SEC Speech: Past, Present, and Future (L. Turner)
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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Past, Present, and Future

Remarks by

Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

Securities Regulation Institute
Northwestern University, School of Law

January 24, 2001

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.

Thank you. The past couple of years have been an exciting time for those of us associated with the capital markets and financial reporting. We have been on a roller coaster that raced to its pinnacle early in the new millennium, only to drop at a pace that left many investors breathless. Yet despite such dizzying experiences and uncertainty, investors have maintained their confidence in our markets--markets that have attracted over 80 million investors, representing a third of our nation's wealth, fueling the greatest economic expansion that anyone in this room, in fact anyone in the history of this great country, has ever seen.

This was not an overnight success. Rather, it was the result of the diligent collective efforts of those in the legal and accounting professions, the corporate community, and Wall Street, who built and continuously improved our market systems and processes--people, who have always remembered that the investing public is our number one customer. People like Kennedy, Douglas, Landis, Cary, Cohen and now Levitt, just to name a few.

In the past couple of years, we have continued that tradition. Recent accomplishments include:

  • The Report of the Blue Ribbon Panel on Improving the Effectiveness of Audit Committees. This Report by a panel of representatives of investors, lawyers, accountants, stock exchanges, and businesses is causing more active corporate governance involving vigilant audit committees.

  • Improvement in the quality of earnings as a result of an initiative on inappropriate earnings management that would not have been successful without participants such as the "Big Five" accounting firms and the AICPA's Auditing Standards Board, who laid the groundwork for Staff Accounting Bulletin No. 99 on Materiality.

  • Over 200 recommendations issued by the Public Oversight Board's Panel on Audit Effectiveness (the "O'Malley Panel") to the accounting profession, audit committees, standard setters and regulators setting forth specific steps that can be implemented to improve the quality of audits and investors' confidence in the numbers.

  • Modernized and strengthened auditor independence rules that were the result of a passionate, public dialogue amongst all of the capital market's participants. This dialogue served a very useful purpose and provided helpful input into crafting a final rule.

  • New disclosure rules built on the principle that each and every investor has a right to get access to information at the same time, not after a select few have profited simply because they received it in advance.

  • And, at a time when just under 10% of the registrants are from foreign countries, a new international accounting standard setter was established with independent board members selected based on their technical competence, not their political or geographical ties. The leadership of the AICPA was a strong voice during this process, for a competent independent standard setter of the highest quality.

But we cannot rest on our laurels. One lesson I learned very well as a business executive was that if you don't take care of your customers, your competition will. Our competitors in a global electronically connected world are getting smarter, more aggressive and looking to improve on our "best practices." As a result, we cannot stand still but must continue to improve, to challenge ourselves, to advance the ball down the field, faster and farther than the competition. We must improve the quality of financial information by making it as transparent as a fine piece of steuben glass. We must ensure that it reflects economic reality.

And to that end, let me lay down a few challenges we need to meet.

Continuous Improvement in the Quality
of Financial Reporting

Investors need transparency. They need to see the results of the business through a clear glass, not a rose-colored glass, not through a kaleidoscope of unnecessary or misleading complexity, not through the eyes and words of a novelist, but through straight, non-fictional reality. And the words and numbers chosen to be disclosed are of tremendous importance to the investor in predicting future performance. Nothing less will do.

The accounting profession needs to continue to focus on the quality of the numbers, and quality of information going to the public, not just the acceptability of the numbers. In our information age, information is power and power resides with those who have information at their fingertips. They say that over 80% of Chief Executive Officers today use their information systems as competitive weapons. Given that change, we need to identify quality information that will provide useful information with predictive value to investors, and we need to make it available in a consistent, comparable, and relevant fashion.

I believe the FASB does have the opportunity to improve the quality and transparency of the financial reporting used in our capital markets. And if they fail to demonstrate the necessary leadership, I believe the IASC under the capable leadership of Sir David Tweedie will take up the charge. Investors now have a two-horse race to bet on. Let's hope it is a race in which we will see only the highest quality financial reporting at the finish line. A race by any standard-setters towards incrementalism or the lowest common denominator will only provide a disservice to investors and the capital markets around the world.

And without a doubt there is room for improvement. For example, most of us had to fly into this conference, yet few if any of us flew on an airplane included on any airline's financial statements. Leonard Spacek, a well known leader in the accounting profession, noted this specific problem decades ago and yet we still have not succeeded in solving this part of the numbers game. How can we look the public in the eye and say we really do have the public's interest in mind when such a cloud hangs over the product auditors opine upon?

