Speech by SEC Staff:
Remarks Before the AICPA National Conference on Current SEC Developments
by Charles D. Niemeier
Chief Accountant, Division of Enforcement,
U.S. Securities & Exchange Commission
December 5, 2000
Good morning. I am the Chief Accountant for the Division of Enforcement. You should know that my views are my own and are not necessarily those of the Commission or the Staff.
Approximately 2000 years ago, the Roman Empire was at its height. Its might and influence spread throughout a substantial portion of the world. In their day, the Romans built an incredible system of roads that allowed trade to expand and flourish between countries. They developed a great system of laws and rules based upon principles of justice and fairness for all Roman citizens. They also built great buildings and monuments as testaments to their greatness. Never before had such prosperity been witnessed.
Today, we have surpassed the prosperity of the Roman Empire. We are now truly living in the most prosperous of times. We have a new economy built substantially on an ever-improving information highway. And in this new economy, American business is the centerpiece. English is the language of business all over the world. And, our financial markets are the envy of the world.
And yet there is one basic thing that distinguishes our markets. That one thing is integrity. It is what makes our markets strong. Without it, our markets would not be able to attract the large sums of money that they do. Those funds would seek safer havens, the multiples would fall, and the new and the old economies would falter.
Why do our markets have integrity? It is because we have the greatest financial reporting system in the world; a financial reporting system built squarely on the shoulders of the accounting profession. You, the accounting profession, are the gatekeepers of the integrity that makes our markets great. Yes, I mean you - whether you are in audit, tax or consulting. Accounting is not just for breakfast anymore.
In the dynamic and rapidly changing environment in which we live, many disciplines are required to maintain the strength of our financial reporting system. But we must not use that as an excuse to forget the basic principles that have made our profession so great. We must never forget the foundation on which the accounting profession was built and which continues to be the cornerstone of our financial reporting system today. Without the audit opinion and the credibility for which it stands, financial statements are mere numbers on pieces of paper.
Today, our financial reporting system is under pressure to improve and evolve. In that regard you, the accounting profession, and we, the SEC, are challenged to meet the demands placed on our system by the new economy. I have great faith that together we will be able to meet those challenges. However, through whatever transformations our financial reporting system may undergo, one thing must remain constant. At all times, we must maintain the credibility that has made our system great. We must never lose sight of the ultimate goal of our system to provide investors with reliable information on which sound investment decisions can be made.
Every time there is a financial reporting failure, a piece of the wall that protects our financial markets is chipped away. It is too easy for us to read about a financial reporting failure and dismiss it as an anomaly or an inevitable cost of doing business. We don't give it a second thought. Why should we? Our markets are strong. We live quite comfortably. And, there is no end in sight to our prosperity. Or is there?
In 410 A.D., the barbarians descended down on Rome from the north and plundered it. So marked the end of the Roman Empire's greatness. Although the barbarians overran the Roman Empire, they did not destroy it the Roman Empire destroyed itself. The seeds of its destruction had been sown years before. Blinded by success, the Roman leaders took the prosperity of the Roman Empire for granted. They believed that their prosperity would never end. They compromised the principles on which the Empire had been built with acts of self-indulgence fueled largely by greed and ambition. By the time the barbarians arrived at the gates of Rome, the might of Rome had already been lost.
We at the SEC believe that today our financial reporting system is strong and intact, but over the last few years, we have seen a trend a disturbing trend. Financial reporting failures have become more frequent. For the last several years, the number of restatements has increased each and every year. And, the size of those failures and the size of the companies involved have become much larger. Even though we believe that the large majority of companies fairly state their operational results, we are troubled by the signs of weakness that we have seen.
We have been forced to ask ourselves how can the largest companies in our financial community - the pillars of our markets - be susceptible to such accounting failures? What we have found is that no company is immune. We have found that sometimes the years of success can actually help to contribute to the creation of an accounting failure.
Almost all accounting failures begin subtly. And usually, at least in the beginning, some form of justification is given for misstating the financials. Perhaps:
- A company has a down quarter.
- It justifies smoothing the earnings for that quarter, because they are inconsistent with other periods and the downturn is viewed as only temporary.
