Remarks to SEC Government-Business Forum on Small Business Capital Formation
Peter J. Wallison
Resident Fellow, American Enterprise Institute
September 29, 2006
These remarks will be about financial disclosure and how it can be improved. This is not just an issue for the SEC or the lawyers and accountants who follow its work. It is and should be a matter of concern for all of us. Ultimately, better disclosure improves the allocation of capital, which enhances productivity and economic growth.
A surprising and troubling fact about financial reporting is that sophisticated investors, managers and analysts-the people who know companies best-don't regard financial statements as a particularly valuable source of information. In survey after survey, financial reports rank way down the list of information that company managers and analysts say they want to know in order to determine whether a company-in some cases their own company-is creating or destroying value.
For example, while ordinary investors and the media consider GAAP earnings the most important information to know about a company, managers think that strategic direction is most important and earnings are eighth on their list. Analysts think market growth is most important, and earnings are fifth.
This is one of those facts that is well known in the financial world, but never seems to seep into the Washington mind. So we have Congress, in the Sarbanes-Oxley Act, creating a whole new regulatory structure-the Public Company Accounting Oversight Board-to make rules for the auditing of financial statements that many sophisticated investors, company managers and analysts don't think are worth much attention.
There are many reasons for the low regard in which financial statements are held. Financial statements tell us something about what happened in the past, but little about what will happen to a company in the future; much of the most important data in a financial statement-the collectibility of receivables, the productive lifetime of equipment or a line of products, or the return a company will be able to earn on its pension fund investments-are matters of simple guesswork by management, are easily manipulated to show a steady growth in earnings over time, and can't be effectively audited.
Most important is the fact that the overwhelming majority of the value now generated by American companies is in the form of intangible assets, which cannot be effectively valued by the cost-based system that is imbedded in Generally Accepted Accounting Principles (or GAAP).
This is because we have now entered the so-called knowledge economy, where value is created by such intangible items as intellectual effort or relationships with suppliers or customers rather than the production of material things by physical plant and equipment.
Let me give you an illustration. In the mid-1990s, AOL was a sensational growth stock. Its growth was driven by a unique method of attracting new members. AOL sent out floppy disks, more or less to everyone likely to have a computer, giving people who owned computers an opportunity to try AOL's services and sign up if they liked what they saw.
At one point, before Yahoo and others began to offer free services based on advertising rather than membership fees, AOL had over 20 million members. Clearly, AOL's membership list-its relationship with its customers-was its most important asset. Not only did its customers pay fees, but advertisers would also pay to reach them. However, that asset was not on AOL's balance sheet.
In 1998, the SEC sued AOL for capitalizing the costs of the floppy disks it sent out and required the company to restate several years of financials so that the costs of this promotional effort were written off in the year in which they occurred.
This was strictly in accordance with GAAP, since GAAP-a cost-based system-does not allow the capitalization of speculative expenses such as advertising or promotion.
However, if you looked at AOL's balance sheet after 1998, you might have wondered what assets were generating so much revenue. The answer is that there was an intangible asset lurking in the background-the company's customer list-developed at great expense (those disks) but not recorded on the balance sheet.
Now you may be thinking that the balance sheet isn't really important-that what's important in today's world is earnings per share-but consider this: The whole purpose of GAAP is to bring into the same accounting period both the revenues and the costs associated with generating them.
The principal way this is done is to amortize or depreciate productive assets so that when these costs are subtracted from revenues it is possible to tell whether the company is earning a profit.
If the asset that is generating the revenues is not on the balance sheet, it can't be depreciated and earnings are hopelessly distorted.
Thus in AOL's case, its earnings were understated in the years in which the company had to write off its promotional costs-even though it was creating its most important asset by doing this-and overstated in the subsequent years in which it was reaping the benefits of these revenues without any associated depreciation costs.
This is an example of how GAAP fails adequately to account for intangible assets, and since about 80 percent of the value generated today by the S&P 1000 has been estimated to be in the form of intangible assets-computer programs, pharmaceutical designs, brand names, employee skills, and contractual relationships with customers, co-venturers and suppliers-it's easy to see why investors are wary of financial statements as a means of measuring the value of a company.
In the case of AOL, there is another factor that investors would have liked to have understood a little better-the quality of the company's management. What's clear now is that while AOL had hit upon a genuinely inspired marketing strategy, it didn't have the management resources to respond to the competitive challenge that arose when companies such as Yahoo and Google began to attack its customer base with their very different business models.
Again, financial statements by themselves will never give investors a clear picture of the resourcefulness of the management and the employees of a company. There may be a way to do this, however, and I will get to it later in these remarks.
The accounting profession has known for about 25 years that financial statements were gradually losing their value, but as long as the media kept focusing on earning per share, and Congress and the SEC kept making laws and adding regulations that assumed that the most important thing to do for investors was to improve the accuracy or the auditing of financial statements, most accountants just kept plowing the same furrows.
Meanwhile, the wheels of bureaucracy and our tort system ground on, so that financial accounting has become more detailed and complicated, more expensive to prepare, and an even greater source of liability.
