Speech by SEC Staff:
Reflections on Times Past, Times to Come
Lynn E. Turner
U.S. Securities and Exchange Commission
At the 10th Annual Conference on Financial Reporting
University of California at Berkeley
November 5, 1999
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 or of the other members of the Commission's staff.
Thank you for asking me to speak to you today. Before I begin, I am obligated by Commission rules to tell you that the views I express here are mine and do not necessarily reflect the views of the Commission, or other members of the Commission's staff.
Financial reporting plays a key role in any capital market. The pride that Americans enjoy in the success of U.S. markets is in large part due to the work of people like you who support the process and maintain the high quality of financial reporting that exists today. So I am deeply honored to be able to share my views with you today.
Today we find ourselves on the brink of a new millennium. The anticipation of this event is palpable. Where will each of us be at the stroke of midnight on December 31st? Will we be celebrating things to come, bemoaning things that could have been, or checking to see if we have running water? Yes, the Y2K bug will be on the minds of many. This shows that even the computers recognize that the start of the third millennium will be an extraordinary event.
For most of us, the occasion will offer a time of celebration. I think the advent of Year 2000 is a perfect time for retrospection, reflection, and some speculation. So, at the risk of beginning the millennium a few weeks early, I will take this opportunity to reflect on the past. Based on these reflections, I’ll also comment on the future. But I do so with caution because, as Yogi Berra said, "the future isn’t what it used to be." Heeding Yogi’s wisdom, I will be a bit more modest in scope. Rather than consider the next millennium, I focus on the next decade. Although a decade is a relatively short period compared to a millennium, if the decade ahead is anything like the decade that is drawing to a close, we will witness remarkable changes in capital markets and in financial reporting methods.
The Decade of the 1990s
As the decade of the 1990s began, the Dow Jones Industrial Average stood at 2600; daily trading volume on the NYSE ranged from 20 to 40 million shares. Prices were quoted in eighths. Most firms filed reports with the SEC on paper. The primary users of the Internet were universities and other research organizations. Who knew what "dot-com" meant? Foreign firms registered with the SEC numbered 434.
The largest public accounting firms were partnerships where every partner risked his or her personal wealth when a fellow partner expressed an opinion on the fairness of a client’s financial statements. Oh yes, and public accounting firms were just that—accounting firms. For four of the six largest firms, accounting and auditing services produced more than fifty percent of their total revenues.
Today, the Dow is above 10,000; the NYSE trading volume has reached 1 billion shares a day. Price quotes have changed from eighths to sixteenths and are on their way to decimal amounts. Registrants file with the Commission electronically via EDGAR. Firms are creating web sites to sell goods and services, and to provide information to investors, sometimes including the company’s financial statements in that information. Investors can trade using Internet accounts. The Internet has bridged distances and reduced communication costs to such an extent that the oceans no longer pose disincentives for trade. Foreign companies registered with the SEC now number more than 1,150.
The five largest public accounting firms are now "professional service firms" that derive only a minority of their revenues from accounting and auditing services. And accounting firm members no longer stake their personal wealth on judgments made by their partners—these organizations are now limited liability partnerships.
What do these changes portend for the coming decade? Let me comment on several issues.
Changes in the Capital Markets
U.S. markets are responding to increased participation by investors. Electronic communication networks—ECNs—are challenging traditional trading venues. Trading periods are expanding—both to accommodate investors who want to trade outside of the traditional trading times and to address worldwide investing activities. Indeed, financial markets, at their most basic level, are being reconstituted by technology and competition. Within the next decade, average investors may be able to view trading activity 24 hours a day by referring to a single computer screen. Significant steps are already being taken to address many of these developments. The Commission and market participants are working together on ways to craft a fairer, more open, and more efficient marketplace.
These changes bring risks, however. Trading volumes may again strain systems—we continue to witness system failures that preclude investors from trading. Further, the explosion of trading volume and the proliferation of trading mechanisms may stretch the capacity of the SEC to effectively oversee the markets. Despite these challenges, the SEC stands committed to fostering continuing evolution in the markets, while ensuring effective regulatory oversight to protect the interests of investors.