- Then, the down quarter becomes a down year,
- Oh, but there is still no need to panic,
- The company has been successful for years and it has been through similar downturns. It has always been able to overcome them.
- And, besides the company has a great plan to overcome this one.
- Then, the unbelievable happens. The great plan to revive the company fails.
- The first down year is followed by another. In part, because revenues and earnings had been borrowed from the second year to improve the first.
- To cover the hole in the second year, the misstatement in the second year is much larger.
- Eventually the company's deep dark secret can no longer to be hidden.
- Upon revelation, billions of dollars of shareholder value are lost overnight as the company's true financial results become known.
In the last few months, we, at the SEC, have issued three Staff Accounting Bulletins to address the trends that we seen. These Staff Accounting Bulletins are all about getting back to basics. They are based on the principles that give integrity to our financial reporting system. Their focus is on providing good and reliable information to the financial statement reader.
First, what in financial statements is material? It is that which is important to a reasonable investor in making an investment decision. And what is important to a reasonable investor?
Reasonable investors want to know:
- Whether the company was able to reach its revenue or earnings targets.
- Whether the company was able to accomplish what it said it was going to achieve.
They also want to know:
- What the company's recurring operating results are.
- And, how much of the company's revenues, expenses and earnings are recurring.
Additionally, they want to know:
- Whether those recurring operating results are going up or down when compared to other periods.
If the financial statement reader is misled as to any of these things then the financial statements are materially misleading.
Just as investors tend to focus on the recurring nature of things, they also tend to discount non-recurring events, such as one-time gains and restructuring charges. Therefore, it is important that restructuring charges and other one-time events not be used to either bury the sins of the past or to set up cookie jar reserves that can later be used to inappropriately improve operating results. Either way, one-time events must not be used to disguise the true operating results of companies.
And, what is the line item in financials that is most often misstated in financial fraud cases? It is undoubtedly revenue. And, in an economy where many companies do not have earnings the significance of revenue is paramount. Yet, in approximately 50% of our financial fraud cases, revenue recognition is a serious problem.
We, at the SEC, believe that the messages in these Staff Accounting Bulletins are important. But, I must also tell you that they will have little impact, if the principles on which they are based are not adhered to. They will be ineffective, if they are simply used as guideposts to find ways around them. Let's face it, there is always a way around a rule. And in accounting, we have rooms full of literature containing rules. There are those that would use our training, use our knowledge and use our expertise in accounting to find ways to circumvent these rules. They want to use the accounting profession as a tool to improperly inflate financial results. If we allow that to happen, then we will have compromised the basic principles that have made our profession great. Once Rome had lost sight of its principles, its impressive system of rules could not protect it. And, neither can our rules protect us, if we lose touch with the basic goal of providing reliable information to investors.
Today, companies are under more pressure than ever to improve their operating results. And, when they cannot do so legitimately, there is a great temptation to turn to accounting. As accountants, we must not allow accounting to be used as a profit center. We must not allow ourselves to be corrupted by those that want to use the accounting profession for their own personal gain.
If history serves as any guide, the barbarians will someday arrive at our gates. And perhaps a better view is that those who would plunder our great markets for their immediate gain are always at our gates. In either event, we need not fear them. That is, we need not fear them as long as we maintain the wall of integrity that protects our markets. What we do have to fear is becoming complacent and taking our successes for granted. We must recognize that our financial markets are vulnerable. We must especially recognize this vulnerability in prosperous times, because that is when we are most susceptible to becoming complacent. We must also recognize this vulnerability in periods of transition because that it when our principles can be lost most easily in the lack of focus that often occurs during times of change.
We at the SEC need you, and believe it or not, you need us. But more importantly investors need us to work together. Because by working together, we can maintain the integrity of our markets through prosperous times and through those that are not so prosperous, as well as through times of transition.
You are the first line of defense. It is now your time to guard the gate. Those that guarded it before you did a remarkable job. But now the future of our great financial reporting system is in your hands. And, to all of you that have chosen this great profession, and on a daily basis, fight the good fight I salute you.