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Speech by SEC Staff:
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| 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 the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission. |
Good morning! Thank you Denny for that great introduction. I would like to thank the conference sponsors, the Financial Executives Institute (FEI), and the American Institute of Certified Public Accountants (AICPA) as well as Conference Chair, Denny Beresford, for this important conference on an issue that has great impact on investors worldwide. I hope that the significant turnout today demonstrates that this should be the start of a recurring, annual event.
It is fitting that this initial conference on quality in financial reporting is here in New York City. For it is here that our capital markets got their initial start, when a group of gentlemen signed the Buttonwood Agreement in 1792, near the Old Wall Street, and formed what would soon become known as the New York Stock Exchange. Now in the beginning, those gentlemen would get together and buy or sell bonds or stocks once a day, while sitting on chairs in a room, with one person calling out the trades. And of course, at that time, the largest market was not here in the United States, but rather in London.
Since those early days, our markets have evolved, changing, and ever improving, and gaining investor confidence. But some of those changes were not positive. Investors panicked and left the markets in droves, for example, in the market crash of 1929-32 and on more than one on occasion in the 1800s.
The 1990s and first years of the new millennium have also tested the fortitude and confidence of investors. We have seen the Nasdaq with a total market capitalization of $386 billion in 1989, less than the market cap for General Electric today, increase by 1248% to $5.2 trillion at the end of 1999. And of course, we have since seen the Nasdaq fall from a high of 5132 on March 10, 2000 to 2059 at yesterday's close, a decline of over 50 percent.
But throughout the trying times of the past year, our investors have remained confident in our markets. Of the $29.2 trillion in market capitalization of the domestic companies listed on the global capital markets, at the end of February, $14 trillion or nearly half was invested in companies listed on the New York Stock Exchange, Nasdaq or the American Stock Exchange (AMEX). That's greater than four times the $3 trillion capitalization of the companies on the Tokyo Exchange, more than five times the $2.4 trillion capitalization for the London Stock Exchange, and more than ten times the $1.2 trillion capitalization for Germany. What a success story for our capital markets, for investors, for the companies they have invested in, and for the employees who work for them.
A Foundation of Quality
But there is a reason for that success story that we should not, and cannot, lose sight of. The reason the U.S. capital markets are so successful is simply that people are willing to invest more capital here because they perceive higher quality financial information than is available any other place in the world. And with that higher quality information, they are able to make more informed and better reasoned decisions on how to allocate their capital. The result is higher returns for investors, lower cost of capital for market participants, and greater availability of capital in the deepest, most liquid markets.
This foundation of transparent high quality financial information, however, was not constructed overnight. And, as I mentioned, there are times when it has shown strains or cracks. During the 1800s and early 1900s, there were several occasions when investors lost confidence in the markets and capital flowed out, with ensuing panics or depressions. The great Panic of 1837, the Panic of 1857, and the stock market crash of 1929 are but a few examples of what a lack of quality information and investor confidence can do. These are lessons that bear repeating lest we repeat history and our earlier costly mistakes.
Clouds of Concern
In the latter half of the 1990s, there has been a growing concern about the quality of the numbers being disclosed to, and relied upon by, investors due to:
1. Ongoing press reports of alleged major financial frauds involving companies with household names and costing investors billions of dollars.
2. Increasing numbers of errors and overly aggressive accounting practices requiring restatements of financials, sometimes covering a number of years.
3. Abusive practices where the numbers are managed to reflect a desired financial result as opposed to the business being managed and actually achieving the reported results.
Working Together to Achieve Progress
While these developments may lead one to see storm clouds on the horizon, there is also some very good news to report. The financial community consisting of business leaders, leading professionals from the legal and accounting professions, standard setters, and stock exchanges have all pitched in during the past three years to shore up the foundation on which our markets are built.
Let me summarize some of these important accomplishments for you.