Full and Fair Disclosure
Just as technology is altering and expanding traditional trading mechanisms, so too is technology changing dissemination of information about companies. EDGAR has been a remarkable, wonderful step forward. Investors can peruse annual and quarterly reports—10-Ks and 10-Qs to those who follow SEC form names—literally within seconds after these forms are accepted. Real-time dissemination aids all investors, but especially individual investors who otherwise may face impediments of time or money in accessing these disclosures.
Immediate access to information has gone a long way towards leveling the playing field for large and small investors. It also has shifted the dynamic for information providers. With more information at the fingertips of investors, analysts are under increasing pressure to provide better forecasts. As a result, corporate managers have come under greater pressure to show earnings that meet forecasts. One way to meet forecasts is to obscure the financial results of the company. This is the genesis of the abusive practices Chairman Levitt calls "The Numbers Game."
No doubt the Commission’s enforcement actions will deter some members of corporate management who are still tempted to play the Numbers Game. But I also hope that recognition of professional responsibility on the part of corporate managers, financial analysts, accountants, and lawyers will bring an end to this insidious practice. I am optimistic that investor demand for true information will also play a role in stopping the use of accounting gimmicks to improve earnings. I am heartened by recent news stories indicating that investors, analysts, management, and the markets are focusing on the quality of today’s reported numbers. Corporate managers willing to wander into the gray areas of accounting to add pennies to their earnings now do so at the risk of a significant decline in the price of their company’s stock and, more importantly, loss of respect from the company’s shareholders and other investors. Auditors who are associated with such reporting also risk losing their credibility. That is a high price to pay, in my view, for a few cents in earnings.
Changing Business—Changing Accounting?
New technologies have spurred new industries. In this decade, we are witnessing a broad shift from an industrial economy to a more service-based one, a shift from bricks and mortar to technology and knowledge. With these new industries come new questions and challenges for accountants.
We have long had a good idea of how to value manufacturing inventory or to assess what a factory is worth. But do the long established views of what is appropriate and transparent disclosure in a manufacturing-based economy also work for a "dot-com" company with revenues but no earnings? What are the key factors that create value in an Internet, technology-based, or service company? Is it the know-how embedded in a workforce of engineers, the creation and maintenance of effective market channels, and key customer relationships, control of key patents, or the ability to continuously stay ahead of the curve in the development of new products? At the Commission and elsewhere, people are asking whether the key drivers of value that affect a company’s stock price are being reflected in a transparent fashion in today’s disclosure documents and financial statements.
Yet this is not a simple question. For example, if as some advocate, the fair value of intangibles should be reported in financial statements, one must be able to measure reliably that value in a consistent, comparable, credible, and unbiased fashion. Our recent experience with in-process research and development raises questions as to whether such measurements currently exist.
But analysts do prepare company-specific research reports that often reflect a dozen or so key business performance indicators. I have issued a call for research to the academic community to examine how such measures might be useful in providing more transparent information on the value of a business to investors.
We also believe we can learn how to improve our disclosures and our business reporting model from those business leaders who have successfully created value for their shareholders. Accordingly, last month Chairman Levitt asked a group of leaders from the financial community to examine expeditiously whether our current disclosure framework can more effectively capture these momentous changes in our economy. This group, and others that have been convened, will continue to address innovations in accounting and reporting to match innovations in business so that we can maintain transparency. Our disclosure and accounting standards must continue to evolve. Answers that may have been acceptable in the past decade may no longer serve well in the future.
Building a Global Financial Reporting Framework
The very same forces driving changes in our own economy are driving changes around the world. As a result, investors and members of the business community seek to improve communications—but differences in languages create barriers.
In business, accounting is the language that firms use to communicate financial data to investors and others. Without a common language—that is, a common set of accounting practices—how will investors interpret the numbers in financial reports from different countries? If anyone doubts the disparate effects that different accounting practices can have, consider the case of Daimler-Benz. Under German accounting standards, Daimler reported a profit of 168 million Deutschmarks in 1993. Under U.S. GAAP, the company reported a loss of almost a billion Deutschmarks for the same period.
