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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks to the 39th Annual Corporate Counsel Institute

by Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

Northwestern University School of Law
Evanston, Ill.

October 12, 2000

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 Professor Ruder for that generous introduction. David has long been a friend of investors, the markets and the SEC.

Today, our markets and investors in those markets are enjoying the longest sustained period of economic growth in the history of this great country. In fact, the U.S. capital markets have been able to attract one-third of the total wealth of this country. The 16 trillion dollars invested in the U.S. markets (by 80 million investors from around the globe) is equal to approximately twice the country's GDP.

And why are the U.S. capital markets so competitive and able to provide capital for so many companies? It is because investors know that the markets provide greater liquidity and higher returns than can be achieved elsewhere. Those same investors have great trust and confidence in the timeliness and quality of the information they receive from registrants. And it is high quality financial reporting that serves as the foundation upon which that trust and confidence are built.

But today, companies and their management are under constant pressure to make their numbers. Stocks of companies are trading at multiples that can only be justified if management can generate revenue growth of 20 or 30 percent or higher each year. And with each quarter comes the analysts' expectations for the bottom line. An expectation that if missed, will often result in a domino effect of lower earnings estimates for the future, corresponding decreases in price/earnings ratios, and a devastating decline in market capitalization. Such decreases can be especially punishing for those companies who use their stock as a currency for compensating executives and other employees, negotiating with suppliers and customers, or acquiring other businesses.

As a result, the temptation for a CEO or CFO to play the "Numbers Game" today is great. The average shelf life of a CEO today is fewer years than you can count on one hand. And CFO's seem to come and go all too often when a company misses its target.

No wonder then, as surveys in CFO magazine and Business Week have documented, there are those business executives that have pressured the CFO to make the numbers. Rather than managing the business, they chose to manage the numbers.

Let me note a story about one of our country's great leaders from Illinois, President Abraham Lincoln. Abe Lincoln is supposed to have thrown a man out of his office after being offered a bribe. The bribe involved a substantial sum, and Abe was really angry. His anger was directed at the man in question, but also at himself. He is reputed to have said, "Every man has his price and he was getting too close to mine."

Abe's insight is worth remembering. None of us are immune to every offer of individual benefit. Unfortunately, unlike Lincoln, there are those who do not recognize that their price has been met until it is too late.

As Corporate General Counsel and Securities Counsel, you too can play a pivotal role in keeping the price of manipulating financial reporting and corporate disclosures too high. As a CFO, I often found the advice of our General Counsel extremely valuable in navigating through difficult issues. I also found him to be an advisor whose counsel ensured we in the management team avoided decisions and actions that could quickly turn into whirlpools from which we could not escape. With that in mind, let me chart for you a map of some of the issues the staff of the Commission is focusing on.

Earnings Management

You would have had to have been in another galaxy or at least another line of business not to have heard we are focusing on inappropriate earnings management. Premature revenue recognition, accruals of future losses and general "reserves" or "cushions," use of unsupportable depreciable lives, and misapplication of the concept of materiality have all been the focus of SEC staff reviews and comments.

In addition, the Division of Enforcement also has stepped up its activity in investigating cases involving financial fraud, in particular inappropriate earnings management. The Division has created the Financial Fraud Task Force under the able leadership of Charles Niemeier. This Task Force is focusing on companies, their management and auditors when the financial statements reflect inappropriate earnings management or other financial reporting or disclosure practices that are not in compliance with Generally Accepted Accounting Principles (GAAP). Too often these abusive practices result in investors losing millions and billions of dollars. As recent cases have shown, the Commission has been willing to use all the remedies available to it including fines, officer and director bars, professional bars, and working with other law enforcement agencies to bring criminal changes in these areas.

Audit Committees

We hope the practices set forth in the Report of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees, as well as the new rules adopted by the stock exchanges, the accounting profession and the Commission will contribute to an improvement in the quality of financial reporting in our capital markets. I would encourage you to discuss with your audit committees, not only the recommendations of the Blue Ribbon Committee, but also the Best Practices set forth in its Report. These practices are set forth in five principles which address the oversight role and responsibility of the audit committee, including the need to oversee both the internal and external audit functions, ensure independent communication with the internal and external auditors, engage in a robust, candid, and probing discussion of the quality of the Company's financial reporting and disclosure practices, and adopt measures to ensure outside auditor's objectivity.

