Thank you for your warm welcome. I am a longtime member of NABE and even held a NABE-sponsored internship one summer during college. It is a pleasure to be here among friends and colleagues. And it is a special pleasure to share the panel with Randy Kroszner. I also must make the standard disclaimer: The views I express here today are my own and not necessarily those of the Securities and Exchange Commission or its staff.
As economists, we all know the importance of financial reporting to our capital markets. Investors, creditors, regulators, and other market participants rely on getting accurate, timely and comparable financial information from public companies. The efficient allocation of capital depends on financial reports that provide a realistic picture of firms' past performance and future prospects.
When information provides a misleading picture, the results can be devastating, as we have seen in recent corporate reporting scandals. The misleading information reported by those companies resulted both directly and indirectly in a serious misallocation of resources.
Beyond intentionally misleading financial reporting, resources can also be misallocated if financial statements do not reflect relevant information. As economists, you should be concerned if accounting standards are not well suited to their intended function of communicating information to end-users, and if preparers of financial statements do not do their best to communicate relevant information as well. As a fellow economist, I want to take this opportunity to give you my perspective and share my concerns.
Simply put, my concern is that financial reporting today does not always reflect economic reality, nor does it always give market participants all of the information relevant to an assessment of public companies. A recent book on financial reporting begins by noting that "[t]he corporate reporting model has failed those whom it intends and ought to serve best. Neither the companies that report, nor the investors who listen, fare well. That must change." The distinguished authors include the current head of the Financial Accounting Standards Board.1
Like Alice in Wonderland, a person can gaze into the looking glass of financial reporting and see a distorted reality reflected back. The current questions about the ability of our current accounting and reporting framework to communicate meaningful information to investors arise, in part, because the economy continues to evolve at a rapid pace, while reporting standards are in a "catch-up" mode. A brief look at the past demonstrates that this situation is not unique in history.
Modern accounting practices have their roots in the early Renaissance and the expansion of trade.2 Double-entry bookkeeping — the recording of resources and claims against those resources — was popularized by Pacioli, the "Father of Accounting," in his 1494 work, the Summa.3 Double entries made it possible to memorialize and follow business activity in a standardized format.4 This reduced the cost of assessing risk and, therefore, of raising capital. This development was a critical prerequisite to facilitating the capital formation needed for the large-scale commercial ventures associated with New World exploration.5
As the focus of the economy changed, so did accounting practices. As the venture capitalism of the 1400s gave way to mercantile capitalism in the age of colonial trading in the 1700s, and to the Industrial Revolution in the nineteenth century, accounting shifted to better accommodate and reflect the prevailing economy of the time.6
The twentieth-century economy was characterized by the growth of corporations, more widespread public ownership of stock and the separation of ownership and management.7 These developments created a need to further standardize the distribution of information to investors. A significant response was the New York Stock Exchange's decision to adopt reporting requirements for the companies listed on the exchange. After the Great Crash in 1929, it became clear that reporting standards were needed for all public companies, so in 1933 and 1934 Congress created the SEC and gave it authority to prescribe financial accounting and reporting standards.
The authority that Congress gave the Commission was intended not only to create better reporting, but also to deter companies from distributing misleading information, by imposing rules according to which regulators could review reports and auditors could audit them. By this time, professional accounting bodies and accounting practices had become widely recognized. Therefore, although the SEC had the authority to prescribe reporting standards, it generally looked to the accounting profession's expertise in setting those standards. The idea of certain "generally accepted accounting principles," or GAAP, arose from the Commission's endorsement of the accounting profession's expertise.
Since the formation of the Financial Accounting Standards Board ("FASB") in 1973, the Commission has recognized FASB's financial accounting and reporting standards as "generally accepted" for purposes of the federal securities laws. Going forward, in the wake of Sarbanes-Oxley, the Commission has reaffirmed FASB as the standard-setter, while we continue to oversee FASB's activities.
It should come as no surprise that developments in accounting historically have been slower than business developments. It should also be apparent that the task of setting standards is not an easy one. To ensure that accounting standards keep pace with business developments, we must continually reassess the answer to the ultimate question, "What do investors really need to know?" Obviously, investors need accurate and relevant historical information, but it would also be helpful to know the key drivers of the business and the risks the company faces.
