Speech by SEC Chairman:
A Financial Partnership
Chairman, U.S. Securities & Exchange Commission
To the Financial Executives Institute, New York, New York
November 16, 1998
Thank you very much for your warm welcome. Thank-you Joe
for your generous introduction. I especially want to thank
Norman Roy for his service. His leadership and energy have
served this organization extremely well. And, with the FEI's
adoption of a code of ethics, Norman has helped put the FEI on an
even firmer footing as he leaves.
I view the SEC's relationship with the FEI as a strong
example of the importance of the public-private sector
partnership. Our partnership has not been without its
disagreements. But, the fact is what we agree on is so much
stronger than what we do not.
We both recognize the ultimate advantage of an efficient and
trustworthy financial reporting system a lower cost of
capital. Disagreements may exist on some of the details, but
fundamentally, we both recognize the tangible benefits of
Without the most relevant and reliable information, capital
will simply not be allocated efficiently. And, while we may
sometimes become consumed by the details, it is often easy to
overlook these benefits and take them for granted. History and
recent events prove that would be a mistake.
Look across the Pacific. These countries are paying a price
for a system defined more by relationship-driven finance than
market evaluation of risk and return. Everyone here knows what
investors expect. They expect clear, dependable and honest
reporting. And, if those expectations are not met, not only will
a company's future be jeopardized, but so will the fundamental
trust that allows our system to operate.
Without the access to deep, liquid markets that transparent
financial reporting provides, companies cannot sustain long-term
growth. Strategies can't be effectively formulated. Plans won't
be properly implemented. Ideas will rarely see the light of day.
Without transparency, your ability to manage your business is
severely constrained. And, it is only a matter of time before
investors take notice.
We both share the same goal of helping to create an
environment where investors remain confident. I'm here today,
not to lecture, but to ask for your support, as partners, in
preserving the highest possible standards of financial reporting.
We need your support in three critical ways: (1) by
avoiding the temptation to sacrifice sound financial reporting
practices for the expectations of Wall Street; (2) helping us to
secure the highest quality global accounting standards; and (3)
by supporting private-sector standard setting even when we may be
displeased with details of a particular result.
As you may know, I recently expressed concern that the
motivation to satisfy Wall Street earnings expectations may be
overriding common sense business practices. In the process, I
fear we are witnessing a gradual, but noticeable erosion in the
quality of financial reporting.
Many of you, I'm sure, are just as frustrated and concerned
about this trend as we, at the SEC, are. It's difficult to hold
the line on good practices when competitors operate in the gray
area between legitimacy and outright fraud.
A gray area where sound accounting practices are perverted;
where managers cut corners; and, where earnings reports reflect
the desires of management rather than the underlying financial
performance of the company.
While the problem of earnings management is not new, it has
risen in a market unforgiving of companies that miss Wall
Street's consensus estimates. For many, this pressure has become
all too hard to resist.
Sales and income are overstated by recognizing revenue for
partially shipped, unshipped or even back ordered equipment.
Fiscal years are extended beyond 365 days to record extra sales
and even sales that the company knows don't conform to what a
"Big Bath" charges are perpetrated under the guise of
corporate restructurings or mergers to avoid future charges
related to normal operating costs. Companies claim "in-process"
research and development, when, in fact, purchased companies
previously reported little or no R&D expenditures. Companies
stash accruals in "cookie jar" reserves during the good economic
times and reach into them when needed in the bad times.
These problems didn't develop over night. And they won't be
remedied over night. I really believe that all of us working
together need to affect nothing less than a cultural change in
the financial community.
And, without your active willingness as financial executives
to stem this trend where numbers represent more desire than fact,
we will forever be fighting an uphill battle. I know what an
analyst's downgrade can do to a company's stock. I know talking
down an analyst's forecast has become as commonplace as a corner
Starbucks in Manhattan. But we have got to break this pattern
where short-term estimates rather than long-term results drive a
Wall Street needs to focus less on quarterly earnings and
more on the long-term health and viability of a company. Don't
settle for anything less. Challenge every analyst to do the
same. If we satisfy short-term needs at the expense of long-term
values, we defy the very principle companies and our markets
operate on the efficient allocation of capital.
It won't be easy to change attitudes and behavior. You may
face reluctance within your own company. But I ask you: wouldn't
your shareholders be better served?
Two months ago, I announced a coordinated plan to address
the practice of earnings management. Since then, the response
from CEOs, CFOs, investors, leaders of the public accounting
profession and academics has been remarkable. While we have a
long way to go, I want to give you an update on our progress thus
First, the AICPA's Public Oversight Board formed a committee
chaired by Shaun O'Malley, formerly head of Price Waterhouse
to review the way audits are performed and assess the impact
of recent trends on the public interest. I know there is a
strong desire to keep costs down in the audit process. But, we
cannot permit thorough audits to be sacrificed for re-engineered
approaches that are efficient, but less effective.