First, The Blue Ribbon Panel on Improving the Effectiveness of Audit Committees issued a report in 1999 with ten outstanding recommendations. With the adoption of the ten recommendations by the stock exchanges, the Commission, and the Auditing Standards Board (ASB), we are starting to see greater oversight of the financial reporting process and external auditors, by audit committees. The Panel's report also listed a number of best practices I would urge each and every audit committee to adopt.
I have been reading many of the proxies being filed this year. I have noted more audit committees meeting four to six times a year and engaging in substantive discussions as opposed to a couple of meetings a year during breakfast. I encourage you to read the audit committee report for Coca Cola that I believe establishes a model and best practice for audit committees. Coca Cola is a household name and this report has been written so investors in households can understand it. It sets forth useful and relevant information for investors to consider. It doesn't read like a report written by a corporate attorney to be read by a plaintiff's attorney. Kudos to Mr. Buffett for that type of plain English report to the company's investors.
A second accomplishment has been the adoption by the Commission and ASB, of new standards that require audit committees to have meaningful discussions about the quality of the company's financial reporting, including such sensitive matters as the accounting policies selected, the judgments used to record such items as restructuring changes and write-offs of in-process research and development, and the materiality of unrecorded adjustments. These discussions also lead to discussions covering the interim financial statements. As a result, I now see issues being addressed by financial management and auditors on a more timely basis. And again, audit committees are becoming more active in their oversight, asking more robust, probing questions on a timely basis.
A third accomplishment was the restructuring of a new International Accounting Standards Board (IASB). This new board, comprised mostly of independent members who were chosen based on their competence, will no doubt be closely followed. We have hope that international accounting standards can be further developed by the IASB that will result in greater comparability, and consistency, and higher quality financial reporting that reflects the actual underlying economics of those companies applying them. I want to thank the AICPA for their support on this project.
A fourth accomplishment was the adoption by the Commission of new rules that will provide the investing public greater confidence in the independence of auditors. The public relies on the auditors, in their role as an independent third party, to ensure the integrity and credibility of the numbers.
Another major development was the report of the Panel on Audit Effectiveness, otherwise known as the O'Malley Panel Report. I commend the accounting profession for their significant contributions to this effort. The O'Malley Panel, comprised of attorneys, businessmen, a former chairman of the Amex and a former chairman of Price Waterhouse, issued a milestone report with over 200 recommendations for the accounting firms and profession. These recommendations, if adopted in full and implemented, will contribute to new auditing standards, and enhanced auditing procedures that are based on what is required to accomplish an effective audit for investors. However, the jury is out on this project as it appears that the profession is getting off to a slow and rocky start in adopting these recommendations as proposed. Unfortunately, an approach based on incrementalism will not serve the investing public.
And finally, the staff of the Commission has issued Staff Accounting Bulletins (SAB) No. 99, 100, and 101. SAB 99 provides greater guidance on and consistency in the application of the concept of materiality in preparing and auditing financial statements. It also focuses attention on those individuals who were intentionally hiding behind the guise of materiality to inappropriately manage earnings. SAB 100 has proven especially timely as it addresses the need for more specificity in the development and disclosure of restructuring plans that are being announced in increasing numbers in our current economic environment. And finally, as many companies are struggling to achieve revenue forecasts, SAB 101 has put in the hand of CFOs, controllers, and auditors, a compendium of the literature on revenue recognition.
Let me mention one additional accomplishment of our earnings management initiative. I had heard from many controllers that they were being pressured to "make the numbers" using whatever means possible . This was borne out by surveys in both Business Week and CFO Magazine. And clearly, many of these controllers were troubled, as I was, about this unethical business practice that is just flat out wrong.
Today, however, I am hearing from controllers that the accomplishments achieved by the financial community are having a positive impact and lessening the pressure they feel. I am hearing that CEOs and audit committees are becoming more cognizant of the need for credible reporting and improved internal controls. And I am hearing that accountants do make an important and valuable contribution to the company in their roles as controllers and preparers of high quality financial reports issued to the company's investors.
