Testimony of
Walter P. Schuetze
before the
United States
Senate
Committee on
Banking, Housing, and Urban Affairs
Paul S. Sarbanes,
Chairman
Tuesday,
February 26, 2002
(Wanted: Accounting that Investors, Members
of Congress, and My Sister Can Understand)
Thank you, Mr. Chairman. Senator Gramm. Members of the Committee.
My name is Walter P. Schuetze.
My brief resume is attached hereto.
Just a few comments about my
experience and background. I was on the
staff and a partner with the public accounting firm KPMG and its predecessor
firms for more than thirty years. I was
one of the charter members of the Financial Accounting Standards Board from
April 1973 through June 1976. I was a
member and chair of the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants in the 1980s. I was Chief Accountant to the Securities and
Exchange Commission from January 1992 through March 1995 and Chief Accountant
of the SEC’s Division of Enforcement from November 1997 through mid-February
2000.
I need to mention that
although I am retired, I am a consultant to the Securities and Exchange
Commission and several other entities under consulting contracts. In addition, I have one remaining tie with
my former firm KPMG in that I am an insured under a group life insurance
contract obtained and administered by that firm; I pay the premium attributable
to me. The views I express here today
are my personal views.
I appreciate very much the
opportunity to testify here today. Your
letter of January 16, 2002 inviting me to testify at this hearing says, “A
number of high-profile business failures in recent years, including, most
recently, the collapse of Enron Corp., have involved significant accounting
irregularities, and the February 26 hearing will examine the issues raised by
those failures for financial reporting by public companies, accounting
standards, and oversight of the accounting profession. You should feel free to address those issues
as you see fit. The committee would also
appreciate any recommendations you may have about ways to deal with the issues
you discuss.” I indeed have a major
recommendation, which I will get to at the conclusion of my remarks.
The public’s confidence in
financial reports of and by Corporate America, and in the audits of those
financial reports by the public accounting profession, has been shaken badly by
the recent surprise collapse of Enron, by recent restatements of financial
statements by the likes of Enron, Waste Management, Sunbeam, Cendant, Livent,
and MicroStrategy, and by the SEC’s assertion of fraud by Arthur Andersen in
connection with its audits of Waste Management’s financial statements in the
1990s, which Andersen did not admit or deny in a settled SEC action last
summer. The public’s confidence needs
to be regained and restored. If that
confidence is not regained and restored, the result will be that investors will
bid down the price of stocks and bonds issued by both US and foreign corporations;
we have seen evidence of that phenomenon in recent weeks. That is an investor’s natural response to
increased risk or the perception of increased risk. This will reduce the market capitalization of corporations, which
in turn will negatively affect capital formation, job creation and job
maintenance, and ultimately our standard of living. So, we are concerned today with a very important matter.
You will hear or have heard
many suggestions for improvement to our system of financial reporting and
audits of those financial reports. Some
will say that auditor independence rules need to be strengthened. That external auditors should not be allowed
to do consulting work and other non-audit work for their audit clients. That external audit firms should be rotated
every five years or so. That external
auditors should be prohibited from taking executive positions with their
corporate clients for a number of years after they have been associated with
the audit firm doing the audit unless the firm resigns as auditor. That peer reviews of auditors’ work need to
be improved and done more frequently if not continuously. That auditors should be engaged by the stock
exchanges and paid from fees paid to the exchanges by listed companies. That the oversight of auditors needs to be
strengthened. That punishment of
wayward auditors needs to be more certain and swift. In that regard, Chairman Pitt of the SEC has proposed that there
be a new Public Accountability Board overseeing the external audit function; this
Board would, as I understand it, have investigative and disciplinary
powers. And so on and on. In my opinion, those suggestions, even if
legislated by Congress and signed by the President, will not fix the underlying
problem.
