Request for Rulemaking Concerning Shareholder Communications
July 29, 2004
July 29, 2004
Mr. Jonathan G. Katz
Dear Mr. Katz:
Re: "Earnings RatingsTM - A Benchmark of Accounting Policies"
This petition for Rulemaking is submitted on behalf of Mr. Richard Furlin and Dr. Jeffry Haber. Mr. Furlin is the former Sr. Director of Analytic Content at Standard & Poor's, and Dr. Haber, PhD, CPA, is an Assistant Professor of Accounting at Iona College.
As described in detail in the attached Petition for Rulemaking, we believe an Earnings RatingTM, which is an assessment of the quality of a company's reported earnings, should be a listing requirement for any publicly traded company. Like a credit rating, Earnings RatingsTM would be a secondary look at auditors' work, and be broadly (and repeatedly) distributed to the general public. Its issuance by private enterprise would apply market forces to influence corporate accounting behaviors. While it would immediately restore investor confidence, an Earnings RatingTM would also help investors by normalizing earning numbers, which today vary widely even within the confines of Generally Accepted Accounting Principles.
Thank you for considering our request. We would be happy to discuss this issue further with the Commission or members of the Commission staff.
Richard S. Furlin
Highly publicized scandals have damaged investor confidence and brought considerable attention to corporate accounting. While Sarbanes-Oxley will assist in preventing some frauds in the future, it still doesn't address the issue that due to legitimate gray areas of accounting reported earnings, so eagerly followed by investors worldwide, are actually "estimates built upon guesses." In other words, company earnings comparisons are not "apples to apples."
We believe the credit market provides a helpful model. Credit ratings, distributed broadly by nationally recognized statistic rating organizations (NRSRO's), influence the debt markets and help to ensure that issuer management will be responsible with cash flow.
An "Earnings RatingTM" is an assessment of a company's accounting policies. Not only is it a benchmark with which to equalize company reported earnings, but it too can influence management's accounting choices. Downgrades may reflect accounting policies out of line with economic reality. If broadly distributed, market forces (not government regulation) will motivate management to choose accounting policies that best reflect their business rather than achieving goals that are not in the long-term best interest of investors and creditors.
Earnings RatingsTM can also increase investor confidence and restore faith in the American financial system. These easy-to-understand letter grade ratings will continuously be published in press announcements and seen on the Internet. Ratings will assure investors that a second set of independent eyes are reviewing the company books.
In 2002, a wave of accounting scandals broke as a number of leading companies admitted to misstating their financial statements and promoting a false impression of their economic status. There was also a general perception that more accounting scandals were just waiting to be uncovered, which led to the third straight down year in the stock market. The fallout was profound. Investors lost confidence in the U.S. financial system, the independent audit process and the accounting profession.
In the aftermath, Congress sought to examine the breakdowns of "watch-dog groups" including securities analysts, the Securities and Exchange Commission (SEC), and credit rating agencies.
The October 8, 2002 report to the Senate Committee on Government Affairs asserted sell-side analysts lacked objectivity, which came as no surprise to anyone on Wall Street. Professional investors have long known sell-side analysts more closely resembled marketing professionals, and have ignored their directional calls (focusing instead on earnings estimates). Unfortunately, the widely distributed "buy" recommendations on "anything.com" by sell-side analysts was attractive to the average investor at a time when self-directed investing was peaking.
The SEC was another putative warden, but in reality resource constraints limit the SEC's ability to detect wrongdoing. "To uncover such fraud requires a considerably more in-depth audit than the SEC has thus far been equipped or oriented to do."1 Furthermore, the Securities Act of 1933 expressly rejected the idea of direct government audits of companies' books.2
Next, as required by the 2002 Sarbanes-Oxley act, the SEC scrutinized the role of credit rating agencies based on their growing influence in the operations of securities markets. Among the findings were that rating agencies should place more weight on the "analytical significance of various account quality issues"3. Credit ratings agencies, on the other hand, are of the view that they do not conduct formal audits of rated companies or search for fraud.
Clearly, there is a divide in what double-checks regulators and investors expected, and what was actually present.
Congress has since tightened governance. The Sarbanes-Oxley act created an accounting industry oversight board to review the practices of accounting firms. Securities analysts can no longer report to investment banking. Also, credit ratings agencies were admonished. Even the SEC will be getting more resources for investigation. Finally, there is a substantial increase in corporate disclosure required by Section 404 of the Act that, according to the Public Company Accounting Reform Board, will cost approximately $1.24 billion, or $90,000 per company. (Other estimates are much higher4).