Things have gotten so bad that even people in Washington are noticing, and there are some steps toward reform underway. But as long as the financial press is made up of former English majors, and the SEC and Congress are dominated by lawyers, it will be a long struggle.
The good news is that some of the reforms-when they occur-will do more, proportionately, for small companies than for large ones.
This is true because the most promising changes will make it just as easy for analysts and investors to get useful information about small companies as large ones, and the important aspects of the business of small companies will be more sharply defined in the future.
Because of all this new activity, there are four issues you will be hearing a lot about in the future: complexity, convergence, interactive data and enhanced business reporting. I'll describe all of them, but the first two seem to me to be a good deal less promising-especially for small and mid-cap companies-than the third and fourth.
Complexity has several elements, including the sheer number of releases, rulings, pronouncements, guidelines, bulletins, standards and interpretations that rain upon the public company landscape daily. You all know what I'm talking about, but this statement of the problem focuses only on overburdened issuers.
This is serious enough, but there is another side to the complexity issue that refers to the bewildering detail with which investors are confronted. There are groups now forming, with the tacit or active support of the SEC, AICPA and the FASB, to address a problem that may be stated as follows: there is so much detail in financial statements and footnotes today that it obscures the important things that investors should know about a company.
It would be great if financial statements could be slimmed down, but I don't see this happening until the tort system is fixed, and that won't happen until a consensus forms about how wasteful and arbitrary it is.
It's the private class action system, and the SEC's own enforcement process, that is driving ever more complex financial statements, and I have trouble imagining how financial statements can be made simpler without giving rise to litigation about the things that were left out. I'm happy to see that people are recognizing complexity itself as a problem-it's the first step on a long road-but no one should expect reforms to happen soon.
Convergence refers to an effort to reconcile the differences between GAAP and International Financial Reporting Standards (known as IFRS). This is the accounting system used in the EU.
Why should we try to do this? Because it would be good for investors if they could diversify their investments into good foreign markets, and good for American companies if they could tap the deep capital markets in Europe and Japan.
The conventional view of many at the SEC is that Americans should not be allowed to invest in foreign markets until GAAP and IFRS converge into a single system of financial reporting. Until that occurs, the SEC believes, it will be too risky to allow U.S. investors to buy the securities of companies that issue their financial reports in IFRS. And as long as the SEC takes that view, European and Japanese markets will not make their facilities available to U.S. investors. They may also retaliate by refusing to allow U.S. companies to offer securities in their markets with financial statements in the GAAP format. The timetable for convergence is something like 2009.
I have said enough already to indicate that I don't believe it is worth the time or the intellectual effort to bring about a convergence of IFRS and GAAP.
Both are cost-based systems of financial accounting, and are thus effective forms of disclosure only for companies that create most of their value through the use of tangible assets such as plant and equipment.
Even if the two systems are somehow brought into some sort of conformity, they will soon diverge again under the political pressures that will be brought on them as the economies in which they function continue to evolve.
Instead, we should open up our markets immediately, and let foreign companies that wish to offer their securities here use IFRS rather than GAAP, but disclose that they are doing so. Investors who are uncomfortable about investing in companies that are not using GAAP can stay away; those who think that IFRS is likely to be as good, or better, than GAAP will have alternative investments.
Under such a mutual recognition arrangement, the EU will allow U.S. companies to issue securities in their markets, using GAAP financials and avoiding the expense of converting to IFRS. The fact is that there is just not enough difference between the GAAP and IFRS systems-given their inherent deficiencies-that would justify either serving as an obstacle to a globalized capital market.
As in the case of complexity, despite all the thought being given to the subject, I don't see any major benefits for small and mid-cap companies any time soon.
But Interactive Data is a different kettle of fish altogether, and if it becomes the standard for financial statement disclosure in the United States, it offers some real potential benefits for small and mid-cap companies. Interactive data is SEC Chairman Cox's term for the techie-sounding system called eXtensible Business Reporting Language, or XBRL.
XBRL is basically a set of definitions that in effect converts the different words and concepts used by companies in their financial reports into a common computer-readable language.
You might think of XBRL as like a bar code; it is not readable by human eyes, but it contains information that the computer displays in human-readable language.
Thus, companies can call the top line in their financial reports sales, or revenue, or turnover, but each of these terms is translated into XBRL with the same meaning. If a company's top line is ordinarily stated net of discounts, that also receives a special and slightly different XBRL tag.
By making financial statements machine-readable, XBRL allows the financial statements of multiple companies to be searched in a matter of seconds, and any specified data extracted and displayed in a spreadsheet.
Let me give you an example. If you want to know the EBITDA (earnings before interest, taxes, depreciation or amortization) of all the companies in the pharmaceutical business, you could do this by downloading their financial statements, searching for the components of this number and inputting these elements one by one into a spreadsheet-a hugely time-consuming activity.
However, if you were searching financial statements that were prepared for use in XBRL format, you could search the financial statements of the entire pharma industry and array their EBITDAs in any way you want, in seconds.
It should be obvious, then, that this system is more likely to result in an analyst searching out and finding this number for small and midcap companies.
In the discussion this morning, most of the talk was about the numbers that appear in financial statements, but we shouldn't leave the impression that interactive data is only useful for financial statement numbers.