The underlying problem is a
technical accounting problem. The problem
is rooted in our rules for financial reporting. Those financial reporting rules need deep and fundamental
reform. Unless we change those rules,
nothing will change. The problems will
persist. Today’s crisis as portrayed by
the surprise collapse of Enron is the same kind of crisis that arose in the
1970s when Penn Central surprisingly collapsed and in the 1980s when hundreds
of savings and loan associations collapsed, which precipitated the S&L
bailout by the Federal government.
Similar crises have arisen in Australia, Canada, Great Britain, and
South Africa. There will be more of
these crises unless the underlying rules are changed.
Under our current financial
reporting rules promulgated by the Financial Accounting Standards Board,
management of the reporting corporation controls and determines the amounts
reported in the financial statements for most assets. For example, if management concludes, based on its own subjective
estimates, that the cost of an asset—say equipment--will be recovered from
future cash flows from operations without regard to the time value of money or
risk, no write down is required even when it is known that the current market
price of the asset is less than the cost of the asset. The external auditor cannot require that the
reported amount of an asset be written down to its estimated selling price; the
external auditor cannot even require the corporation to determine the estimated
selling price of the asset and disclose that price in its financial statements. So, when it comes time to sell assets to pay
debts, there often are surprise losses that investors then see for the first
time. Management also makes similar
assessments in determining the amount of inventory obsolescence, the allowance
for bad debts, and whether declines in the values of investments below cost are
“other than temporary.”
Under our current accounting
rules, corporate management often records sales and trade receivables at 100
cents on the dollar even though a bank or a factor would pay only pennies on
the dollar for those trade receivables.
We saw that phenomenon in the past few years in the telecom rage where
sales and receivables were recorded followed several months later by write offs
of the receivables. On another front,
we currently are seeing swaps of assets and the recognition of gains in what is
effectively a barter transaction, even though the fair value of what was
exchanged is apparently negligible.
Except for inventories and
marketable securities, none of these asset amounts in the financial
statements—trade receivables, commercial and consumer loans receivable, real
estate loans, oil and gas reserves, mineral deposits, pipelines, plant,
equipment, investments--is subjected to the test of what the cash market price
of the asset is. Yet, we know that most
individual investors, and, in my experience, even many sophisticated
institutional investors, believe that the reported amounts of assets in
corporate balance sheets represent the current market prices of those assets;
nothing could be farther from the truth.
And under the FASB’s
definition of an asset, corporations report as assets things that have no
market price whatsoever; examples are goodwill, direct response advertising
costs, deferred income taxes, future tax benefits of operating loss carry
forwards, costs of raising debt capital, and interest costs for debt said to
relate to acquisition of fixed assets.
I call these non-real assets.
Today’s corporate balance sheets are laden with these non-real assets;
this is the kind of stuff that allows stock prices to soar when in fact the
corporate balance sheet is bloated with hot air. Of course, when it comes time to pay bills or make contributions
to employees’ pension plans, this stuff is worthless.
The same goes for liabilities. Corporate management determines the reported
amount of liabilities for such things as warranties, guarantees, commitments,
environmental remediation, and restructurings.
Again, this is as per the FASB’s accounting rules.
The upshot is that earnings management
abounds. Earnings management is like
dirt; it is everywhere. SEC
commissioners have made speeches decrying earnings management. Business Week, Forbes, Barron’s,
the New York Times, the Wall Street Journal, and the Harvard
Business Review carry hand-wringing articles about earnings
management. Earnings management is
talked about matter-of-factly on Wall Street Week and on Bloomberg TV, CNBC,
CNNfn, and MSNBC. Earnings management
is a scourge in this country. Earnings
management is common in other countries as well because their accounting rules,
and the accounting rules promulgated by the International Accounting Standards
Board, are much the same as ours.