Second, the New York Stock Exchange and National Association
of Securities Dealers are sponsoring a blue ribbon committee to
develop recommendations to strengthen the role of audit
committees. John Whitehead and Ira Millstein are co-chairing
this effort. Also included are the Chairmen and CEOs of Ernst &
Young, PriceWaterhouseCoopers, Pfizer and TIAA-CREF, along with
Charles Bowsher, former Comptroller General of the United States.
I am pleased that two experienced and highly regarded CFOs
are also serving on this committee Frank Borelli from Marsh &
McLennan Companies and Dennis Dammerman of General Electric.
I feel passionate about audit committees. For some of you,
this might be the first time you have ever heard someone
associate passion with a board function. But, I believe
qualified, committed, independent and tough-minded audit
committees represent the most reliable guardians of the public
interest. There is no reason why every company in America
shouldn't have an audit committee made up of the right people,
doing the right things and asking the right questions.
Third, the Independent Standards Board created to re-
evaluate the rules governing the "independence" of the audit
profession has tentatively agreed to recommend more frequent,
more focused and more frank communications between auditors and
the audit committee. Services, fees, expectations and
independence all need to be clearly delineated. And, as
financial executives, you need to actively and aggressively
assess the independence of your auditor. If you don't, who will?
Only audit committees and CFOs can effectively ask if their
auditors are truly independent. Only audit committees can ask
everyone including CEOs, financial executives and the
independent auditors if high standards are losing out to
questionable practices. You don't have an obligation to a Wall
Street number. You don't have an obligation to meet some
arbitrary internal target. But, you do have a clear obligation
to every shareholder that has invested his or her trust and
future in your company.
Fourth, the Commission's staff is currently working on
proposals to augment disclosures related to loss accruals.
Through these accruals, "cookie jar" reserves arise. This
proposal may come in the form of changes to the current
Regulation S-X Schedule for Valuation and Qualifying Accounts.
We are also working on issuing interpretive guidance in the
form of SEC Staff Accounting Bulletins that address revenue
recognition, loss accruals and materiality. I expect the
guidance in these bulletins to draw on existing standards and
identify critical factors related to accounting choices.
In addition, if you visit the SEC's or AICPA's website, you
will find a detailed letter from the Commission's Chief
Accountant Lynn Turner. The letter more fully articulates the
Commission's views on such topics as in-process R&D, asset
write-offs, revenue recognition, liability accruals, known
immaterial violations of GAAP, and the role of the audit
committee. These topics are also the focus of SEC staff reviews.
Fifth, we are taking still additional steps to internally
address the practice of earnings management. The Division of
Corporate Finance recently launched an Earnings Management task
force. This group will coordinate and focus efforts on detecting
and challenging deterioration in financial reporting practices.
The Division of Enforcement, as well, has stepped up their
focus in this area. We are pursuing, for example, a number of
remedies against a company and its senior management for
allegedly creating or increasing "excess reserves" in the absence
of an underlying basis.
Today, America's capital markets are the envy of the world.
Our efficiency, liquidity and resiliency stand second to none.
That hasn't happened by accident. For a good part of this
century, our system of financial reporting has come to be
characterized by its high quality and transparency. This has
instilled an unparalleled degree of confidence and trust.
But that confidence and trust can become all too fleeting if
integrity falls victim to illusion. If a company fails to provide
meaningful disclosure to investors about where it has been, where
it is and where it is going, a damaging pattern ensues. The bond
and the company is shaken; investors grow anxious; prices
fluctuate for no discernible reasons; and the trust that is the
bedrock of our capital markets is severely tested.
International Accounting Standards
Transparent financial reporting must reign supreme not
only here in this country but around the world. Today, there
is a growing tendency among exchanges to consolidate. Already,
NASDAQ is discussing common links with foreign exchanges such
as the Hang Seng in Hong Kong and the Deutsche Borse.
Pan-European investment approaches within a single currency
environment will, no doubt, promote greater liquidity, lower
costs and increased access.
As technology and the forces of more globally integrated
markets redefine the operation of capital markets, new demands
for capital are increasing that must be satisfied at a global
level. There has been an international effort, as many of you
know, on several projects to reduce differences in reporting and
We are very sensitive to the costs associated with
non-uniform standards particularly those relating to
accounting. But as we attempt to answer the call for more
harmony, we must focus, first and foremost, on the needs of
capital markets, and capital market participants.