Interactive data, or XBRL, can also be used for text disclosures, and in the same way. As long as a text disclosure is consistently defined, it can be searched and displayed as easily as a number.
For example, many oil companies disclose their oil and natural gas reserves in their financial reports. This number usually appears in a footnote text discussion of the issue. As long as all companies define reserves and identify the text as a discussion of reserves, XBRL would allow a computer, in seconds, to compare all their reserves.
In the same way, XBRL will also make MD&A discussions in the prospectus more useful to investors by facilitating comparison between companies. For example, if an MD&A contains a discussion of market share, this data will also be searchable in all filings and displayed in seconds in a spread sheet. This will also make things easier for issuers, because the company's data system can be structured to keep track of data on market share or reserves, and plug it in automatically as the 10-K is being prepared.
Finally, there is enhanced business reporting. I would be surprised if many of you have heard much about enhanced business reporting, or EBR, since the idea is still in the germination stage.
It's an effort to make up for the deficiencies of GAAP that I described earlier by identifying the elements that drive increases in company value in each industry, and developing metrics that will measure a company's performance with respect to each of these elements.
The value drivers are called key performance indicators (or KPIs), and once they are in place for an industry it will be possible to compare companies on this basis as well as their financial performance in GAAP terms.
The relationship between XBRL and EBR is very close. XBRL is about format; EBR is about substance. If the substance-the information about companies that goes beyond the financial statements-can be developed effectively, XBRL provides the format through which this information can be quickly and inexpensively searched and used.
Well, what information is missing?
As I noted earlier, GAAP financial statements are losing their usefulness and disclosure value as, increasingly, companies create value through the development and deployment of intangible assets.
I used the example of AOL, but there are many, many others. When a company creates a new software program, it does so through the ingenuity of its employees, but their salaries are written off under GAAP. Even if the salaries were capitalized, they would have only the vaguest relationship to the real value of the software.
This is quite different from the old world of manufacturing, where companies would purchase equipment to produce their products. This equipment had an arms-length cost that was recorded on their balance sheets and was depreciated over time. The depreciated value of the plant and equipment on balance sheets, reduced by liabilities, was a rough estimate of the value of a company.
So, in the 1970s, the market value of companies was roughly equal to their net asset value, a 1-to-1 ratio. By the late 1990s, this ratio was 6-to-1. It has now declined a bit to the 5-to-1 range according to numbers I've seen recently, but the point is that investors now have no clear source of information about the value of companies.
Balance sheets are no longer useful because of the dominance of intangible assets that are not recorded there, and earnings are a volatile indicator that says little about a company's future.
Most financial analysts prefer to discount cash flows-on the theory that cash is less manipulable than earnings-the expression often heard on Wall Street is that earnings are an estimate; cash is a fact-but discounting today's cash flows still involves a prediction about the future.
So, at best, sophisticated investors are guessing about whether companies are really adding value, and this is somewhat troubling when market-to-balance sheet ratios are at 5-to-1.
Surveys of sophisticated investors, corporate managers and analysts indicate that they prize information that financial statements and other disclosure documents do not now provide-information about management skills, employee retention rates, customer turnover rates, product development cycle time, employee and customer acquisition costs, and quality of intellectual capital.
These are important drivers of value for most firms, but their relative importance may vary from industry to industry.
In fact, there are key performance indicators that are unique and vital to understanding particular industries, but not important at all in others.
Productivity in exploratory activity may be important for an extractive industry, but not at all for a software developer. Speed in getting a product to market may be vitally important for a pharmaceutical company, but less so for a shoe manufacturer.
In other words, investors want and need information that is not currently available in company reports. And where it is available, it isn't reported in a consistent way by all companies so that the competing companies can be assessed or compared across these dimensions.
The purpose of EBR is to develop both the key performance indicators and to get them adopted by whole industries, so that these comparisons are possible.
Small and mid-cap companies have a big stake in this effort. As we have seen, when it gets too expensive in time or resources to follow both a small cap and a large cap company, analysts will transfer their efforts to the large cap company.
XBRL, as I noted earlier, makes it possible for analysts and investors generally to compare the information-both numerical and textual-that companies now disclose.
But this information is not sufficient for sophisticated investors and analysts fully to understand which companies are adding value and which are not.
For that, key performance indicators will be necessary, and if they are developed and deployed over time it will be possible for investors to gain a greater understanding of where their capital should be placed. Our markets will become even more efficient in allocating capital, and efficient small and mid-cap firms will get the attention from investors that they now find difficult to acquire.
In other words, technology in the form of XBRL, combined with the difficult intellectual effort of developing key performance indicators for all industries, could in the future level the playing field between large and small firms in the competition for capital.
So, how can this be done? There has been resistance by companies-they may be concerned about liabilities or giving too much information to competitors. These legitimate issues can be addressed. The important thing is to get started. The SEC has a role, consistent with its mission to advance the interests of investors: it should convene industry groups to develop KPIs. XBRL is a start-but it's only a format. The next objective is EBR.
Small and mid-cap companies have a major stake in these developments, and I urge you to follow them closely. Thank you.