For many in the American business community, this very important issue will boil down to three questions. First, will there be a level playing field for all domestic and foreign publicly-traded companies? Second, will I be able to have a meaningful voice in the standard-setting process? And third, what are the ultimate implications for the cost of capital and, when necessary, the ability to raise capital in a liquid market?
The International Accounting Standards Committee ("IASC") has been working to develop a common, worldwide language for financial reporting. A common language—one that can be understood by investors around the world—raises aspirations that we can eliminate one more impediment to global investment. But I recall the words of George Bernard Shaw, who observed that England and America are two countries separated by a common language. And there is some truth to that. In the United States, a baby wears a bonnet on its head. But in England, a mechanic raises the bonnet of a car to check the oil. Are we all really speaking the same language?
Earlier this year, the International Organization of Securities Commissions ("IOSCO") and the SEC staff began their assessment of a set of standards developed by the International Accounting Standards Committee. We must determine whether the IASC standards do, in fact, constitute a language that requires transparency, consistency, and comparability for companies reporting financial information in a global capital market. And we have to look at the actual reporting that results—not just focus on what—in theory—would be reported. The actual results depend not only on the existing accounting standards, but also depend critically on the reporting infrastructure.
The first aspect of this infrastructure is the process that produces and interprets accounting standards. Standards that look good on paper must be effective in use. Experience with standards adopted by the FASB in the United States demonstrates that even carefully deliberated standards sometimes require modification or revision after adoption. Further, new business practices sometimes give rise to the need for new accounting standards. An effective standard-setting body must be able to respond both to the need to improve existing accounting standards and to create new accounting standards as new business practices dictate. Currently, the IASC is attempting to restructure its organization into a more effective and credible international standard setter. We are watching this process with keen interest.
In the United States, several different standard-setting structures have been used over the past 50 years. Our experiences with the Committee on Accounting Procedure ("CAP"), the Accounting Principles Board ("ABP"), and now the FASB, have taught us that for an entity to be credible it must select its members on the basis of technical competence and devotion to the public interest. The standard setter must be independent and objective in developing standards that provide transparent, unbiased information for use in the capital markets. It must resist the temptation to achieve harmony by trying to accommodate the interests of various groups at the expense of producing a meaningful language. Perhaps an alternative standard-setting structure will be required to meet the needs of our capital markets for high-quality transparent financial reporting, if acceptable criteria are not met.
Finally, any global financial reporting system must include an infrastructure that extends beyond the standards and the standard setters. This infrastructure must include high-quality auditing standards, strong international audit firms with effective quality controls, profession-wide quality assurance, and meaningful regulatory oversight.
Profession-wide quality assurance is an especially relevant issue in today's environment. International auditing firms have been quite successful in branding their names worldwide. Today, you can't walk through an airport, ride a bus, or open a magazine without seeing ads for many of these firms. But don't mistake their omnipresence for omnipotence over worldwide quality control.
An affiliated firm in South America or Asia is just that—affiliated. There is no guarantee that the foreign affiliate adheres to anything resembling the high-quality auditing standards that U.S. firms must apply to their U.S. clients. Even if the laws of many jurisdictions do not prescribe sufficiently rigorous audit standards, I see a compelling market need for firms to require their worldwide affiliates to subscribe to the highest possible global standards.
The organizing agreement between these affiliated firms and their parents must ensure a consistent quality of audits on a worldwide basis. In the aftermath of the 1997 and 1998 crises, the World Bank questioned the quality of audits in the international arena. I must say, I share that concern.
The international financial institutions, key foreign financial regulators, and the SEC are now actively discussing how we can join together to ensure that we have high-quality, public-oriented, independent audits that guarantee credible financial reporting for both global investors and markets. I know that this is as much a concern for the profession as it is for regulators around the world. A global economy demands that investors have confidence in financial numbers on a global basis.
