Alfred M. King
11102 Fawn Lake Parkway
Spotsylvania, VA 22553-4667
June 12, 2002
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Ladies and Gentlemen:
Reference File No. S7-16-02
I fully support the underlying thrust of your efforts, particularly in the light of the Enron debacle. In that case, according to press reports, Enron's management made apparently wildly optimistic assumptions regarding future prices of energy and commodities over a 20-30 future period. The resulting income statements were apparently overstated and losses were hidden.
Unfortunately, from my perspective at least, it appears that your proposed cure may be worse than the disease. How safe is safe? I fear that prevention can run amok. In the case of the proposed disclosures you are going to overwhelm the reader of financial statements, and we will not really be any wiser or safer.
The writer is an officer of a major appraisal firm. I have had over 33 years experience evaluating published financial statements of publicly traded firms. In many valuation assignments I must review anywhere from seven to ten published reports of so-called `comparable' firms. Right now, in fact, I am performing a valuation assignment for a Fortune 50 consumer goods company. I have had to look, in detail, at financial statements for the client and an additional nine companies. As a matter of interest, I list below the number of pages in the most recent annual financial statements, including footnotes and the MD&A:
Sara Lee | 31 pages |
Kellogg | 29 " |
General Mills | 26 " |
Coca Cola | 51 " |
Colgate | 22 " |
Anheuser Busch | 34 " |
PepsiCo | 30 " |
Campbell Soup | 24 " |
Kraft | 35 " |
H.J. Heinz | 46 " |
In each company there is a single Income Statement and a single Balance Sheet, which accounts for two or three pages. Add in a few more for the other required schedules and you still have presently a lot of footnotes and MD&A in each company. I fear your proposal will significantly add more.
If I understand your proposal correctly each of the companies would have to disclose up to perhaps five areas in which different estimates would have arrived at different amounts than those reported in the Income Statement and Balance Sheet. For each accounting estimate there would have to be an upper and lower range showing the maximum and minimum amounts which reasonably could have been presented.
Assuming that the accounting estimates are, to use your assumption, truly `material', it would mean that I as a reader would have to look at the published financials from multiple perspectives. I would be able to calculate a range of earnings and Earnings per Share (EPS). Then, if all the estimates went one way or the other (totally favorable or totally unfavorable) I would have either much more income, or much less income. Of course, some of the potential adjustments might go in opposite directions, thus minimizing the range. Without figuring out all the permutations and combinations it is easy to see that, with little effort, I would be able to calculate at least 25 different earnings amounts, presumably ranging around the actual amounts reported. This does not even take into account the impact of the 25 different earnings amounts on 25 related, but different, Balance Sheets.
Now I would presumably be able to do this for each of the ten companies in my universe, assuming the estimate ranges for each company are not correlated. At this point I have `lost the string' in how I would go about analyzing the industry in order to evaluate my subject company. Which of the 25 estimates per company would I use?
In practice I would use the published audited results and totally disregard this seemingly bottomless pit of alternatives. Right now GAAP requires companies to disclose a range of the impact of changes in health-care costs. I know that I have never utilized this information, and to the best of my knowledge no other professional appraiser in our firm, Valuation Research Corporation, utilizes it either in evaluating a company or its comparables.
Now multiply this availability of estimate ranges by five times, for every company.
While I totally support your objectives, I do not believe that adoption of these rules will in fact make it easier for shareholders, creditors or analysts to truly understand a business. In practice, I submit, it will add a layer of complexity that will be counter-productive. Good companies will end up confusing the financial statement reader. The `Enrons' of the world will be no more forthcoming than they have to be and their estimates will probably be wildly off anyhow. Looking back at Enron, is it reasonable to believe that if your proposal had been in effect in 1999 and 2000 that many analysts would have come to different conclusions?
In fact, I submit that the analysts would have been `guided' by the company to use the upper (more favorable) end of the range of each estimate! Instead of casting a more conservative picture it is easy to envision how analysts would have been even further off!
At a minimum, before adopting the proposals, I suggest that you try and field-test your proposal with perhaps 10-15 companies in one industry. Then take the `new' statements to analysts who follow that industry and ask them how, if at all, they would change their evaluations of the firms. My personal view is that they would take an optimistic perspective on the `good' companies and a negative perspective on the `poor' companies. Relative rankings would not change. Estimates by the analysts of future operating results, using their existing models, likewise would not change.
Also, you should develop a sample filing with five key policies, and the associated ranges, and ask users to comment on the usefulness.
A simpler approach, and one I recommend, would be simply to require companies to disclose what the critical accounting assumptions are, without going into the ranges, up and down. What is most troubling is not the additional information about accounting but the virtually interminable permutations and combinations
Before you make GAAP and financial reporting more complex, think of this from the users' perspective. How many of us really want, and will use, the new information you are demanding? There has to be a cost benefit analysis. The preparers can give you the cost side of the equation. As a user I am in a position to evaluate the `benefits'. Unfortunately, I believe they are negative.
As a point of interest, our firm is privately held and does not report publicly. Nevertheless we do report monthly to shareholders, using GAAP, and have an annual audit by one of the major accounting firms. Please note that, as a matter of policy, these views are my own and are not a formal representation of Valuation Research Corporation.
I would be pleased to answer any questions you may have.
Very truly yours,
[signed]
Alfred M. King