Or what about a company that acquires entities many times smaller, and says it's a uniting of stockholders interests or a pooling as opposed to an acquisition? Does that really make economic sense? Show me the CEO who went into such a transaction with an opening line for the target of, "I'm not interested in buying your business, I just want to unite our interests!" Senator Gramm, while he raised many questions, recognized the problem with this view. In his opening statement at a Senate Roundtable on Goodwill earlier this year, he said, "The basic problem with pooling accounting is that when two companies merge, or one acquires another, by simply looking at book value, you create a balance sheet that in no way reflects the reality of the new company…"

And the standards we have today for determining when a business, or an intangible asset such as goodwill, or a manufacturing plant, has lost value are just not working. In fact, the leading indicator for accountants today of when an economic loss has occurred is a change in the CEO. In letters to the FASB, constituents such as Arthur Andersen and Ernst & Young have been critical of positions taken by the FASB on this issue. Arthur Andersen stated: "We think the Board's proposed impairment approach is a 'swing and a miss' on both conceptual and practical grounds." Ernst and Young also noted several practical shortfalls in the FASB's proposals. Further, the current FASB standards and proposals on impairment lack much of the quality operational and practical guidance provided by the U.K. Accounting Standards Board in Financial Reporting Standard No. 11. I hope the FASB will consider the views of these constituents and other standard-setters and respond by providing practical guidance that works that can be verified and audited and that will ensure assets are measured at their fair value on a timely basis. As we all learned in a painful experience ten to twelve years ago with the failed financial institutions, the lack of measurement and timely recognition of impairment in an asset's fair value can cost investors, auditors, and the public dearly.

Reflecting Economic Reality and Operationality
in Quality Standards

The accounting standards developed by the accounting profession cannot be so broad they result in inconsistent application, a lack of comparability, or an inability to be verified or enforced. Yet at the same time, they cannot become so complex that they cannot be deciphered by those in the field who have to do the actual accounting and auditing. For example, the standards promulgated by the FASB's Emerging Issues Task Force on accounting for financial instruments with beneficial conversion terms, or to be settled with one's own stock or cash, have become so complex that I am seeing instances where people in the field simply can no longer understand them. And in some instances, it is because the standard does not reflect the economics of the transaction. Rather, the standard reflects compromises that fail to meet the FASB's criteria for quality set forth in their concept statements.

As a result, I hope accounting standards developed in the future will include: (1) a discussion of the basic principles the standard-setter is trying to establish, (2) implementation guidance to facilitate consistent implementation and enforcement of the standard, and (3) a discussion of how the standard improves the quality of financial reporting by satisfying the criteria for quality established in FASB Concepts Statement No. 5.

Each and every accounting standard must truly reflect the economics of the underlying transaction, and the financials as a whole must truly reflect the underlying economics of every transaction. Consistent, comparable reporting of all the information relevant to an investor in an unbiased neutral fashion has been the framework established by the FASB. That is why they are considered the premier accounting standard-setter today. And our markets support that belief.

Perhaps, the Business Roundtable said it best in a recent comment letter they sent to the SEC:

"We believe the following:

  • That the strength and stability of U.S. capital markets is critical to the strength and stability of world markets and economies;

  • That the strength and stability of U.S. capital markets is due in part to the strength and quality of U.S. generally accepted accounting standards, which have been supported by a high quality financial reporting infrastructure that includes: high quality auditing standards, high quality auditing firms with effective quality controls, profession-wide quality assurance, due process and active regulatory oversight; and

  • That investor confidence in U.S. capital markets is based on 'perception,' as well as reality."

Adding Value through Predictive Information

Let me move on to another opportunity for us to better serve investors. Today we are in an information age, where information means power and value to those who have it. And with the advancements in technology and communications, people are creating, demanding and using more information than ever before.

Our capital markets and investors should also be able to benefit from how these advancements can enhance our financial reporting models. As a former CFO, I full well know the power that information systems can generate today. I firmly believe that there is information available today that can make our capital markets more efficient and maintain their competitive leadership.

For example, information such as backlog, revenues per employee, percentage of revenue dollars spent on research and development, marketing and capital expenditures, the utilization rate and capacity of a manufacturing plant, the amount of revenues generated from new products introduced in the year or from the top ten customers, the number of design wins, and the size, nature and type of patent portfolio, all can aid investors in assessing the value being created in a business.

We need to consider disclosure of Key Performance Indicators, or KPI's. Every analyst and company know KPI's tremendous predictive value for investors, and I firmly believe that the profession needs to find a way to bring this into our disclosure system-- there may be other predictive information as well.

I believe companies should be given the latitude to do this, and as a starting point, identify 10-12 key items that should be required to be disclosed to investors, consistently over time. I believe each company should be given the choice of the items to be disclosed. These are likely to be the items already disclosed to, or calculated by, the registrants' analysts. I believe investors and the markets will challenge the company who plays games with the items selected.