There have been many other achievements that are equally as important, but I cannot mention them all for lack of time.
Suffice it to say the accounting profession, the AICPA, including the SEC Practice Section, the Public Oversight Board, the Business Roundtable, FEI, the Association of Investment Management and Research (AIMR), the American Accounting Association, international securities regulators, and many others have all contributed to these successful efforts to improve the quality of financial reporting.
Although progress has been made, our job is not done. While some take the view that the United States has the best financial reporting in the world and therefore we should not "tinker" with it, I strongly disagree. Like any successful businessmen, we should always be alert to opportunities for improving our standards and processes on a continuous basis. We should constantly search for ways to make our financial statements more accurately reflect the economics of the business. For example, as the well known Arthur Andersen partner Leonard Spacek noted in the 1960s, most leases are nothing more than financings. Yet today, forty years later, financial statements continue to fail to reflect the economics of these transactions. And what about asset impairments? Does the fact that every change in a CEO seems to be accompanied by a large restructuring and impairment charge engender confidence in the quality of the company's financial reports? I think not.
So let's spend a few moments on a couple of topics that I believe can contribute to improving transparency and accountability for quality financial reporting.
Investors Deserve Real Analysis From Real Analysts
First, let me start with the issue of how analysts are serving investors. An article in the Financial Times dated March 20, 2001, emphasized a recurring theme I quite often hear today. That article's title? "Shoot All the Analysts." Now it could have said shoot just some, or shoot a few, but no, the editor said shoot them all. Unfortunately, this demonstrates that all analysts are being "tainted" by the actions of those who fail to serve the public interests of investors.
But rather than becoming caught up in the emotion of the article, I thought one should try to obtain some facts. I did obtain some facts that I would like to share with you.
First, as of April 2, 2001, based on approximately 26,000 analysts' recommendations, I found1:
a. 7,657 or 29.8% recommendations of strong buy
b. 9,740 or 37.9% recommendations of buy
c. 7,961 or 31.0% recommendations of hold
d. 274 or 1.1% recommendations for sale, and
e. 81 or 0.3% issued recommendations for strong sale.
I understand some also use the terminology "out perform" for hold but based on these statistics I am not sure who the companies are outperforming!
Let me make it a little more interesting by giving you the same statistics near the market peak on March 1, 2000:
a. 10,025 or 35.8% of the recommendations were for strong buy.
b. 10,303 or 36.8% of the recommendations were for buy.
c. 7,430 or 26.6% of the recommendations were for hold.
d. 164 or 0.6% of the recommendations were for sale, and
e. 56 or 0.2% of the recommendations were for strong sale.
There is little change in the recommendations between the years. Yet there have been very fundamental changes in the capital markets, in the economy, and in the revenues and profits of many companies. As I mentioned earlier, Nasdaq hit a high of 5132 on March 10, 2000, and since then, it has fallen approximately 3100 points. In the fourth quarter of 2000, a record 794 earnings warnings were issued. That was followed by a record 895 warnings in the first quarter of 2001. There have already been as of the beginning of this week, 119 warnings for the 2nd quarter, which is 80% higher than where we were at the same point on January 23rd, and the meter is still running. Since October, Moody's, a rating agency, has downgraded the short term debt ratings of 66 companies while upgrading just 11. Yet in light of all of this, as the market began its downward shift a year ago, less than one percent of the recommendations were for sales. And today, after the markets and investors have lost trillions in market capitalization, just over one percent of the recommendations are for sale. I believe this lack of quality research and reporting would lead Benjamin Graham, the pioneer of high quality security analysis, to wince. Such research and recommendations no doubt lead investors to challenge the credibility of analysts. Don't you ask yourself, just how poor is the performance of the stock of the companies with sales recommendations?
