Speech by SEC Staff:
|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 Alan Levenson for that generous introduction and for the opportunity to speak at this prestigious conference.
As I looked through the schedule of presentations and list of presenters, I was impressed by the quality of the conference. Nonetheless, as the keynote, I am obligated to tell you that the views I express this morning are my own, and do not necessarily represent the views of the Commission, the Commissioners, or my colleagues on the staff.
I always enjoy working with a group of sharp legal minds. I recently saw an ad by a law firm in the Wall Street Journal, which said:
"Our lawyers communicate by Cell phone, fax, email, video conference and the occasional telepathic vibe".
Now, it's that telepathic vibe part I really like, and always did suspect was the case with many of my colleagues from the Bar! It is something we always wished for in the auditing profession.
The American Investor
But since I don't have your telepathic powers, let me share with you some important facts that are relevant to much of what you will hear today. Share Ownership 2000, using data from a 1998 survey under the auspices of the Federal Reserve Board, reports that there were 84 million direct and indirect (through mutual fund, self-directed retirement accounts or pension plans) shareholders in 1998, representing 43.6 percent of the country's adult population. That is a 21 percent increase from the number of 69.3 million just three years earlier and a 61 percent increase from 52.3 million in 1989.
These stockholders come from all walks of life, young and old, rich and not so rich. Over one in five stockholders is under the age of 35, and one in eight is over the age of 65. And interestingly, half of those stockholders have an annual income of less than $57,000 and only 18 percent have family incomes that exceed $100,000. Indeed, the average stockholder today is the average American who lives next door, is your aunt or uncle, a close friend or family member.
In addition to individual investors there are the institutional investors, especially pension and mutual funds, which we are likely to trust with our savings for retirement. These institutions now hold $9.7 trillion or 50.8% of all U.S. equities. They also hold $1.8 trillion in foreign equities, or 10.6 % of their total equity holdings.
What did all of these investors mean to our capital markets last year? Well, trading volume set new records with over 1.56 billion shares being traded on the New York Stock Exchange ("NYSE") on December 15th. This compares to 16.4 million shares that traded on the infamous day of the stock market crash, October 29, 1929.
So what does this information tell us? It tells us that average Americans today, more than ever before, are willing to place their hard earned savings and their trust in the U.S. capital markets. They are willing to do so because those markets provide them with greater returns and liquidity than any other markets in the world and because they have confidence in the integrity of those markets. That confidence is derived from a financial reporting and disclosure system that has no peer. A system built by those who have served the public proudly at organizations such as the Financial Accounting Standards Board ("FASB") and its predecessors, as well as the stock exchanges, the auditing firms and the Securities and Exchange Commission ("SEC" or "Commission"). People with names like J.P. Morgan, William O. Douglas, Joseph Kennedy, and in the accounting profession, names like Spacek, Haskins, Touche, Andersen, and Montgomery.
Has Quality Improved?
Often I am asked however, "Lynn, do you really think the quality of financial reporting today is as good or better than it was in, say, 1990?" It is a good question that all of us in this room should be asking. It occurred to me, though, that it really should be a three-part question:
1. Is the quality of the product we produce for our customers, the investing public, higher today than what it was ten or twenty years ago,
2. Has that quality continuously improved as much as it could have, and
3. What grade would investors give us on the quality of our product?
Important, Successful Accomplishments
Let's first take stock of our accomplishments and respond to the questions of whether the quality of financial reporting has improved.
I entered the accounting profession in July 1976, twenty-five years ago. The FASB was barely three years old, and had only issued 13 standards. The Auditing Standards Board or ASB, was relatively young and had only issued 13 standards. Audit committees, which were recommended by the SEC beginning in the 1940's, were more a novelty than reality and there was no formal system for reviewing the quality of firms' controls to ensure effective audits.
Since 1976, I believe the accounting profession, the business community, and the SEC have taken steps to improve the quality of financial reporting. Perhaps some of the more notable achievements have included:
Because of these accomplishments, I believe that the transparency and quality of financial reporting today is better than what it was twenty-five, or even ten, years ago. And investors owe a debt of gratitude to those who have led the efforts to make these changes.
However, we must consider whether our accomplishments have achieved the goals and recommendations set forth for the profession in the various reports I mentioned earlier.