We need to put a stop to
earnings management. But, until we take
control of the reported numbers out of the hands of corporate management, we
will not stop earnings management and there will be more Enrons, Waste
Managements, Livents, Cendants, MicroStrategys, and Sunbeams. How do we take control of the reported
numbers out of the hands of corporate management? We do it by requiring that the reported numbers for assets and
liabilities, including guarantees and commitments, be based on estimated
current market prices--current cash selling prices for assets and current cash
settlement prices for liabilities. And
by requiring that those prices come from, or be corroborated by, competent,
qualified, expert persons or entities that are not affiliated with, and do not
have economic ties to, the reporting corporate entity. And by requiring that the names of the
persons or entities furnishing those prices, and the consents to use their
names, be included in the annual reports and quarterly reports of the reporting
corporate entity so that investors can see who furnished the prices.
Let me give you an example of
what I am talking about. Pre-September
11, 2001, the major airlines, to the extent that they own aircraft instead of
leasing them, had on their balance sheets aircraft at the cost of acquiring those
aircraft from Airbus and Boeing. Let’s
say that cost was 100 million dollars per aircraft. The market prices of those aircraft fell into the basement
post-September 11 to about 50 million dollars per aircraft and remain there
today although prices have recovered somewhat.
Yet, under the FASB’s rules, those airlines continue to report those
aircraft on their balance sheets at 100 million dollars and are not even
required to disclose that the aircraft are worth only 50 million dollars. Under mark to market accounting, the
aircraft would be reported at 50 million dollars on the airlines’ balance
sheets, not 100 million dollars.
I could give you many more
examples, but I will add just one more.
In the late 1970s, this country was experiencing great inflation. The Federal Reserve Board raised short-term
interest rates dramatically. Long-term
rates shot up. As a consequence, the
market value of previously acquired residential mortgage loans and government
bonds held by savings and loan associations declined drastically. But, the regulations of the Federal Home
Loan Bank Board and the FASB’s accounting rules said that it was OK for the
mortgage loans and bonds to be reported at their historical cost. Consequently, the S&Ls appeared solvent
but really were not. This mirage
allowed the S&Ls to keep their doors open and in so doing they incurred
huge operating losses because their cost of funds far exceeded their interest
income on loans and bonds in their portfolios.
Some of the S&Ls decided to double down by investing in risky real
estate projects, also accounted for at historical cost, and proceeded to lose
still greater amounts, which losses were also hidden on the balance sheet under
the historical cost label. (The Federal
Home Loan Bank Board even went so far as to allow S&Ls to capitalize and
report as assets losses on sales of assets, but the FASB said no to that
procedure.) Of course, when the Federal
government had to bail out the insolvent S&Ls in the 1980s, the Federal
government paid for the losses that were hidden in the balance sheet under the
historical cost label and the operating losses that had been incurred while the
S&Ls kept their doors open because of faulty accounting. Had mark to market accounting been in place
and had the Federal Home Loan Bank Board computed regulatory capital based on
the market value of the S&Ls’ mortgage loans, government bonds, and real
estate projects, the S&L hole would not have gotten nearly as deep as it
ultimately did.
Various members of Congress
have said in recent hearings about Enron that a corporation’s balance sheet
must present the corporation’s true economic financial condition. A corporation’s true economic financial
condition cannot be seen when assets are reported at their historical cost amounts. The only objective way that the true
economic financial condition of a corporation can be portrayed is to mark to
market all of the corporation’s assets and liabilities. Recall my earlier example about the cost of
aircraft being 100 million dollars and the current market value being 50 million
dollars. Mr. Chairman and Members of
the Committee: Is there any question that the 50 million dollars presents the
true economic financial condition and the 100 million dollars does not? Moreover, following today’s FASB’s
accounting rules produces financial statements that are understandable only to
the very few accountants who have memorized the FASB’s mountain of rules. Indecipherable is the word Chairman’s Pitt
has used in recent speeches. On the
other hand, marking to market will produce financial statements that investors,
members of Congress, and my sister, who also happens to be an investor, can
understand.
The various proposals that
have been made to cure Enronitis will not cure the problem. I liken our current accounting system to
bridges built from timber, which bridges keep collapsing under the weight of
eighteen-wheelers. The public demands
that expert consulting engineers be called in to oversee the building of
replacement bridges. But the
replacement timber bridges keep collapsing under the weight of
eighteen-wheelers. More expert
consulting engineers will not make the timber bridges any stronger. What needs to be done to fix the problem is
build bridges with concrete and steel.