Let me submit another piece of evidence for your consideration. The Wall Street Journal dated March 22, 2001, quoted a memo by the head of European research for a leading investment banking department. The memo stated:
"Both the Company and the client banker need to be notified, in advance, of the recommendation change that we plan to make. If the company requests changes to the research note, the analyst has a responsibility to either incorporate the changes requested or communicate clearly why the changes cannot be made."
And to think I was worried about business conflicts and independence of auditors.
Unnecessary Pressure
Shortly after I came to the Commission, I met with a number of financial executives from one of the high technology industries. From my perspective, one of the purposes of the meeting was to gain their insights into the issue of earnings management. One of the executives told the story of how recently he had been discussing with an analyst that there was a possibility his company may be short a few pennies on the earnings estimate. And the analyst's response? "You're a smart CFO, I'm sure you can figure out how to cover the difference."
"Creating Magic With Numbers"
And on a more personal note, when I served as CFO of a semiconductor company, the CEO and I were going through the process of selecting investment bankers. One day, we had one of the "blue blooded bulge bracket" firms in. During their dog and pony show, one of the analysts noted that our company had some goodwill on the books and recommended that I ought to write it off before the public offering. I sensed this was one way they could create a higher value for the pending public offering. However, I remember responding that a write-off probably would not be feasible because (1) we were profitable, (2) had very positive cash flows, (3) that it seemed the company would be running afoul of an accounting standard to do so, and (4) at the same time I was going to be telling investors this was a worthwhile buy (or "strong buy" using analysts' jargon) I would be conveying to the SEC staff, who would be reviewing my filing, that this company had problems. And the analyst's response? Don't worry, they would develop some "sound" reasoning for me. I said, "I don't think so." Later on they made the fateful decision to approach the CEO again and try to get his buy-in to the writeoff. I say "fateful" decision because that move sealed the investment banking firm's fate and I didn't have to deal with them any more.
So now you have the facts, and let's ask a few questions.
1. Do any of you in the audience believe analysts are providing useful, meaningful buy sell recommendations to investors on a timely basis? (OK, maybe buy recommendations, but what about sell recommendations?)
2. Do any of you believe analysts are really providing independent unbiased research?
3. How many of you believe analysts are focused on long-term value creation versus short-term results and pressuring management to achieve these results?
4. How often have you seen an analyst disclose their business relationships and past, present, or especially expected future underwritings when making a recommendation on television or in writing?
5. How many of you think the Financial Times had the title of their article right?!
Time for Change
Don't get me wrong. I have worked with some great analysts as a CFO. And I think analysts can and should play a useful role in analyzing and providing credible information to investors. I just don't believe that happens as frequently as it should today. Instead, it seems as if some sell analysts should just remove the word "analyst" from their title and acknowledge they are really part of the sales function.
Conversely, I would hope that those analysts who still take pride in turning out reports based on independent, indepth, and robust research, as well as the industry organizations such as AIMR and SIA would develop meaningful standards and best practices to address the obvious shortcomings I have mentioned. This must include standards that address conflicts, provide greater disclosure to investors of any existing or potential conflicts, raise the quality of research, emphasize long-term value creation over short-term results, put forth meaningful definitions to be followed in issuing recommendations, and demonstrate a renewed commitment to professionalism, quality information, and investors. If not, then I believe it will be time to consider Regulation LT - Lots of Transparency.
Now let me shift for a few moments to the role of the Chief Financial Officer.
The Important Role of the Chief Financial Officer in Quality
I believe CFOs need to present a clear, transparent financial report that tells the whole story. As Warren Buffett has asked, if you (i.e., the CFO) were investing in this company, has all the information you would want to know been made available to investors in an unbiased fashion? Too often today, we see the numbers being "spun," or important information about key trends or key and critical performance indicators being left out. And let's not forget, quality financial reporting means going beyond those minimum boundaries established by the rules governing financial reporting. The Commission's MD&A rules say it best, your disclosures must enable investors to see the business through the "eyes of management."