In addition, we must ask ourselves, what grade would investors give us?
The Ever-Appearing Mole
Let me note that dealing with financial reporting issues is like playing the "mole" game at the arcade. One issue pops up and no sooner have you knocked it down, then another pops up. It takes a constant, vigilant effort on the part of the entire accounting profession and the SEC to stay ahead or even abreast of the issues that confront us.
Changing and Challenging Times
No doubt, the times we live in today are perhaps more challenging than ever. Consider these points:
So ask yourself, what grade do you think the average American investor would give these auditors who missed a $100 million dollar or a $1 billion dollar error in the accounts? Better yet, what grade would your college professor have given you for such a miss?
An Ice Cube or An Iceberg?
In light of these developments and statements by others, one of the most frequent questions I am asked is just how widespread are the problems with financial reporting? Is there more than what meets the eye? My experience as an audit partner, a CFO and business executive, and as a regulator tells me the answer to that question is yes. And to use an analogy - I wonder at times just how big is the iceberg below the waterline?
Working Together for Continuous Improvement
So should we chalk up the achievements of the past quarter century and say the improvements made to the quality of financial reporting are sufficient? Given the disturbing trends and cultures just highlighted I think not. Rather, we should continually move forward to strengthen the trust and credibility investors place in the accounting profession. We do not have to look far for ideas because there are recommendations that have been made over the past twenty-five years in the reports I have cited, which have not yet been implemented and would greatly enhance the quality of financial reporting. Let me cite some of those and other ideas.
Improvements for the SEC
Let me start with the recommendations for the SEC. First, the O'Malley Panel recommended we increase our enforcement efforts and we are doing just that. We created the Financial Fraud Task Force headed by Charlie Niemeier, from whom you will hear later on today. And while Charlie has only 25 accountants in Washington D.C. to investigate approximately 250 open cases, they have worked long and hard to bring cases such as those involving W.R. Grace and its auditors, as well as Livent, MicroStrategy, and the more recent Sunbeam case.
I encourage people involved with financial reporting to carefully read and consider the clear messages in the Sunbeam release. One message is that if management is going to rob Peter to pay Paul through such methods as "channel stuffing," you must disclose it to the company's shareholders. A second message is that if management is going to manage earnings through "Big Bath" charges or inventory write-downs only to generate profits in later periods, it is no longer an issue for the Chief Accountant but for the Division of Enforcement. And finally, if an engagement partner tries to "justify" overly aggressive accounting practices of a client, rather than standing his or her ground and requiring the proper adjustments, that partner may very well be charged with fraud.
Second, the Cohen Commission, the Treadway Commission, GAO, Financial Executives International (FEI), and others have recommended strongly that the SEC adopt a requirement for management reports on internal controls. As the Cohen Commission report stated, "Users of financial information have a legitimate interest in the condition of the controls over the accounting system and management's response to the suggestions of the auditor for correction of weaknesses." I couldn't agree more and have asked the staff to work on a draft of a proposal we can present to the next Chairman for his consideration.
Third, the Garten Committee, in their recently issued report, recommended that the Commission issue a concept release soliciting ideas and comments on how the historical financial statements and disclosures might be supplemented with information that will add transparency to those factors that increase or decrease the value of a company in the market place. For over a year I have been calling for companies to disclose Key Performances Indicators (KPIs). In 2000, I wrote to the AICPA and asked them to join this project by providing transparent, comparable definitions of KPIs such as revenue per employee (i.e., Do independent contractors count as employees?), sales from new products (i.e., What is a "new" product?), and EBIDTA (i.e., companies calculate EBIDTA more ways than you have fingers on your hands). Unfortunately, to date, the AICPA has been slow to act on this request. During recent months, the Office of the Chief Accountant has been working on a draft of the concept release recommended by the Garten Committee.
Improvements for the Accounting Standards Setters
First let me say that I believe we have the preeminent accounting and financial reporting in the world due to the quality of work performed by FASB and its predecessors, and the AICPA's Accounting Standards Executive Committee. They have the type of jobs where they get mountains of criticism and sands of praise, and no doubt they have to call their moms periodically to see if someone still loves them. But let me state unequivocally, investors are grateful.
