R.G. Associates, Inc.
The Fidelity Building
210 N. Charles Street, Suite 1325
Baltimore, MD 21201
Jack T. Ciesielski, CPA, CFA
March 28, 2000
Mr. Jonathan G. Katz
Secretary, U.S. Securities and Exchange Commission
450 Fifth Street, N.W.,
Washington, D.C. 20549
Re: File No. S7_03_00
I have studied the proposed rule concerning supplementary financial information, referenced above. As a user of financial statements and a general observer of accounting issues, I would like to state at the outset that I support the SEC's proposal. Financial transparency is lacking in a great number of accounts that commonly appear in the financial statements of many firms; accounts that can be seriously considered to be "soft spots" in financial reporting, for they are inherently built upon estimates and are the product of management judgment. That judgment may be swayed by pressure to "make the estimates" of Wall Street analysts, to meet earnings targets in order to achieve performance bonuses, to prevent non-compliance with borrowing covenants, or any number of situations where a management might be tempted to use "soft spot estimates" to achieve an accounting result that does not portray economic events - which is the sole purpose of an accounting system.
This is not to say that managements routinely manipulate such accounts for illicit purposes. The problem is that when such actions come to light, confidence in our system of financial reporting is sorely tested - and that lack of confidence may extend to our capital markets. Worse, such actions usually come to light after damage has been suffered by investors. The market is a voracious consumer of information; if the kind of disclosures discussed in this proposal were required on a quarterly basis, market participants would very effectively use them to make judgments about the quality of earnings being reported. In short, earnings management might be uncovered sooner and more efficiently when the market is provided the tools for analyzing such behavior.1 Currently, there is a serious lack of information for monitoring and evaluating such conduct.
Another benefit of the information provided by the proposal is that it might prevent earnings management from occurring. Firms linked to earnings management issues see their stock prices suffer mightily when such actions are exposed; making it easier for market participants to uncover earnings management would provide a powerful incentive for managements to avoid such conduct. Reputational capital is not an asset that managements care to squander.
I have no doubt that this proposal will be met with howls of disagreement from the corporate sector. The typical responses that I would expect to hear: this information is too costly to provide; it's not something that analysts and investors want; and financial statements are already too complex and full of information that nobody uses. I disagree with all of these arguments. First of all, the information requested is no different than what should be routinely prepared by a firm's accounting staff for the outside auditors to use in their year end audit work; it should be part of their analytical review of quarterly financial information, as well. There's no reason to believe that the preparation of these schedules should appreciably increase the cost to produce financial statements, even if they are provided on a quarterly basis - unless insufficient attention was being paid to these accounts in the first place.
With regard to the second argument: it's true that analysts and investors do not often pick up pen and paper to request of the SEC or FASB that certain information be built into the financial statements. That doesn't mean they're satisfied with the status quo. Analysts and investors don't care for the baggage that accompanies the demise of firms that find the bottom of the bag of accounting gimmicks. Most analysts I know are concerned about managed earnings and misleading financials, and would be eager to analyze the kind of information proposed in this document if it were available. Oftentimes, analysts and investors are simply not familiar enough with the due process of the SEC and the FASB to take the time and inform them of their concerns.
As for the third argument: financial statements are more complex than they used to be because modern business is more complex than it used to be. I believe the information to be required by this proposal would be widely used, because it addresses many of the concerns harbored by analysts.
Those are my general comments. I would also like to address the specific questions put forth by the Commission in the proposal.
1. Are there other specific loss accrual or valuation accounts that should be added to the list of accounts identified within proposed Item 302(c)?
I believe that the list of items identified in the proposed Item 302(c) is complete, but I appreciate the fact that it is not a restrictive list.
2.Should specific percentage tests be used to trigger specific account disclosures within the proposed rules? For example, should disclosure of loss accrual account activity be required only when the balance sheet item and change during the period exceeds a certain pre_established numerical threshold (for example, 5% of total assets or 3% of pretax income)? If so, what is an appropriate threshold?
I do not believe that "trigger tests" should be applied to this information. I believe it should be presented irrespective of balance sheet or income statement size tests; if a simple bright line is created, I believe that some companies will actively work to slide under the threshold. Ironically, those are the companies whose behavior needs to be displayed in this information.
3. Should the placement of the proposed data be moved within MD&A or to some other section of the filing to enhance the prominence of the disclosures?
I believe that the placement of the data in the MD&A would be an improvement; the financial statements would fit together more cleanly if one could directly compare the assertions made in the MD&A with the information provided by these schedules. In fact, the best treatment might be to have these schedules woven directly into the discussion of operations.
If the schedules appeared anywhere at all in the financial statements, however, it would be a great improvement in financial reporting.
4. Should presentation of the proposed data be limited to the Form 10_K?
I believe that the information would be best presented in the annual report to shareholders, where other useful information already resides.
5. Should the disclosure requirements be restricted to those registrants that exceed a certain size or meet some other threshold? If so, what would be the appropriate threshold?
I don't believe that such requirements should be restricted to registrants of a certain size or other threshold. The kind of behavior which this information would reveal is not restricted to companies above a certain threshold, so providing an exemption to companies of a lesser size might be tantamount to giving carte blanche to earnings management that can be kept hidden.
As a matter of fact, the COSO Report issued last year indicated that small companies were often engaged in abusive accounting practices. If that's the case, the argument for requiring these disclosures for smaller companies is strengthened further.
6. Are there circumstances where registrants may appropriately exclude disclosure about loss accruals related to litigation because of concerns about confidentiality while still conforming with GAAP? If so, please describe such circumstances in detail.
I would oppose exempting disclosures related to litigation loss accruals on the grounds that they would then become the "earnings management account" of first resort.
7. Should the disclosures concerning valuation and loss accrual account activity be required when interim financial statements are presented?
The information should appear in every 10-Q as well. Earnings management can occur every time earnings are reported, and these schedules will help analysts and investors to detect such activities. In accounting trade publications, one can often find companies boasting of how they have taken advantage of the tremendous advances in the automation of financial information production in order to shorten the process of closing out books at the end of an accounting period - and to improve the information provided to management. Why shouldn't shareholders and other users of financial information be provided the same benefits? There should be no reason that this information cannot be provided on a quarterly basis; I believe that it would provide only an unalloyed benefit to the markets.
8. Should the disclosures concerning changes in property, plant, equipment, and intangible assets and related accumulated depreciation, depletion, and amortization be required when interim financial statements are presented?
Those disclosures should be required on an interim basis as well. A company may "make its numbers" by selectively selling individual long-term assets and realizing a gain; such actions are undetectable in the financial statements without the kind of information these schedules provide.
To conclude, I would like to thank the Commission for proposing such an improvement to the financial reporting process. The information it provides is very basic and useful, and would be greatly utilized by many market participants. If you need elaboration on any of my comments, do not hesitate to contact me.
1 See the attached Barron's editorial, "More Second-Guessing," August 24, 1998.