Effective Self-Regulation in a World of Change
As we approach the new millennium and reflect on the events of the 20th century, the extent of change within the accounting profession has been great. The beginning of the century saw professional certification of accountants. Then came passage of income tax laws during World War I. Next came the ’29 market crash, ensuing enactment of the securities acts, and the creation of the AICPA and its Committee on Accounting Procedure. The CAP was followed by the APB, and then the FASB. The Public Oversight Board ("POB") and the SEC Practice Section ("SECPS") were established. The challenges brought on by the Federal Trade Commission created other changes. All of these events have profoundly affected the public accounting profession. In addition, if you took a snapshot of a public accounting firm in the 60’s or 70’s, it would clearly show a firm that was nationally rather than globally focused, one whose principal strategy and business was tied to auditing, and whose principal technology was a Monroe calculator and a Xerox copier. How we have changed!!
Today, the picture shows global organizations that are multidisciplinary financial service firms, with less than a third of their revenues from the audit practice, driving efficiencies in their processes and work with client-server and e-commerce based systems.
But a third picture also develops of the self-regulatory system that provides oversight, accountability, and credibility for the public accounting profession. And this picture has not changed in the past twenty-five or so years. Despite continuous improvement and Total Quality Management initiatives with respect to the business of accounting firms, the regulatory scheme has remained unchanged.
As a result, I believe it is now time to act in a timely manner to evaluate and improve the outdated self-regulatory system we have in the profession today. Certainly we at the Commission have high expectations that the O’Malley Panel, created by the POB, will serve up some credible recommendations. We are also reaching out to others in the profession to develop effective solutions.
Keep in mind that in calm waters, every ship has a good captain. It is the real leaders who can anticipate and plan for rough waters ahead. Let me give you an example. Jim Copeland, chairman of Deloitte & Touche, recently testified before the O’Malley Panel and noted the need for change—for personal accountability by auditors. It is this type of real leadership, where professional leadership is demonstrated through actions, that the profession must depend on if it is to maintain the brand value of the CPA logo. I commend Jim for his dedication to improving the profession.
The task that lies ahead of us will not be easy. We must be conscientious and search for innovative ideas. During his testimony to the O’Malley Panel, Jim Copeland offered one. Jim contrasted the processes used to investigate fraudulent financial reporting with those used to investigate problems in the airline industry. He stated: "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 also is 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."
I hope we have the vision and leaders within our profession to develop such systems that are founded on serving the public interest. The AICPA’s Vision project is examining how the profession should move forward in the new millennium. Where is the vision for moving the profession’s twenty-plus year old regulatory system into the future? Who will assure that the public’s trust and confidence is maintained? Those who reject progress on this important task are merely blind to the need for continuous improvement in a world of constant change.
Auditors’ Integrity and Independence
Let me switch topics briefly. I want to discuss auditors’ independence. Let me read you what the Supreme Court has said on this important issue:
"By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporations' creditors and stockholders, as well as the investing public. This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires fidelity to the public trust" (emphasis added). U.S. v. Arthur Young & Co., 465 U.S. 805, 817-818.
Needless to say, this statement is a guiding principle for an independent public accountant. The public attaches value to the services of CPAs, because it believes that the auditor is truly acting in an independent, objective, and unbiased fashion.
Over the years, as a partner in the profession and as a senior executive in management, I’ve learned that service providers can maintain customer and market loyalties only if there is truly a value added by their services that distinguishes them from other service providers. For auditors, that one distinguishing characteristic is an auditor’s independence.
Yet I am disturbed by and concerned for my profession. Over the past year, we have had to take enforcement actions against firms and their professionals for breaching the elementary and fundamental independence rules of their firm, the profession, and the SEC. We have seen auditors who have invested in the very client they were auditing. We have seen contingent fee arrangements and auditors auditing their own work and numbers. We have seen auditors providing legal services in violation of the Commission’s rules and the SECPS membership rules. And it is not over— we at the Commission are going to pursue these matters with the tenacity of Sherlock Holmes.
In fact, our investigators have shown that a culture exists amongst some in the profession that seems to justify ignorance and noncompliance with the rules. There is a lack of self-accountability and responsibility amongst some professionals that has caused great consternation and trouble for public registrants. Newspaper articles over the course of the past year have cited instances where a lack of care and diligence by professionals caused registrants to change auditors. In one instance, the new auditor correctly required a change in accounting that, when announced, resulted in a $400 million drop in shareholder value. I believe those in accounting firms who demonstrate a disregard for the independence rules, and as a result negatively affect their clients, their fellow professionals, and their firms, should and must be disciplined. The accounting firms, the AICPA, state regulatory boards, and the SEC will all need to take effective and timely steps in this regard.