Leadership
CFOs need to establish themselves as strong leaders on the executive management team. This means they need to have the spine and resolve to "just say no" when the CEOs or others pressure them to manage the numbers, especially when others are having difficulty managing the business. CFOs need to remember the lesson in the article in CFO Magazine titled, "Jailhouse Shock." That article listed 22 CFOs who were serving time or awaiting sentencing. In several cases, the CFO was spending years behind bars and away from family, a career destroyed, and the embarrassing notoriety of being labeled a fraud on the front page of your local, if not national, newspaper. Let me read just a few for you:
CFO Phar-Mar - 2 years, 9 months
CFO Miniscribe - 2 years
CFO California Micro Devices - 2 years, 8 months
CFO Ferrofluidics - 5 years, 3 months
CFO Bernard Food Industries - 6 years
CFO Lumivision - 10 years
CFO Bennett Funding Group - 30 years
And four of the CFOs were waiting for sentencing, facing terms of 5 to 115 years in prison. Remember, investigating and prosecuting financial fraud cases have become a priority at the Commission, with District Attorneys, and other law enforcement agencies. Manipulating the numbers, even when trying to play it as close to the edge as possible, has its price. CFOs need to just say No!
CFOs also need to establish formal written policies setting forth not only high quality accounting policies, but also reasonable, effective internal controls that will ensure the financial records reflect all the company's policies, generally accepted accounting principles, and safeguard the company's assets. These policies and control procedures also should ensure that all the information necessary for a complete accounting and disclosure to investors of all relevant information is made on a timely basis.
I am concerned by recent press reports and disclosures the staff has seen. These reports and disclosures raise a question about the timeliness of accounting for and disclosure to investors of significant trends within business and industry today. As a result, I recently sent a letter to the eight largest accounting firms that follows up on our Audit Risk Alert Letter of last October. This letter is intended to convey a clear message: a lack of timely, complete, and transparent disclosures will result in amended filings. You may access it on the SEC's website at http://www.sec.gov/info/accountants/staffletters/sampleletter.htm.
Public and Internal Reporting on Internal Controls
Financial Executives International has stood for, supported, and recommended for many years the inclusion of management reports on internal controls in annual reports to shareholders. The Panel on Audit Effectiveness also recommended that the audit committee receive an annual report from management each year on the effectiveness of a company's internal controls. These recommendations clearly establish a "best practice," many companies already practice today. I strongly believe the CEO and CFO should sign off on a report to the investing public that the company's internal controls are operating effectively. This will then complete the package of public reporting by the "three legged stool" upon which quality financial reporting depends -- the auditors, the audit committee, and management. And as the Report of the Committee of Sponsoring Organizations noted, over 80% of financial frauds involve the override of internal controls by the CEO and/or CFO.
Balanced, Unbiased Reports to Investors
Let me also challenge CFOs who handle investor relations and public disclosure functions in a company, to treat all investors in a balanced and fair fashion. Selective disclosure of material information to some, but not all analysts and investors, is in my opinion, indefensible. Would you as a CFO be willing to look at those investors you had not informed about important facts, and tell them you had told others, who in turn had capitalized on that information in the markets? Do you really believe that is ethical and condone such practices? I have yet to see a CFO who is willing to answer this question "yes" in public, and I believe that confirms that selective disclosure is totally improper. I believe it is the lesson we all learned a long time ago; if you weren't willing to tell your mom about what you were up to, you probably shouldn't have been doing it!
Honest and fair dealings with investors and analysts also extends to press releases. "Everything But Bad Stuff" or EBS press releases do not present a complete or transparent picture. Often they appear to be trying to lead investors away from the "real" numbers, from real net income, and from real cash inflows and outflows. For example, press releases that add back expenses to earnings such as marketing costs, costs to start up new businesses or product lines, and interest, fail to note these are real costs paid for with "real" cash. Or what about those who always want to add back just selected "noncash" expenditures such as goodwill amortization. If these people are really so mesmerized by cash flows, how about disclosing to investors the value of stock issued or the amount of cash paid for the investment, the amount of subsequent cash flows generated, and the actual rate of return earned in future years from these investments? Why does that seem to be missing from ongoing press releases? It would seem if these returns were what was originally represented to investors, then companies would be willing to disclose them.
