U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the Annual AICPA Conference


Charles Niemeier

Chief Accountant, Division of Enforcement and Chief Counsel of the Financial Fraud Task Force
U.S. Securities and Exchange Commission

Washington, D.C.

December 7, 2001

The SEC, 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 the author and do not necessarily reflect the views of the Commission or the staff of the Commission.


These comments reflect my personal views and not necessarily those of the Commission or other Commission staff.

The Spartans and Change

Many years ago lived a people that developed a great set of principles by which they lived. So great were these principles that we know this people even today for their well-disciplined and stoic lifestyles. I am talking about the Spartans.

For many years, their well-disciplined lives gave them superiority over their neighbors. In fact, they became so confident in their way of life that they did not recognize a need to adapt to the world around them. As their neighbors grew economically, intellectually and even militarily, the Spartans did not change.

In time their neighbors developed great fleets of ships for commercial and military use, as well as new weapons, such as the catapult. By approximately 200 B.C., the Spartans found themselves in a world where they were no longer superior. As a consequence their society was eventually absorbed by the civilizations surrounding them.

What was true then for the Spartans remains true for us today. None of us can afford to rest on our past laurels. All of the great leaders of the accounting profession have had at least one thing in common. They have had the vision to know what the accounting profession needed to do in order to stay in step with the world evolving around it. Because of them, accounting is the great profession it is today.

But, it is now up to us to continue with that vision. Under the leadership of our new chairman, Harvey Pitt, we at the SEC are quite aware of the changing world around us, especially the changes in our financial markets and businesses that require us to adapt with the times.

Financial Enforcement Trends


In Enforcement we are particularly sensitive to these changes, principally because we find ourselves today conducting more financial fraud investigations than ever before.

However, far more significant than the number of investigations we are conducting is the size of the companies we are investigating. Today we are investigating more Fortune 500 companies than ever before. Although, only a few years ago, we only rarely investigated a Fortune 500 company, today we have numerous such investigations underway. And, along with the increasing size of the companies we are investigating is the increasing size of the market impact of the financial failures.

And, there are several others trends we see.

Increase in Information from Informants

We see an increase in information we receive from informants. Because we understand that informants often have an ax to grind, we take the information we receive from informants with a grain of salt. However, even people with self-serving motives can be very informative. So, we carefully consider all such information that we receive in the context of information that we obtain from other sources.

Increase in Interest from Criminal Authorities

We also see increased interest from the criminal authorities. Five years ago, the criminal authorities were rarely interested in securities law cases. Today, we routinely find ourselves conducting investigations parallel with or in tandem with the criminal authorities. And, as the size of the companies that we are investigating increases, so does the appeal of the cases to the criminal authorities.

Increase in Investigations of Non-US Operations

Another trend is that we find ourselves more than ever before investigating non-US operations. In part, this is a by-product of investigating larger companies. From what we have seen so far, we are concerned about the quality of audits in non-US jurisdictions. The increase in investigations of non-US operations has also intensified our concerns about the difficulties that we often experience in attempting to obtain the audit workpapers of non-US accounting firms.

Quarterly Filings

We are more likely to focus on problems in the quarters, even where the issues are resolved by yearend. It is not enough that a company get its accounting right once a year. The markets are too volatile. In one year, we recently witnessed a market lose over 60% of its value. Additionally, we have found that many financial reporting problems begin in a quarter.

Issues that We Often See

The largest single problem that we find in investigations continues to be with revenue recognition. Some common revenue recognition problems include bill-and-hold transactions and transactions where one of the parties is economically dependent on the other.

But financial fraud is constantly evolving. Today, we are seeing a new breed of financial reporting problem: situations that appear to many to be subtle, but which in fact have the same devastating impact as the old cooking the books schemes.

A century ago, there was a toy that consisted of a flat panel on stick. On one side of the panel was a man and on the other side was a horse. If the stick was spun fast enough it appeared that the man was sitting on the horse. That is the impact that a lack of quality of earnings can have. In effect, we are seeing illusions being created that can effectively hide a company's true operating performance through a lack of transparency.

An important aspect of quality of earnings is comparability of current period financials to earlier periods. For example, we are finding situations where changes in estimates are used to make the operating results look better than they really are. Because the changes in estimates are not disclosed, investors are inappropriately left to believe that the positive effect of the changes in estimates on earnings is due to operational improvements.

How Do Companies Get in Trouble?

The following are some common scenarios that can lead to a company having a financial reporting failure:

  1. Top-side adjustments for which there is insufficient support.
  2. Continuous changes in estimates without disclosure that have the impact of improving operating results. An example would be consistently increasing the depreciable life of an asset.
  3. Extreme pressure being placed on operations to make aggressive targets in an environment where there are poor internal controls.
  4. Bill-and-hold transactions, but especially where the number and size of the bill-and-hold transactions are progressively larger each period.
  5. Offering progressively larger sales discounts at period end, where the sale would have taken place in a subsequent period anyway. By so doing, companies can make a target in the current period but at the cost of creating a shortfall in a subsequent period.
  6. Dependency on acquisitions to make revenue and/or earnings targets.
  7. Netting one-time gains into operating results without disclosure, especially netting one-time gains against operating expenses.

In the later stages of a financial fraud, we often see the use of several these scenarios at the same time, which usually works to exacerbate the magnitude of the financial reporting problems.