However, the accounting firms, SEC Practice Section of the AICPA, and the Public Oversight Board also need to quickly consider what changes in quality controls, policies, and procedures in firms are necessary. The controls and systems that are in place at some firms today were created in another era. These antiquated models must be replaced with a new model that includes:
- Ongoing training throughout the firm,
- Documented policies and procedures that all professionals must be required to be familiar with,
- An effective monitoring system and quality controls,
- Internal and external testing of compliance with the system, including selective testing of individual data, and
- An effective disciplinary mechanism.
No doubt the need for such systems and changes is being brought on by fundamental changes in the business, structure, and personnel of the accounting firms. Perhaps in light of these changes, we need to consider how we can bring greater transparency and sunlight to this issue. The Independence Standards Board ("ISB") has started this process by requiring auditors to discuss fully their relationships with a registrant’s audit committee each year.
But perhaps it is time to communicate directly to investors so that they can become more fully informed about such matters and can make their own judgments. From 1978 to 1981, registrants presented information to investors on fees paid to their primary audit firms for audit and non-audit services. Some foreign countries have similar approaches. In light of the changes that have occurred in the profession and from an international perspective, I believe we need to consider revisiting this issue.
Looking Further into the Future
The issues that confront us in the next decade nearly fill the window. But I want to discuss briefly images that are farther out on the horizon. First, my reflections on the past.
Less than two hundred years ago, farming was the primary economic activity. Business activities were conducted by individual proprietors or a few partners working together. Then came the industrial revolution. Railroads dramatically reduced the geographic barriers of mountains and distance. Businesses could imagine providing manufactured goods for an entire region and even the entire continent. Large corporations emerged.
With these new forms of business came requirements for business capital that were unknown in earlier times. The growth of capital markets fueled dramatic changes in the economy and in the lives of those affected by it. Individuals could save for their futures by investing in these businesses. In order to invest, however, investors had to understand the risks and opportunities.
The rudimentary elements of today’s regulatory system began to form. Financial statements provided a window to see into the company—to assess whether a firm represented a good investment opportunity, and to monitor the results of its operations. Managers prepared financial statements annually to convey to investors the results of the year’s activities. Accounting methods were not as well developed then, but managers were able to use accounting methods of that time to prepare income statements and balance sheets that were quite similar in format to those that we observe today. Auditing also played a key role in this development. Outside auditors, who were independent of the firm’s management, enhanced the credibility of management’s financial statements.
But that structure was far from perfect. Accounting methods were often imprecise and varied among accountants. Auditors were the only line of defense for investors; sometimes their defenses were not strong enough. The consequence was that investors, and markets, suffered. This situation seems to have some similarity to the financial reporting problems we see today. In the words of Yogi Berra, "Its déjà vu all over again."
The market ills of the early 1900s were addressed by Congressional intervention. Congress created the SEC to, among other responsibilities, oversee accounting standards and the financial reporting process in order to protect investors. The results of these changes speak loudly. Because of these underpinnings, today we enjoy vibrant capital markets that are the envy of the world.
But once again, the structure is showing signs of wear. Accounting practices are sometimes less than precise; auditors are sometimes less than vigilant. And technology is creating new challenges to our regulatory scheme. But we are not facing the crisis that led to the formation of the SEC in 1934. And this is because the SEC has been able to meet market challenges. It is prepared to alter the current regulatory scheme as needed to continue to meet these challenges, and to foster innovations in markets. But the basic principles that guide the Commission’s work – transparency, fair competition, and investor protection – will endure. Simply stated, high-quality financial reporting and independent auditing can never be compromised. Yet the Commission cannot act alone in guaranteeing these principles. The accounting and auditing professions, and indeed, the entire business community, must hold fast to the lasting constants that will preserve us through the changes that—like the new millennium—lie ahead.