However, will these measures be effective? Will they restore investor confidence? Will they truly protect investors even through the next bull market? Although sell-side analysts must be separated from investment banking, their bonuses are still based on the overall company success, and investment banking drives Wall Street profits. Credit rating agencies still maintain they do not perform audits. Will the SEC continue to have their increased budgets years from now when the fervor has died down? Can a company's audit committee of a few people truly protect investors? As former SEC Chairman Richard Breeden warned, "three or four individuals, no matter how much talent and time they are willing to bring to the job, are not going to match the internal and external audit functions."5
Will all the expense companies are now incurring be worthwhile? Mr. Breeden also cautioned, "the law forces companies to pay more attention to internal controls. That is one of the great successes of the statue. But I'm very concerned that this will be turned into process rather than substance." 6 The question remains, who will be looking at all the increased disclosures and procedures now required of companies at great expense? Audit firms and sell-side analysts?
Leaving aside instances of fraud, let's look at auditing from another standpoint - general measurement of a company's financial condition.
One of a company's most important pieces of financial information is its earnings figure. According to the Financial Accounting Standards Board, "the primary focus of financial reporting is information about earnings and its components."7 Furthermore, "earnings information is commonly the focus for assessing management's stewardship or accountability. Management, owners, and others emphasize enterprise performance or profitability in describing how management has discharged its stewardship accountability." 8
This information is broadly relied upon. "Investors, creditors and others ... may use earnings information to help them (a) evaluate management's performance, (b) estimate "earnings power" or other amounts they perceive as "representative" of the long-term earnings ability of an enterprise, (c) predict future earnings, or (d) assess the risk of investing in, or lending to, an enterprise ... Measures of earnings and information about earnings disclosed by financial reporting should, to the extent possible, be useful for those and similar uses and purposes." 9 And since investors assume that the earnings are correctly prepared in accordance with accounting guidance when there is an unqualified auditor's report, earnings are used to place a value on the business. The commonly used price-earnings (P-E) ratio provides the basis for comparisons of valuations between entities.
However, all earnings are not the same. The truth is that most of the numbers in every publicly traded company's financial statements are the product of lots of "estimates piled upon large doses of guesswork."10 For any given transaction, there might be a wide variety of acceptable accounting principles from which to choose. The effects of applying different principles might result in great disparity, but, nonetheless, if an acceptable method is chosen and properly applied the auditor has little choice but to accept the accounting.
Even the accounting profession realizes that the recognition judgments they make are primarily intended to increase reliability in the very long run, but may result in significantly different results when examined in yearly segments. "Earnings and its components relate to an individual enterprise during a particular period. Over the life of an enterprise (or other very long period), total reported earnings equals the net cash receipts excluding those from capital changes ... but that relationship between earnings and cash flows rarely, if ever, holds for periods as short as a year ..."11
In 2002, Standard & Poor's calculated what they considered to be "core earnings", or earnings associated with the operations of the business (thus excluding investment windfalls, adding stock option expenses and other items). How big was the difference between core and reported? According to S&P, companies in the S&P 500-stock reported on average $26.74 earnings per share for the 12-months ending June 2002, but the core earnings were just $18.48, a 31% difference.
Many believe accounting is black and white. However, it is more often the case that accounting is shrouded in shades of gray. "Uncertainty about economic and business activities and results is persuasive, and often clouds whether a particular item qualifies as an asset or a liability of a particular entity ... [and the amount at which it is recorded (author note)]." 12
While Generally Accepted Accounting Principles adequately measure the value of an enterprise for a variety of purposes, it is clear investors need a better means for investment comparison and protection. We believe the success of credit ratings provides a model.
The Earnings RatingTM
Credit ratings were first published by John Moody, founder of Moody's, in 1909. They are expressed in letter grade and provide an assessment of creditworthiness or the likelihood that debt will be repaid. The credit agencies maintain they simply provide guidance for investors. "Credit ratings are currently used more as benchmarks for market participants than as a source of information for investors. Approximately 95% of corporate bonds are held by institutional investors, which have their own in-house analysts to assess the value of the bonds in which they invest." 14
The "Earnings RatingTM" is a benchmark to measure accounting policies15. The assessment it provides is the "quality of reported earnings."
The guiding principle in evaluating all "gray areas" and setting the benchmark is how do management's accounting choices reflect the operations of the company. The grading system is based on A, B, C, D and F, with the following narrative grade descriptions:
A: In every respect the accounting choices mirror the core operations of the company
B: In most respects the accounting choices mirror the core operations of the company
C: In some respects the accounting choices mirror the core operations of the company
D: In many respects the accounting choices do not mirror the core operations of the company
F: In most respects the accounting choices do not mirror the core operations of the company
Earnings RatingsTM would work in a very similar fashion to credit ratings. The Earnings RatingTM would be derived through the deliberation of an Earnings RatingsTM Committee which would weigh-in on the company's accounting policies, benchmark them against others within the Standard Industrial Code (SIC), determine the impact those choices had on the reported number, and ultimately decide on the rating. Nonpublic information such as divisional earnings would be required and kept confidential. If a rating were to be changed, companies would have a chance to appeal, which will be limited in both time and submission of new information. Ratings change announcements would be made in press releases and broadly distributed via all financial information channels and systems.
While very simple in concept, the implications would be enormous and solve multiple problems experienced today.