But again, improvements can and should be made. First, it has taken too long for some projects to yield results necessary for high quality transparency for investors. For example, in the mid 1970's the Commission asked the FASB to address the issue of whether certain equity instruments, like mandatorily redeemable preferred stock, are a liability or equity. Investors are still waiting today for an answer. In 1982, the FASB undertook a project on consolidation. One of my sons who was born that year has since graduated from high school. In the meantime, investors are still waiting for an answer, especially for structures, such as special purpose entities (SPEs) that have been specifically designed with the aid of the accounting profession to reduce transparency to investors. If we in the public sector and investors are to look first to the private sector we should have the right to expect timely resolution of important issues.
Second, the Cohen Commission recommended in 1977 that the FASB amend APB No. 20 to require a standard note to the financial statements covering accounting changes and requiring, not just recommending in certain instances, disclosure of ALL changes that materially affect interperiod comparability, including "changes in accounting estimates." I believe that disclosure of all items affecting comparability would assist investors in better understanding what has affected the numbers they are analyzing. It also would put sunlight on some of the issues affecting financial reporting that have been relegated to the "dark room."
Third, the O'Malley Panel recommended the FASB work more closely with the ASB to ensure that new standards result in accounting that can be verified and audited. Auditors have challenged whether accounting under such standards as FASB Statement of Financial Accounting Standards (SFAS) No. 121, on impairment of long-lived assets, in fact can be audited. The ASB as well as the AICPA Accounting Standards Executive Committee (AcSEC) and accounting firms recently expressed reservations regarding the FASB's proposal on accounting for business combinations. I share those concerns. Today's U.S. impairment standards are resulting in nothing more than one-time "Big Bath" charges that lack relevance or economic reality. The reality is that if there is a decline in the value of a business, it is a decline over time, not overnight. Those who report these charges would like to have investors believe that billions, even tens of billions of dollars in value are being lost in a single 90-day quarter. In one press release I read, management announced a multi-billion dollar writeoff and explained how business had slowed so dramatically. But when I looked at the Form 10-Q for the previous quarter, which had been filed just a month earlier, it lacked a clear picture that would provide investors with the ability to see what was happening to the business through the "eyes of management." It also calls into question whether the auditors are fulfilling their responsibilities under SAS No. 8. As a result, I hope the FASB will spend more time, and engage in a greater dialogue, with the ASB as it develops new standards to avoid some of the pitfalls of the past.
Finally, I note that in the 1990's the Board issued SFAS No. 121 ("Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of"), which is now being rewritten. In addition, SFAS No. 125 ("Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities") had inherent issues that required amendments in Statement No. 140 ("Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125"). SFAS No. 133 ("Accounting for Derivative Instruments and Hedging Activities") resulted in SFAS No. 138 ("Accounting for Certain Derivative Instruments and Certain Hedging Activities") before the original standard even became effective.
I do give the FASB credit for the willingness to review a standard it has recently issued. I believe this should be an expected practice for all standards five to ten years or so after they are issued. After all, perfection is a target we all strive for but it can be elusive. For example, just ask successful businessmen who have made acquisitions of companies in the telecom, high technology, or securities industries that turned out unsuccessful. Not everything pans out the way we expect.
But at the same time, I challenge whether there has been sufficient field-testing of the operationality and practicality of some standards when they are in their development stage. I wonder if "how to" or other types of implementation issues raised in comment letters have been adequately thought through and addressed. I believe the need for some of these prompt amendments highlight this concern. I strongly encourage the Board to take the necessary steps to improve its standard setting efforts in this regard. As the United Kingdom's Accounting Standards Board noted in a recent comment letter, extensive testing greatly contributed to the success of its Financial Reporting Standard No. 11, "Impairment of Fixed Assets and Goodwill."
But notwithstanding my comments or other criticism you might hear of the FASB's standards, we have to keep in mind that their standards such as SFAS No. 133 on accounting for derivatives have made a significant improvement in the quality and transparency of information investors are receiving. Those who argue that SFAS No. 133 should be rescinded must have short memories. We cannot afford to forget the losses investors suffered in the early and mid 90's and the headlines involving household names such as Gibson Greetings Inc.; Bankers Trust; Kidder, Peabody Group, Inc.; Procter and Gamble Co.; and international companies such as Metallgesellschaft. Investors were negatively affected because they were unable to see the losses totaling tens and hundreds of millions of dollars, even billions, that had been incurred by these companies as a result of derivatives. And even today, as companies have adopted SFAS No. 133, we are seeing adjustments that exceed a billion dollars. It is only right that investors have the right to this transparency. While some argue the cost is too great, I ask, what has been the cost to investors of being "blind" to such numbers? We can only wonder why is it that some companies want to keep their investors "in the dark"?