Our experience has clearly shown that high-quality
accounting standards result in greater investor confidence
improving liquidity, making fair market prices possible, and
reducing capital costs for all issuers, domestic and foreign.
Participation in U.S. capital markets delivers great benefits
but membership has a price. While we are looking for ways to
reduce costs, we won't do so by diminishing the benefits our
markets deliver to participants.
I don't presume to demand that the world's capital markets
adopt our standards. But, any set of global accounting standards
must result in transparency, comparability and full disclosure.
I know this orientation this equity market culture has
not been the historical frame of reference in many countries.
The Asia crisis and the contagion it set off have made clear the
significance of transparent, timely and reliable financial
Recently, the World Bank questioned international accounting
firms who lend their credibility to audits of foreign companies.
Some of these companies who wish to raise capital on
international markets are practicing accounting techniques that
simply don't measure up. I share the World Bank's concerns. If
we want investors to have confidence in the numbers on a global
basis, then auditors need to ensure that the highest quality
independent audits are being conducted everywhere and anywhere.
Transparent financial reporting makes business sense not
only by providing access to cheaper funds, but in opening new
opportunities as well. Less than five years ago, Daimler Benz
became the first major German company to list in the U.S.
Looking back, I view Daimler's listing as a turning point for the
principle of shareholder value.
That listing was part of a transformation to an equity
culture that delivers value and information to investors
through the marketplace. As many have since noted, a U.S.
listing gave Daimler the means and I'm not just referring to
capital to gain acceptance of its bid for Chrysler.
Soon, we will move forward with our assessment of the core
standards and the Commission will seek input from various
constituencies, including financial executives. I ask that you
be active in this process. Help us by asking hard questions, and
by engaging the process, as we seek to ensure that we have high
quality international financial reporting standards.
Independent Standard Setting
Lastly, I want to say a word about the importance of
independent standard setting. I know many here have taken issue
with the private-sector standard setting process. It is not
perfect, but then few things are.
The Financial Accounting Standards Board has filled the role
of independent standard setter admirably for twenty-five years.
Independent standard setting has served to protect the basic
rights of investors and strengthen public confidence in our
It is compellingly clear to me that objectivity and fairness
in standard setting can only be guaranteed if the process is
insulated from political agendas and special interests. If that
independence is compromised, our markets will pay a heavy price
because of declining investor confidence.
From its inception, the FASB has been criticized by those
unhappy with its pronouncements. Constructive criticism, when
accompanied by frank dialogue between those who make the rules
and those who must abide by them, is healthy. Part of the role
of a standard setter or regulator is to ensure that the process
does not become insulated or unresponsive.
However, criticism that seeks to undermine or intimidate
rather than further the process is not healthy. We should not
give up on a process that, time and again, has produced unique,
rational, and unbiased judgment.
While I usually refrain from making forward-looking
statements, let me make a prediction. It's quite likely that in
the future someone here won't like FASB's position on a
particular issue. That's no revelation. As society and markets
become more sophisticated, the issues only become more difficult.
Tension between those who set the rules and those who must obey
them is natural. In the absence of such tension, there would
only be suspicion.
I believe the system merits certain basic considerations
not for FASB's sake but for the sake of everyone who has a
stake in the vibrancy of our financial markets. Our mutual
interests are better served when we all work within the process
to help achieve a satisfactory outcome. That's the only way to
reach a sustainable consensus. And, it's the only way to ensure
that our markets are served with the best possible financial
As one looks out at the landscape of today's business
environment, it's clear that a multitude of challenges exist.
Expectations of unprecedented growth have been tempered by the
vagaries of the business cycle. Global economic uncertainty is no
longer a distant academic discussion or vague policy concern, but
a very real factor affecting a company's bottom line.
Market risk and economic uncertainty have caught individual
and institutional investors unaware. And, throughout all of
this, technology continues to revolutionize how people invest,
how companies do business and how markets function.
In many respects, these are not easy times. Change is ever
more rapid. Pressures proliferate. Responsibilities overlap.
Objectives run counter to each other. Demands often are at
cross-purposes. But, investors, regardless, continue to value
information that informs rather than distorts.
And that is why the fundamental values of our markets
transparency, disclosure and comparability must remain signal
priorities. Your individual and collective commitment to a
financial reporting system that honors and practices these values
is absolutely necessary for long-term health and prosperity
not only for your company but for our country.
America's financial partnership between the public and
private sector has been and will be a crucial element to our
success. Working together, we have instilled a truism that goes
to the very heart of our success: markets exist through the grace
I ask that we continue to fortify this partnership; to
continue to make it the most effective and productive in the
world; and to continue to serve investors' interests and by
extension all of our interests.
Thank you very much.