Speech by SEC Chairman:
A Financial Partnership

Remarks by

Arthur Levitt

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 high-quality disclosure.

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.

Earnings Management

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 customer ordered.

"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 company's stock.

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 far.

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 between shareholders 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

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 disclosure requirements.

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 statements.

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

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 markets.

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 reporting standards.

Conclusion

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 of investors.

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.

http://www.sec.gov/news/speech/speecharchive/1998/spch227.htm