I also believe that accounting firms need to help the FASB with its work by being more forthright, comprehensive and transparent in their comment letters. On more than one occasion, I have heard the national office of a Big Five firm criticize in private a FASB proposal. Some of those comments I believe were valuable and constructive. Yet, when I read the firm's comment letter, the points that had been discussed with me were not made or were made in such a fashion it would take telepathic vibes to understand them. On one occasion, I even went as far as to call the Board and ask for a meeting with the firms one more time, which Board members willingly did. At that meeting, many significant issues were discussed, which ultimately contributed to a better final product. The issue of objectivity and professionalism in comment letters, which was set forth in the 1993 POB Report, remains today and requires a renewed effort. The accounting and legal professions should not let competitive pressure for clients deter them from improving professional standards and negatively affect what is a good standard-setting process.
Similar to the challenge to the accounting firms, I also believe industry needs to do a better job of speaking out on important financial reporting issues. During the past couple of years, I have had several prominent companies in America tell me they strongly support the FASB on a controversial proposal. Their executives clearly were concerned about the quality of financial reporting, the importance of the independence of the private sector standard setter, and the proposals on the table. I applauded them for their interest and willingness to discuss the issues with the staff. But when I asked them to join with others and express their viewpoints and support publicly, they were unwilling to do so because of the risk of offending other members of the business community. All I can say folks is, that just doesn't count. There are two types of people in this world, leaders and followers. You can't be like the cat wanting to get the fish in the fish tank, but not willing to get its paws wet.
Improving the Effectiveness of Audits
Let me finish by teeing up some considerations for auditors. The O'Malley Panel Report contains over 200 recommendations for improving the effectiveness of audits. Such recommendations are interesting since many come from the Panel's Quasi Peer Reviews, most of which were captained by the same individuals who captained the regular peer review of that firm and previously had issued a "clean" report on the firm's quality controls. To improve the effectiveness of audits, we need to ensure that auditing firms and the ASB fully implement these recommendations on a timely basis. To that extent, I have asked the POB to report publicly on the progress made on the O'Malley Panel's recommendations.
On the plane to this conference, I was reading an article in the May 2001 edition of the magazine "Profit: Business To E-Business." The article was based on an interview with James Schiro, the CEO of PricewaterhouseCoopers. The article noted:
"The Naked Economy -an economy where the veil of privacy is stripped away from companies and markets by the sheer unstoppable, expository power of the internet-is the driving force behind a major initiative PricewaterhouseCoopers (PWC) launched in January 2001. Called the Opacity Index, the program quantifies the costs of remaining closed in a fully exposed economy. `We've established a clear correlation between the cost of capital and opacity and transparency,' Schiro says. `At a country level, the less transparent you are, the higher the cost of capital. If you don't have banking regulations, a reliable legal environment, accounting regulations; if the corruption factor is high-if you don't have a level playing field-its going to cost you more to obtain capital.'
"The same holds true for businesses, according to Schiro. `Some companies want to maintain their privacy. But the market is putting a very high premium on transparency.'"
This is a point that Jim Schiro and I agree on. In today's environment, transparency is important and a lack of it brings an economic cost to the markets and market participants. Fortunately, the PwC survey shows that the U.S. enjoys one of the greatest levels of transparency, resulting in lower costs.
But I also believe that what is good for the goose is good for the gander. While there has been a call for enhanced disclosures by companies, this should also apply to the public accounting firms who have been granted a franchise by the government and who provide a vital public service in the performance of independent audits. The good news is that the recently adopted proxy disclosure rules regarding the fees auditors charge for their various services is a positive move in the right direction. The disclosures provide the investing public and audit committees with information not previously available, which will allow them to assess and judge for themselves the independence of the auditors. The disclosures clearly show the economic benefits to the accounting firm for the public service function of providing audits and reviews of financial statements versus the economic benefit and pull from providing all other services.
