to keep us in the U.S. focused on our long tradition of high quality standards. Indeed, as I travel abroad, I hear time and time again that the FASB is the benchmark by which all other standard setters are measured. I would hope that in the U.S., we all keep in mind the recognition given to our standard setter and its processes. We need to continue to support the efforts of the FASB.
Yet we can and must continue to improve on the quality of our own accounting standards. In that regard, I believe we need to continue to examine our financial reporting and disclosure model for ways to improve it. In the quickly changing environment we live in, the financial reporting of the past may very well be inadequate for the future. We must challenge ourselves to think boldly and out of the envelope in finding ways to improve transparency for investors and the capital markets. At the SEC, we are looking forward to the work of the Garten Committee and the results of its efforts in this area. We also are looking forward to the work of the FASB Business Reporting Model project. Hopefully both of these efforts can make significant contributions to the quality of financial reporting.
Finally, on this front, let me mention some basic characteristics of accounting information that are identified in Statement of Financial Accounting Concepts No. 2. ("CON 2"). CON 2 states that accounting information should be relevant and reliable. To be reliable, it should exhibit verifiability, neutrality, and representational faithfulness. And it should exhibit comparability and consistency. These are the qualities that we look to in determining high quality, transparent financial reporting. Concepts from times long ago, like conservatism and matching concepts that, like the horse and buggy, served us well in the past are not characteristics that serve us well today. In the current era, you need a different vehicle, one that provides transparency in the fast-paced, and rapidly changing, business conditions.
To Tell the Truth the Role of Analysts
Let me turn finally to the role of analysts as partners in producing high-quality financial statements. Analysts can play a very important, very valuable, role. They can bring information and insights to investors. But just as managers and auditors must choose between a high road and a low road, analysts must do the same. Analysts who take the high road are sophisticated, knowledgeable readers of financial statements. They dig into the numbers to seek out inconsistencies. They analyze the quality of the reporting to identify questionable accounting tactics used by managers who seek to present a misleading picture to investors. When it comes time to recommend stocks to buy and stocks to sell, they tell the truth their recommendations include everything from strong buys to strong sells.
But let's deal with what reality is in today's markets. On a scale of one to five, where one is a sell and five is a strong buy, there are no ones and twos. In fact, you are as likely to see a sell recommendation on the Street as you are a Tyrannosaurus Rex. Instead, the analyst reports read more like the report cards for the children at Lake Wobegon where every child is above average.
What is worse, too often analysts don't seem to be able to distinguish between managed earnings and the real thing. There seems to be a lack of in-depth analysis into the numbers being reported. Some analysts don't seem to grasp fully the meaning and implications of some of the large one-time charges or aggressive accounting practices. Too often, they are asking financial management for selective disclosures rather than doing their own homework.
The result is a marketplace where a company that misses an earnings forecast by one penny may lose more than 15 percent of its market capitalization in a single day. This makes no sense. Companies aren't built in a quarter, and they shouldn't be destroyed overnight. No wonder managers who want to present high quality, transparent financial statements have trouble sleeping at night. They have to worry that, by showing the real economic ebb and flow of the business, their stock may take a beating because of analysts who just want to see a smooth earnings series. If analysts continue on this course, their credibility will be no different than that of the navigator on the Titanic as it headed for the iceberg. They will lose everything and unfortunately, so will a lot of innocent investors and managers.
But let's look at the other choice recommendations that will improve the process.
First I would suggest that the Association for Investment Management and Research ("AIMR") take a look at some of the questions and concerns that corporate America, the accounting profession, and investors are raising with respect to the credibility of analysts. Analysts need to address those questions and concerns or risk having others address those questions for them.
Second, analysts need to take the high road, do their own analysis and seek out inconsistencies and other questionable accounting tactics that impact the quality of earnings. They should tell the truth they should say that a company's financial statements are high quality when managers produce transparent financial statements. And they should call attention to low quality financial statements. They need to dig down into the numbers, understand them, and carefully factor into their analysis what those numbers mean to the value of a business, not only in the short term, but also in the longer term.
Finally, analyst reports need to start reflecting something other than fiction to the investing public they need to call a horse a horse. If you look at the horse's mouth and the teeth are missing, don't act like a horse trader who says you're getting a good animal.
Let me close by asking you to think of the lighthouse that stands alone on the cliffs, guiding ships by night, and assuring they miss the danger of unknown reefs. Similarly, high quality financial reporting is the beacon that lights the way for investors.
And in this day and age of tremendous challenges, our profession and other members of the financial community must work together to keep the beacon brightly lit, no matter how strong the storm. We must face the challenges and find ways to turn them into opportunities. And as Helen Keller said, "When one door of opportunity closes, another opens; but often we look so long at the closed door that we do not see the one that has been opened for us." I hope for the sake of our profession and for the benefit of investors, we can find the open door.