I also strongly encourage audit committees to seriously consider the recommendations of the Panel on Audit Effectiveness, commonly referred to as the O'Malley Panel. Included in these recommendations are:

  1. The audit committee should obtain each year from management, a report on the effectiveness of the Company's internal controls,
  2. Audit committees should pre-approve non-audit services provided by the independent auditor, and
  3. In making the determination of what non-audit services should be approved, the audit committee should consider the following ten factors which are designed to determine if the service has an impact not only on how investors will perceive an auditor's independence, but also on how the services affect audit quality:

    a. Whether the service is being performed principally for the audit committee.

    b. The effects of the service, if any, on audit effectiveness or on the quality and timeliness of the entity's financial reporting process.

    c. Whether the service would be performed by specialists (e.g., technology specialists) who ordinarily also provide recurring audit support.

    d. Whether the service would be performed by audit personnel, and if so, whether it will enhance their knowledge of the entity's business and operations.

    e. Whether the role of those performing the service would be inconsistent with the auditors' role (e.g., a role where neutrality, impartiality and auditor skepticism are likely to be subverted).

    f. Whether the audit firm personnel would be assuming a management role or creating a mutual or a conflict of interest with management.

    g. Whether the auditors, in effect, would be "auditing their own numbers."

    h. Whether the project must be started and completed very quickly.

    i. Whether the audit firm has unique expertise in the service.

    j. The size of the fee(s) for the non-audit service(s).

I believe the Panel, which included respected corporate board members and representatives of the legal profession, developed an outstanding list of factors. I urge each and every audit committee to seriously consider them as they determine if it is appropriate to approve a specific non-audit service provided by the independent auditor.

During the four days of public hearings the Commission recently held regarding auditor independence and the accounting profession, we heard from a number of prominent members of audit committees. They commented that audit committees also need to ensure that the audit fee is reasonable and is sufficient to permit the auditor to perform a high quality audit. Comments also were made that the audit committee should also inquire as to whether the audit partner's compensation is tied in any way to the cross selling of any non-audit services.

Three Intriguing Questions

Let me close off my comments on audit committees by noting some recommendations Warren Buffet has shared with us. Mr. Buffet has stated that each audit committee should ask their auditors three intriguing questions:

  1. If the auditor were solely responsible for preparation of the company's financial statements, would they have been prepared in any way different than the manner selected by management? The audit committee should inquire as to both material and nonmaterial differences. If the auditor would have done anything differently than management, an explanation should be made of management's argument and the auditor's response.
  2. If the auditor were an investor, would he have received the information essential to a proper understanding of the company's financial performance during the reporting period?
  3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

The answers to these questions really indicate whether, if the auditor was running the company, the same financial statements and disclosures would have been published and the same internal controls would have been established.

Staff Accounting Bulletins

Let me move on to the Staff Accounting Bulletins (SABs) the staff issued as part of the earnings management initiative. These SABs were on the topics of materiality, restructurings and asset impairments, and revenue recognition.

With respect to the SAB on materiality, the U.S. Court of Appeals for the Second Circuit stated in a recent decision that " SAB 99 is thoroughly reasoned and consistent with existing law--its non-exhaustive list of factors is simply an application of the well-established Basic analysis to misrepresentation of financial results--we find it persuasive guidance for evaluating the materiality of an alleged misrepresentation." (Joseph A. Ganino v. Citizens Utilities Company 2000 U.S. App. LEXIS 22493, at #8 (2nd Cir. 2000). They also noted that two of the factors set forth in SAB 99 were of particular relevance to the case at hand. They were:

  1. Whether the misstatement masks a change in earnings or other trends, and
  2. Whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.

I would like to remind you of a couple of additional key points addressed in SAB 99. First, a few companies in the past, in select industries, have adopted accounting practices that are not in accordance with GAAP. Those companies initially would argue the amounts are immaterial and then when they became material, would argue they were industry practice and part of GAAP. In SAB 99, the staff rejected such an argument. Each and every company needs to follow acceptable accounting practices that are consistent with GAAP. The old argument of "all my competitors do it," just doesn't fly.

The second point reiterated in not only SAB 99, but also SABs 100 and 101 is that each company needs to have internal accounting controls that provide reasonable assurance with respect to the financial statements being prepared in accordance with GAAP.

I mention this because the staff has seen an increasing number of restated financial statements filed with the Commission in recent years. This rise in restatements is unfortunate for investors. And the number one reason for restatements is revenue recognition.

SAB 101 on revenue recognition provides four basic concepts necessary for revenue recognition, that are already set forth in various accounting standards. These four concepts include:

  1. There must be persuasive evidence that an agreement exists.
  2. The sales price must be fixed and determinable.
  3. Collection must be reasonably assured.
  4. Delivery must have occurred or the services rendered.

Since the staff issued SAB 101, we have received a number of questions regarding the application of its guidance as well as the various existing accounting standards on revenue recognition. To address these questions, the staff has worked closely with representatives of six of the accounting firms as well as a number of public companies to develop a list of frequently asked questions and the answers to them. That guidance is available on our website at www.sec.gov/offices/account/sab101fq.htm. I can also tell you that the AICPA Auditing Standards Board is developing additional guidance for auditors on auditing revenues in a client's financial statements.

The last SAB I will mention is SAB 100. This SAB reiterates the guidance in Statement of Financial Accounting Standards No. 5, Commitments and Contingencies, issued in 1975. That standard prohibits a company from setting up "general accruals" or "cushions." Yet with the issuance of the SAB, the staff has been asked, "What is the applicable guidance to follow if such an account exists?" The staff has responded by noting that SAB Topic 5F provides the applicable guidance.