The same goes with accounting.
In the 1970s, after the surprise collapse of Penn Central, the auditing
profession instituted peer reviews—where one auditing firm reviews the work and
quality controls of another auditing firm.
In the 1970s, auditing firms also instituted concurring partner reviews
where a second audit partner within the public accounting firm looks over the
shoulder of the engagement audit partner responsible for the audit. These procedures have been ineffectual as
shown by the dozens of Enrons, Waste Managements, Sunbeams, MicroStrategys,
Cendants, and Livents that have occurred since then. Coincidentally, the Financial Accounting Standards Board also
came on the scene in 1970s; it was going to write accounting standards that
would bring forth financial statements based on concepts. What happened was that the FASB wrote a
mountain of rules that produce financial statements that nobody understands and
that can be and are gamed by corporate management. What all of that amounted to
was continuing to build timber bridges that keep collapsing under the weight of
eighteen-wheelers. We need to stop
building timber bridges. We need to
build concrete and steel bridges. We
need to mark to market all assets and liabilities.
Now, you may ask—how much will
concrete and steel bridges cost? Can we
afford to build concrete and steel bridges?
My response is that we cannot afford not to build concrete and steel
bridges. How much of the cost of the
S&L bailout was attributable to faulty accounting; the amount is unknowable
but no doubt was huge. How much does an
Enron or Cendant or Waste Management or MicroStrategy or Sunbeam cost? The answer for investors is billions, and
that does not count the human anguish when working employees lose their jobs,
their 401-k assets, and their medical insurance, and retired employees lose
their cash retirement benefits and medical insurance. By some estimates, Enron alone cost 60--70 billion dollars in
terms of market capitalization that disappeared in just a few months. Waste Management, Sunbeam, Cendant, Livent,
MicroStrategy, and the others also cost billions in terms of market
capitalization that disappeared when their earnings management games were
exposed. And, these costs do not
include the immeasurable cost of lost confidence by investors in financial reports
and the consequent negative effect on the cost of capital and market
efficiency.
By my estimate, annual
external audit fees in the United States for our 16,000 public companies, 7,000
mutual funds, and 7,000 broker/dealers total about 12 billion dollars. Let’s say that 4 billion dollars is
attributable to mutual funds and broker/dealers. (Incidentally, mutual funds and broker/dealers already mark to
market their assets every day at the close of business, and we have very few
problems with fraudulent financial statements being issued by those
entities. Mark to market works and is
effective.) That leaves 8 billion
dollars attributable to the 16,000 public companies. Assume that the 8 billion dollars would be doubled or even
tripled if the 16,000 public companies had to get competent, outside valuation
experts (and not the public accountants because they are not competent
valuation experts) to determine the estimated cash market prices of their
assets and liabilities. We are then
looking at an additional annual cost of 16--24 billion dollars. If we prevented just one Enron per year by
requiring mark to market accounting, we easily would pay for that additional
cost. And, when considered in relation
to the total market capitalization of the US corporate stock and bond markets
of more than 20 trillion dollars, 16—24 billion dollars is indeed a small price
to pay.
The question arises: Who should mandate mark to market
accounting? I recommend that there be a
sense of the Congress resolution that corporate balance sheets must present the
reporting corporation’s true economic financial condition through mark to
market accounting for the corporation’s assets and liabilities. I recommend that Congress leave implementation
to the SEC, much the way it is done today by the SEC for broker/dealers and
mutual funds. There will be many
implementation issues, so the SEC will need more staff and money.
My testimony today is a
summary of a lengthy article that I wrote about the definition of assets and
liabilities, earnings management, and mark to market accounting that was
published last year in Abacus, a University of Sydney publication, and
which was the basis for the RJ Chambers Research Lecture that I presented last
year at the University of Sydney. That
article and lecture are attached hereto.
I will be pleased to answer
the Committee’s questions.
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