The AICPA has been a strong proponent of increasing the amount of information that should be disclosed to the public and investors. I believe the report sponsored by the AICPA and FASB on the business reporting model highlights much of that information. However, I believe the AICPA also must provide guidance to ensure that such public disclosures meet the qualitative standards of high quality financial information. And to meet that test, I have called upon the AICPA to sponsor, through their standard setting process with oversight by the FASB, a task force of various constituents that will provide common definitions for disclosures that are proposed such as EBITDA, statistical ratios, and other non-GAAP financial performance measures.

Implementation of O'Malley Panel Recommendations

Bear with me now as I shift the focus from accounting standard setting to the report of the O'Malley Panel. This Report is the work product of very knowledgeable committee members including three prominent attorneys, two of whom are former SEC Commissioners, two former Chairmen of the American Stock Exchange, an academic, a business executive and investor and the former CEO of Price Waterhouse, Shaun O'Malley. The report has over 200 recommendations for participants in the capital markets including audit committees, the SEC, the accounting firms, and the Public Oversight Board, which serves as an independent overseer of the profession. We, at the SEC have already taken positive steps to implement the Panel's recommendations to us.

Guidance for Audit Committees

Earlier this month, Chairman Levitt sent a letter to the Audit Committee Chairs of 5,000 public companies. We wanted to be sure that the O'Malley Panel Report was brought to the attention of audit committees, and that they had the opportunity to give consideration to the Panel's recommendations. For those of you who are legal counsels for audit committees, I would encourage you to participate in this process.

Some of the recommendations of the Panel that I believe are very important to improving the audit process and quality of financial reporting include:

  • Each year, management should provide a written report to the audit committee addressing whether the company's internal controls are operating effectively. This is a sound recommendation for any audit committee in light of the Committee of Sponsoring Organizations' Report that highlighted the breakdown of internal controls at the management level in most financial fraud cases;

  • The performance of external and internal auditors should be reviewed annually by the audit committee;

  • The audit committee should be advised of plans to hire personnel of the audit firm into high level positions;

  • The audit committee should be proactive in ensuring factors, such as time pressures on auditors, are addressed so as not to negatively impact the credibility of audits; and,

  • The audit committees should pre-approve non-audit services above an established threshold and consider certain guidelines with respect to their discussions of the auditor's independence. Members of the Bar have raised the question of guidelines on auditor's independence for audit committees, and I believe the O'Malley Panel Report can serve a useful purpose in filling that void.

An Initial Charter for the Public Oversight Board

The Public Oversight Board has been working for almost a year now on trying to reach an agreement with the accounting profession and large accounting firms on a charter. The POB initially drafted a charter last February that had been accepted by Ernst and Young and PricewaterhouseCoopers last spring. Unfortunately, the cutoff of funding by the profession for a special review of the profession's compliance with the existing independence rules provided an even greater impetus for a new charter.

Today, the POB has presented an updated and revised charter to the profession. It falls short of a number of recommendations in the O'Malley Panel Report related to the selection of standard setters the POB will oversee, supervision of their staff and "no-strings attached" funding. However, on the continuum of continuous improvement, the latest draft of the charter does represent progress and an advance of the ball down the field. I hope the AICPA's Board will consider and approve it at their next Board meeting in February. The consequences of the failure to reach an agreement on the charter, or a weak POB that is unable to represent the interests of the investing public, will ultimately lead to some new form of a self-regulatory structure.

Improving the Self Disciplinary Process Through Sunshine

The last issue I want to address, one that will have a long lasting effect in the future, is related to the profession's self-disciplinary process. That process is in part carried out through the Professional Ethics Executive Committee (PEEC) of the AICPA. Currently PEEC is a body of approximately 20 members, three of whom were recently appointed from, and as representatives of, the public. I commend the AICPA Board and its members for taking this initial step towards providing sunlight on this important aspect of any profession.

The profession and Commission have also been discussing the need for increasing public representation on the PEEC to equal membership with members from the profession. A number of the large accounting firms have publicly supported taking this next step. I hope the AICPA Board will give those of us in its membership the opportunity to better meet our commitment to the public by approving a membership vote on this issue at its next meeting.


In closing, I would like to give credit to all of those market participants who, over the years, have pushed for and supported the changes that have been made--changes that ensure our customer, the investing public, remains confident in the markets and number one on our priority list. It is the combined efforts of these participants and their combined experiences that have taken us from a past that included the 1929 stock market crash and resulting economic disaster, to the unequaled economic boom of today, and that also hopefully will guide us as we chart our course through the uncertainty of the future.