Let me stop for a moment here and note that I met with the Committee on Corporate Reporting of FEI approximately two months ago. During that meeting, I expressed my concerns about EBS Press Releases and asked if the Committee would consider trying to develop some type of guidance to address some of the abuses in press releases. Just last night, Phil Livingston of FEI and Phil Ameen of General Electric shared with me the product of their cooperative efforts with National Investors Relation Institute (NIRI). These efforts have developed a set of earnings press release guidelines. I would like to thank these organizations for their efforts and timely response. I encourage you to access the guidelines at www.fei.org/news/FEI-NIRI-EPRGuidelines-4-26-2001.cfm.
While I have not yet had a chance to study the guidelines in-depth, I would hope every CFO and every investor relations officer, as well as every audit committee, would take to heart those recommendations in the guidelines that state:
The recommendations cited above are sound and represent progress in the right direction.
You Can Enhance Disclosures to Your Investors Today
We have heard some say the historical financial statements and information is no longer relevant and that financial disclosures need to be enhanced. However, Jack Bogle, the well-respected founder of Vanguard, has noted that perhaps it was the markets, and not the financial reporting model that was wrong. Unfortunately, those investors that have been reading their quarterly portfolio statements printed at the end of March, 2001, have learned the old fashioned way that historical earnings, not just revenues, real cash inflows and outflows, and the amount of cash left, do count.
However, I do believe greater disclosure on a recurring basis of key performance indicators would be helpful and would enhance the quality of information investors receive. These indicators do provide information about value creation in a business. For example, indicators such as manufacturing plant capacity and utilization, backlog, trends in bookings from top ten customers, employee turnover rates, the description, nature and number of patents, and technology licensing information, would all be useful to investors. This information is typically already available, as it is the information management is customarily using to manage their business.
However, one of the Big Five Accounting Firms recently conducted a survey of the retail industry which noted that analysts and investors surveyed indicated non-financial indicators such as corporate strategy, quality of management, brand reputation, customer retention, systems and processes, intellectual capital, research and development, innovation, and social and environmental policies are not adequately reported. But, I wonder who is going to set the standard for reporting on the quality of management? And what would these standards say about Ray Kroc, founder of McDonalds, or Thomas Edison, given they had more than one misstep before becoming successful. I encourage corporate business leaders, investors and public accounting firms to undertake to work together to develop enhanced disclosures that are clearly understandable to investors and disclosed on a comparable, consistent basis. This would include defining the terms used in the disclosures such that they have a clear and transparent meaning to the investors who will read them.
Yet there is nothing today that prevents companies from disclosing additional useful and meaningful information. Indeed, to the extent it is forward looking information, the Commission has already afforded registrants safe harbors that can be utilized.
Finally, let me note that the CFO has a responsibility for ensuring that the Company's external auditors are independent. AS CFOs are accumulating the data for the new proxy disclosures on the auditor's independence, they should ensure that auditor fees do not include fees for prohibited services such as bookkeeping, valuation, legal, and executive search services. They also have a responsibility for ensuring the provisions in the new rules on internal audit and information technology services are fully complied with.
Closing
Let me close by noting the U.S. does have the preeminent markets in the world today, but they were not always so. They began as a small group of men who desired to improve the system. We have continued their initial efforts right up to today. But that continuous improvement cannot cease here. It must go into the future. I look forward to your comments and thoughts during this initial conference on quality, and in future conferences to come.
1 Information from Thomson Financial/First Call.
http://www.sec.gov/news/speech/spch485.htm
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