The Dangers of Smoothing

To understand how to address these trends, we have studied the major financial reporting failures of the last few years. What we have found is that no company is immune from having a reporting failure. In fact, years of success can actually make a company more vulnerable to having one, because the company may view itself as not being at risk. Most financial reporting failures do not begin with a bang. In fact they usually begin quite subtly.

We all know that when a company misses its target even by a penny or two in a quarter, the company's stock is often brutalized. And, it is tempting for a company to take the easy way out and smooth the earnings. But smoothing is only a short-run band-aid that can be quite costly in the long run.

I understand that if you place a frog in hot water, it will jump out. But if you place that same frog in a pot of cool water and slowly heat it to a boil, the frog will cook to death. Just like the Spartans, the frog fails to sense that the environment around it is changing until it is too late. In a similar way, companies smoothing their earnings often do not recognize the effects of smoothing until it is too late.

There are at least three potentially disastrous consequences of smoothing. First, once a company starts smoothing its earnings, it can be almost impossible to stop. That is because the inflated earnings become the floor for measuring future performance. Often the company is forced to progressively increase the amount of improper accounting in order to cover up past improper conduct.

Secondly, smoothing can result in a company not addressing real operational problems. By smoothing, a company can avoid immediate adversity, but that adversity may be exactly what the company needs.

To illustrate this point, let's look at an example from nature. Say that we plant two acorns — one in a dense forest and the other on a hill by itself. The oak tree that grows from the acorn planted on the hill is exposed to all of the elements of nature — sun, wind, and storms, while the tree growing from the acorn planted in the forest is protected. To survive, the tree on the hill is required to have deeper roots and as a result, becomes a large and strong tree that is able to withstand the elements. Because the tree in the forest is protected, it does not develop as strong a root system and as a result remains a frail sapling. In a similar way, a company that smooths its earnings may initially avoid the need to face the cause of poor operational performance, but as a result it does not fix the real operational problem and accordingly does not become a stronger company.

The third potentially disastrous consequence of smoothing is the loss of credibility that can occur when the market is surprised by the unveiling of financial misstatements. This loss of credibility is probably the most significant consequence of smoothing. A loss of confidence can cause even a company with solid core operations to fail. That is because the negative impact of a lack of credibility can be far greater than the sum of the misstatements in the financials.

And, once a company loses credibility, it is difficult, if not impossible, for a company to get it back.

How Can a Company Stay Out of Trouble?

Here are a few suggestions:

  1. No matter how tempting it may be, don't start smoothing.
  2. If you are smoothing your operating results, stop. It may be difficult to do so, but it is much better to stop now as it usually becomes more difficult to do so as time going on. Additionally, just because you believe that you have been getting by with smoothing does not mean that you will be able to get by with it in the future.
  3. Maintain good internal controls. I cannot overemphasize this point. We have found that even extremely large companies can have serious internal control problems.
  4. Always report both good and bad results. By doing so, it is less likely that the market will be surprised.
  5. Apply a common sense test to your filings. Are investors able to determine how the company is doing, both good and bad?
  6. Whenever you are in doubt, play it safe and disclose. Some areas of GAAP are gray, but with adequate disclosure you can go along way toward eliminating the chance that investors will be confused.
  7. And, when in doubt, contact the Office of Chief Accountant or the Division of Corporate Finance and "Get it Right the First Time."

What About Pro Formas?

We encourage companies to volunteer information to investors. In that regard, we believe pro forma information can be helpful. However, information releases that are effectively no more than sales pitches are not helpful and can be misleading, especially where they are presented in the guise of being balanced operating results. If pro forma information does not include bad news and that bad news is required for investors to have a balanced understanding of the company's operations, then the pro forma information may be materially misleading.

This week the Commission issued a warning to companies and investors regarding pro forma information. In the warning, the Commission commends the press release guidelines jointly developed by Financial Executives International and National Investors Relations Institute. Those guidelines state that companies should include GAAP numbers when releasing pro forma information and include a plain English explanation of how the pro forma information differs from the GAAP numbers.

Accounting as a Profit Center

If you have missed everything else I have said today, do not miss this!

There is an area where our profession is particularly at risk. There are those in business today who view accountants as tools that allow them to make their targets when they cannot do so legitimately. We must not allow ourselves to be used in such a way. Our duty is to ensure that whatever is reported is reported with integrity.

We must stand up to those who want to use the complexities of the accounting rules as a means to hide a company's true operational results from those who the rules were intended to protect-the investors. For every rule, there may a way around it, but it will be much more difficult to get around that rule if we are standing in the way.

What Can You Do?

Unlike the Spartans, the accounting profession is not stagnant, but it is up to you to make sure it does not become so. Every CPA is empowered, and in fact has a duty, to do whatever he or she believes is the right thing to maintain the integrity of the profession. You may be asking yourself, what can I do? I am not a member of FASB. I am not CFO. And, I am not a partner in an accounting firm.

A little over 300 years ago, a seamstress effected a change that has had a major impact on our lives ever since. General George Washington presented her with the design of a flag and asked her to make it. Even though she was just a seamstress and George Washington was arguably the most powerful person in America, she did not make the flag that Washington designed. Instead, she changed it. In the place of the six-pointed stars that Washington had indicated, she used five-pointed starts, and, instead of making the flag square as it had been designed, she made it rectangular. Why did she make the changes? As she explained to Washington at the time, she made the changes because they made it a better flag.

That woman of course was Betsy Ross and in 1777 Congress enacted a special resolution declaring the flag design that incorporated her five-pointed stars and rectangular shape to be the official flag of the United States of America.

May God Bless America!



Modified: 12/11/2001