Unfortunately, GAAP may not provide the most relevant information to investors for valuing companies. For example, many companies now derive much of their value from intangible assets. GAAP — which does a relatively good job of reporting the cost of tangible assets, such as a company's equipment — is less effective in providing relevant information on intangible assets, such as technology rights, human capital, and innovation. As a result, the value of huge sectors of our economy may not be accurately reflected by financial reports.
GAAP's problems go beyond its failure to keep pace with changes in the economy. The current accounting literature, which includes many detailed bright-line tests, is also vulnerable to financial engineering, where companies engage in transactions not for the economic benefit, but to take advantage of accounting treatment so that the company appears to the market to be more successful than perhaps it really is. An example is accounting for SPEs or special purpose entities, which have, in some cases, been used to overstate income, equity and cash flows and understate debt. The issue regarding SPEs is whether or not an entity has to be consolidated into the sponsoring company's financial statements. Under recent, but now revised, accounting practices, the test that arose was that if an independent third party held equity equal to 3% of the amount of assets in the SPE, then the entity did not have to be consolidated. As economists I'm sure that you can see the problem: An arrangement could be designed where the sponsor avoided consolidation but took almost all of the risks, and the problem can be exacerbated if the 3% is not actually provided by a third party. New reporting standards have now focused the analysis on the risks and rewards.
Conversely, the fact that GAAP allows different accounting treatments for similar economic activities may have perverse consequences. Companies may opt for the less economically desirable transaction in order to enjoy perceived accounting advantages. As a result, those who rely upon the transparency of financial reports suffer. For example, despite the fact that performance-based stock options are widely regarded by corporate governance experts as better performance incentives than options that are not performance based, most companies have historically issued fixed-price options with no performance conditions. Why? Apparently because performance-based options generally have to be expensed, while non-performance based options do not.
Because GAAP is not designed to provide some of the information that today's investors might find most relevant, we need to focus on improvements in business processes and business reporting that make the desired information available. This additional information could, for example:
There are myriad other examples of what improved business reporting could provide that would allow a fuller understanding by investors of a company than that provided by even the best financial statements taken alone.
The impact of the imperfections of GAAP and the shortcomings in other business reporting is exacerbated by the market's myopic focus on very specific numbers — notably earnings per share. Assumptions and estimates in financial reporting are not — and will never be — perfect. However, the market's obsession with quarterly earnings per share has tempted some managers, facilitated by auditors, to use and abuse GAAP rules to increase reported revenues and decrease reported expenses to maximize reported quarterly earnings. (Note that I said maximize reported quarterly earnings — not maximize profits or long-term shareholder value.) So, perhaps it shouldn't be surprising that there are some companies that do whatever they can to make those quarterly numbers look good — by discouraging accounting standards that reduce the ability to manage earnings and by the aggressive, misleading, or even fraudulent application of the rules.
The focus on quarterly earnings per share has, in my view, resulted in inefficiencies in the market. In an efficient market it should not matter whether important information is in the footnotes to the financial reports or in the income statement itself, or, depending on the type of information, even available outside the financial statements, through improved business reporting. But it does seem to matter, and one reason why it does may be the focus on quarterly earnings per share to the exclusion of other material information. That phenomenon would explain why, for example, despite the fact that information about stock options or pension losses is already available in footnotes to the reports, the inclusion of that same information in the "magic number" of quarterly GAAP earnings is so controversial.
So the question is, how do we change our financial and business reporting system to put the focus on creating value, not just creating numbers? Unfortunately, there is no "quick fix." But, in my view, a combination of a shift in approach and better practices will go a long way towards improving the current landscape.
Most importantly, we must reduce the financial reporting system's reliance on rules and move towards an objectives-oriented system. Standards have to be flexible enough to reflect a company's business while being sufficiently standardized so as to let the market compare different companies. I support our staff's recommendation, in its recently released study on principles-based accounting, to migrate the fundamentals of our accounting standards towards an objectives-oriented system. Under an objectives-oriented accounting system, financial standards would consist of concise statements of substantive accounting principles, where the objectives are appropriately set forth, and where few, if any, exceptions are included. Standards would also give an appropriate amount of implementation guidance without bright-line rules, and would be consistent with, and derive from, a coherent conceptual framework.