One item these disclosures have brought to light is the seemingly low fees some companies pay for the audit of their financial statements. "Low balling" of audit fees is a serious issue that was raised by various people who testified during the public hearings that the Commission held on the topic of auditor's independence. The disclosure of the amount of audit fees will hopefully identify for audit committees situations where the compensation for the audit raises the question of whether or not there is adequate compensation to ensure a high quality audit is performed. In addition, we will be monitoring the fees where there are changes in auditors to assess whether the concerns regarding "low balling" are valid.
The O'Malley Panel held public hearings as part of its deliberations during which the accounting profession's self-disciplinary process was discussed. One of those who testified was James E. Copeland, Chief Executive Officer of Deloitte & Touche, and he made a number of good points. He noted,
"In an environment in which concerns have been raised about public confidence in the effectiveness of audits, we should look beyond debates about whether the level of fraudulent financial reporting is, or is not, tolerable, or whether these incidences are, or are not indicative of systemic weaknesses.... Perhaps we should look to the experience of the airline industry. When an airplane goes down, an investigation ensues and as a result of that investigation, findings are publicly reported. Based on those findings, the airlines take corrective action, which is also highly publicized. One objective of the disclosure of that corrective action is to bring closure-to give confidence to travelers that all reasonable efforts are being taken to assure their safety and that the same factors should not contribute to other accidents in the future. When losses from fraudulent financial reporting occur in the capital markets, largely for legal reasons, today's processes do not provide investors with timely closure and accordingly, the opportunity to restore confidence is lost."
The recommendation for a system that would result in an independent investigation of alleged failures in financial reporting and audits, the timely reporting of the findings from those investigations, and public reporting of corrective actions, is an excellent idea whose time has come. That is why we have been urging the profession to take steps to bring greater public participation to its self-disciplinary process, and to bring that process into the sunshine. We have been concerned in some instances where in the past, as the Commission noted in its 1999 Report to Congress, the SEC had taken disciplinary actions but the profession had not.
The good news on this issue is that at the same time the profession was agreeing to a new charter for the POB, and the Commission was completing its rulemaking on auditor's independence, a number of the Big Five accounting firms issued press announcements supporting greater participation by the public in this process. Now is the time to put actions behind those words. Now is the time for the accounting profession to bring credibility and sunlight to its disciplinary process.
In the end, the accounting profession needs to have an effective self-disciplinary mechanism that reports the findings of all of its investigations to the public, including those where the findings are that a quality audit was performed as well as those where a passing grade is not warranted. At the same time, we need to make sure that the rights of all parties are adequately protected, including investors, auditors and companies.
I also hope the auditing firms will significantly enhance the quality of the audits that their foreign affiliates perform for subsidiaries of U.S. companies as well as foreign companies who list on the U.S. capital markets. The recent report of David Cairns, former Secretary General of the International Accounting Standards Committee, highlights the lack of compliance with IASC standards, in part due to lax audits.
Investors and regulators worldwide depend on independent auditors to perform robust and effective audits, thereby ensuring compliance with home country or IASC GAAP. However, that is not the universal product received today.
And all too often, when a problem does develop and investors lose money, the accounting firms in the U.S. tell the SEC and investors they do not own or control the foreign affiliates. In fact, that may very well be the case - it is just a global co-branding, co-marketing alliance. As the Commission noted in its International Concept Release, this is an issue that requires attention. Too often it has resulted in accounting firms attempting to thwart timely investor and Commission enforcement proceedings by withholding access to audit workpapers. This is a problem other U.S. regulators have faced as well. Ultimately, if the profession continues to delay such processes I believe the staff will need to recommend to the Commission further rules, as discussed in the concept release.
Let me close by again noting that the past quarter century has been productive and successful with improvements in the quality of financial reporting. But as with any business, continuous improvement is necessary to keep up with the fast pace and ever changing challenges we face in our global economy. If the accounting profession is to receive an "A" for our efforts from investors, our customers, for our efforts, it will not come from the path of least resistance but from a passionate desire to serve society and the public. And that is why we are still called certified PUBLIC accountants.
|Home | Previous Page||