“EBS” Earnings Releases

Let me move on to another topic that is receiving much attention in the financial press today. The issue is earnings releases. In particular, what I will call "EBS" or "Everything but Bad Stuff" releases. Today, we are seeing earnings releases published that convey an incomplete or inaccurate picture to investors. For example, I have seen earnings releases that present:

  1. Earnings before marketing costs,
  2. Cash earnings per share that bear no relevance to cash flows but rather are merely earnings adjusted to eliminate amortization of selected 4costs,
  3. Earnings before losses from new product lines,
  4. Any one or combination of the above, but with one time gains from sales of investments added back.

Such numbers generally are disclosed in the first part of a press release, and labeled as "Pro Forma" earnings. But often, they do not provide a clear or complete picture to investors. As a result, I counsel investors to be wary of such disclosures and the story being presented. I believe investors in such circumstances need to be sure they read the full Form 10-Q, where hopefully all the facts are presented in a complete and balanced fashion. I also encourage audit committees to consider the quality of the earnings press releases being issued today and assess whether they are in fact providing a transparent, clear picture to the investors they represent.

Analysts also need to play a more constructive role in improving the quality of press releases. Rather than just accepting the numbers management might set forth, the analysts need to get behind those numbers and understand the underlying story. The analysts need to challenge "pro forma" numbers that are presented as "cash earnings" when in fact they are not.

I believe if the members of the financial and business community, including financial executives, analysts and the accounting profession, are not able to stem the tide of unbalanced and incomplete earnings releases, a regulatory response might be necessary.

Management's Discussion and Analysis

Last but not least, the staff continues to focus on Management's Discussion and Analysis (MD&A). This is a vital and important component of the disclosures a registrant is required to provide investors and the markets. As the Commission has stated, MD&A should "give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant's financial condition and results of operations, with a particular emphasis on the registrant's prospects for the future."

As you prepare this year's MD&A, there are a number of developments that will be relevant to a company's disclosure. First, oil and gas prices have climbed, increasing utility, transportation, production and other costs. In addition to rising costs for oil and gas, the economy has experienced an increase in interest rates that could affect a company. As FRR 36 states, registrants are required to disclose such events unless they are immaterial or it is remote they will have a material effect on a company's liquidity, financial condition or results of operations.

As a result of the changes in the stock market or as a reaction to business conditions, some companies have initiated treasury stock acquisition programs. Sometimes these are accomplished by increasing the borrowing of the company which in turn will increase interest costs. The impact on trends of earnings, including earnings per share, interests costs and liquidity, can all be materially affected by such treasury stock programs. In such instances, disclosure of the programs and their impact would be required.

The changing values in the stock markets and interest rates also can have a significant impact on a company's pension plan, and the cost and funding requirements of the plan. The staff has noted some companies have had significant decreases in pension cost, and in some cases, even pension profits being generated. Where events affecting pension plans are material to a company's results of operations, financial condition or liquidity, those events and their effects should be disclosed in MD&A. Failure to provide required disclosures would result in a registrant needing to file an amended Form 10-K.

Another development in the making is an increase in the level of activity in financings involving highly leveraged transactions or companies. As we all experienced in the 1980's, and Asia in the 1990's, such transactions can have very significant effects on both lenders and borrowers. For that reason the Commission has explicit guidelines for disclosure of highly leveraged transactions in MD&A. It is important that investors understand what impact or potential material impact these transactions might have on a registrant.

The level of merger activity has also been on the rise in recent years. With that activity and a growth in product offerings, comes the need for registrants to assess the need for the proper segment disclosures in MD&A and business sections and financial statements included in the filings with the Commission. Too often we are finding material information being provided to management or selected analysts which has not been properly reflected in the company's filings.

I have also noted that the decline in the value of the euro is affecting some companies. Consistent with the position the Commission has taken in several enforcement cases in the 1990's, I urge companies to appropriately disclose the impact that changing values in currencies, such as the euro and dollar, are having on their operations.

Last but not least, in second and third quarter earnings releases, some companies have noted a slow down in their sales and sales growth rates. SAB 101 contains a discussion of a number of items that can materially affect a company's revenues and financial statements. I would encourage you to review the disclosures noted in SAB 101 as you prepare your MD&A for the current year.

Audit Risk Alert Letter

As it has done in previous years, the staff has prepared what we often call our audit risk alert letter. That is because we provide it to the American Institute of Certified Public Accountants in connection with its preparation of the annual risk alerts to auditors. This letter addresses a number of issues the staff is focusing on in our reviews of filings and we hope providing our thoughts to you in advance of your preparation of this years' filings will be helpful to you. That letter is available on the website at www.sec.gov/offices/account/audrsk2k.htm.


I hope I have provided you with a useful list of items that are receiving the staff's attention at the Commission. We look to you, the Corporate and General Counsels, to provide guidance to your boards and management teams. By working together, I believe you can and will make a significant contribution to improving the quality of information your shareholders receive.

Thank you.