Speech by SEC Commissioner:
Accountants as Gatekeepers
Adding Security and Value
to the Financial Reporting System
Comissioner Isaac C. Hunt, Jr.
U.S. Securities & Exchange Commission
Federation of Schools of Accountancy
October 26, 2001
Good afternoon. As a former law school professor and dean, it is a particular pleasure and an honor to address the Federation of Schools of Accountancy. The people in this room are on the front lines, continuously advancing accounting programs to meet the changing needs of today's business and accounting environments.
Before I begin speaking about what the SEC views as the importance of accurate financial reporting and auditing, I am obligated to state that the views that I express here today are my own and do not necessarily reflect the views of the Commission, other Commissioners, or the Commission's staff.
At the present time, all of us involved in designing and supervising our financial reporting system – the accounting profession, the standard setters, the regulators – are under pressure to improve that system by seeing to it that the information it provides is more timely andmore useful, both to the sophisticated experts and to ordinary investors. You, in the accounting and teaching professions, and we, the SEC, are challenged to meet the demands placed on our system by the constant advancements in communications, information systems, and the globalization of the financial markets. Let's today begin a dialog about how we can work together to face these challenges.
Let me start by reminding everyone about the philosophy that shapes the SEC's approach to regulatory issues. As most of you know, the SEC was established in the wake of the 1929 market crash and ensuing Depression. The SEC is a market regulator. That is, the SEC does not regulate by passing on the merits of securities offerings. Rather, SEC regulation aims to maintain fair and orderly markets and to protect investors primarily by requiring securities issuers to make full and fair disclosure of all material information, so that investors have a basis for making informed decisions. Therefore, the quality and credibility of disclosure documents filed with the SEC by public companies is at the heart of this approach.
As we enter this new century, many of the worlds' capital markets, particularly in advanced economies, are probably more liquid and efficient than at any other time in history. However, as we saw in the 1997-1998 Asian market crises and again beginning in March 2000, investors flee when markets are viewed as risky. Markets are only viewed as safe and stable if investors trust and understand the underlying financial reporting structure. Based on these and other instances of investor wariness, past evidence suggests that the stability of markets is based, in large part, on the veracity of the information underlying the market.
Therefore, the topic that I will focus on today is the importance of improving the quality of the financial reporting process. Specifically, I would like to address the important issues of managed earnings and "pro forma" financials. In addition, I'd like to urge my fellow educators in this room to focus on the critical importance of improving guidance on valuation methodologies and models in accounting curricula.
The Financial Reporting Process
While the financial statements and supporting disclosure documents are management's ultimate responsibility, accountants within a company should do all that they can to ensure those statements and supporting documents are accurate, complete, and provide a reliable picture of the company.
Why is this so critical? Because the capital formation process hinges on the willingness of investors to make investments in the securities of public companies. Investors commit their personal funds to companies relying, at least in part, on management's representations and the auditor's opinion that a company's financial statements fairly reflect the financial position, results of operations, and cash flows of a company.
The federal securities laws, to a significant extent, make accountants the "gatekeepers" to the public securities markets. The Commission and its staff have always understood and supported this proposition. These laws require, or permit the Commission to require, that independent public accountants certify financial information filed with the SEC. As we all know, without an opinion from an independent auditor, a company cannot satisfy the statutory and regulatory requirements for audited financial statements and cannot sell its securities in the U.S. markets.
In the fiscal year ending September 30, 2001, over 14,000 registrants filed annual reports with the Commission. While the Commission staff reviews filings, the staff is not able to review in detail all financial statements filed with the Commission. Therefore, the Commission must rely heavily on the accounting profession to be primarily responsible for the large volume of financial information that undergirds the Commission's full disclosure system.
Moreover, Congress, in creating a system in which investors and the Commission must rely on the accounting profession, granted the accounting profession an important public trust. The system Congress envisioned is predicated upon accountants working within corporations, as well as the independent auditors, adhering to strong ethical standards to ensure that financial statements conform to US GAAP. Congress did not make this grant without considering the alternatives. As part of its deliberations, Congress considered creating a corps of government auditors to review and audit companies' financial statements, and even considered federal licensing of accountants. Instead, Congress chose to entrust the accounting profession with the responsibility for auditing the financial statements of companies registered with the Commission.
This trust in management accountants and independent auditors forms the foundation of the financial reporting process. The resulting disclosure provided by these financial professionals forms the bedrock of our financial markets.
Unfortunately, the Commission has recently noticed certain worrisome trends relating to the integrity of financial information. Current market conditions have increased the pressure on companies to meet past or projected earnings levels. As a result, some managers have engaged in manipulation or "smoke and mirrors" to enhance their companies' earnings and, in turn, the companies' share prices. When such chicanery is discovered, the resulting and inevitable restatements of earnings have caused investors to lose billions of dollars, and confidence in the market.
Pro Forma Information (or "Our Business as We'd Like it to Be")
Additionally, recent years have seen an increasing use of "pro forma" earnings, essentially unaudited financial statements or statements not in conformity with GAAP. The growing use of pro forma earnings has undoubtedly been fueled by management's desire to paint a rosier picture than GAAP might otherwise allow. Investors who are overwhelmed by the sheer volume of filing information might not understand the difference between pro forma earnings and audited financial statements or may not fully comprehend the importance of audited financial statements.
Even more disturbing is that pro forma earnings may be "materially misleading" to reasonable investors, violating the federal securities laws.
The best use of pro forma statements is a limited one. As you may know, the Financial Executives International ("FEI") recently provided guidelines for the presentation of pro forma earnings. These FEI guidelines state "pro forma results should always be accompanied by clearly described reconciliation to GAAP results."
While we might all enjoy reading about an idealized version of things on occasion, I think that we'd all agree it's best to leave that kind of writing to authors of fiction and reserve the drafting of financial statements to financial professionals. When dealing with financial statements, pragmatism or reality over fantasy is preferred.
In today's dynamic economy, investors have become increasingly interested in the fair value of a company's assets and liabilities, as well as historical cost information provided in financial statements. Further, many existing and proposed accounting standards require companies to measure more assets and liabilities at fair value. As a result, there is an increasing need to improve the quality and comparability of fair value measures and the auditing of those measurements.
The Commission has urged the American Institute of Certified Public Accountants ("AICPA") to take a more proactive leadership role, by developing detailed, broad-based guidance on valuation models and methodologies. Efforts to educate accounting professionals are important as well. Preparers, auditors, and even investors need to become more educated on fair value estimates – how they are calculated, what they mean and when they are used. In addition, educational curricula need to be modified to more effectively teach valuation techniques, the meaning of value, and how financial instruments work.
The Commission believes that the AICPA and the Federation of Schools of Accountancy are best poised to adopt models and methodologies that will equip accountants with the knowledge and skill to effectuate these kind of valuation techniques.
It is critical that accountants and accounting professors continue to monitor and update current financial disclosure trends to ensure accurate and meaningful disclosure from public companies. Only then will investors have the information necessary to make informed investment decisions. Continuing accurate reporting is, in turn, essential to maintaining the sanctity and integrity of today's markets.
In conclusion, I wish to stress the tremendous challenge facing both the SEC and the accounting professionals: the challenge is to maintain high-quality financial reporting, and a strong capital market. I have faith that, working together, we can achieve those goals.
Thank you for your time and attention today. I look forward to working with all of you in the future.