I believe such an objectives-oriented system would give companies and auditors the ability to deliver numbers grounded in economic reality, while providing the comparability the market needs. Reporting the economics of a company — as opposed to technical compliance with detailed rules — would be the ultimate obligation of companies and their auditors. Of course, we cannot ignore that such a framework, perhaps even more than the current framework, would rely on companies to approach the task of financial reporting in the utmost of good faith. Rather than spending energy figuring out how to skirt the accounting standards, preparers and auditors should focus on the spirit of the standards. They should stand back and ask, "Does the information make sense? Have I provided investors and other users with an appropriate view of the company as seen through the eyes of management?"
In addition, while we improve our financial reporting system, we should take the opportunity to increase the compatibility of our accounting standards with international accounting standards in furtherance of the global economy, through cooperation with the International Accounting Standards Board ("IASB").
I also believe that we need to improve business reporting standards, an admittedly challenging endeavor. Meanwhile, overall business and financial reporting can be improved by the use of tools already at management's disposal. Most significantly, under our current framework, companies should use the Management's Discussion and Analysis ("MD&A") section of their filings to disclose important matters not reflected in financial statements, including key drivers and risks. I am discouraged that, in too many cases, companies do not do as good a job of this as they could. The MD&A requires managers to provide forward-looking information where it is reasonably likely that known trends, events or uncertainties may materially impact the company. Instead of merely reciting information already in the financial statements and footnotes, companies should give a detailed analysis of material year-to-year changes and trends about operations, liquidity, cash flow and capital resources.
For example, management should use the MD&A to explain accounting for pension funds. GAAP allows for the "smoothing" of earnings in pension funds, which in recent periods has led to "phantom" earnings. Companies have reported earnings based on assumptions of, for example, 9% return on pension funds, while those same funds are actually losing money. To the extent pension accounting assumptions are material to the financial statements, management should use the MD&A to explain in plain English how the company accounts for its pension plan, the assumed rate of return or discount rate, and the pension plan's effect on the company's operations, earnings, cash flow and liquidity. Since the choice to use smoothing in pension accounting is an option, the MD&A would be an ideal place for management to describe why it has chosen to smooth its pension expense, rather than to reflect changes in its obligations on a current basis.
Further, our certification requirements for CEOs and CFOs anticipate that they will use the MD&A and other means to bridge the gaps in GAAP. It is important that certifying executives understand that they are required to certify that their periodic reports fairly present their financial condition in all material respects. This requirement goes beyond being able to show that the financial statements are in technical compliance with GAAP. The typical CEO may not be fully versed in GAAP. However, if GAAP numbers show a rosy scenario, but the CEO and CFO know the business is having problems, there is clearly a disconnect. If the GAAP financials are not consistent with the CEO's and CFO's reality, then it is incumbent on them to look at the key factors driving the GAAP numbers and re-evaluate them or describe the reasons for the discrepancy.
To conclude, I believe that management should concentrate on the best way to run the company, not manage GAAP numbers. When put up to the looking glass, financial reports should resemble the company's operations, not some fanciful Wonderland that management wants the market to see. We want companies to provide information that will enable shareholders and other market participants to make the best decisions possible. For our capital markets to function well, management should not focus on contriving an appearance of success; instead, management must create real value and show the market that reality. I assume that, as business economists, you would agree.
Thank you.
1 Eccles, Robert; Herz, Robert; Keegan, Mary; and Phillips, David, The Value Reporting Revolution, 2001, PricewaterhouseCoopers L.L.P., at 3.
2 Weis, William L. and Tinius, David E., "Luca Pacioli: Accounting's Renaissance Man," Management Accounting, Montvale, July 1991.
3 Ibid; Tsuji, Atsuo and Garner, Paul, Studies in Accounting History, 1995, Greenwood Press, at 160.
4 Previts, Gary John Previts and Merino, Barbara Dubis, A History of Accountancy in the United States — The Cultural Significance of Accounting, 1998, The Ohio State University, at 5.
5 Ibid.
6 Previts, at 5-6.
7 Buckmaster, Dale and Jones, Scott, "From Balance Sheet to Income Statement: A Study of a Transition in Accounting Thought in the USA, 1926-1936," Accounting, Auditing & Accountability Journal, 1997, Vol. 10, Iss. 2, 198.