2001 RJ Chambers
Research Lecture
at
Great Hall
The University of
Sydney
NSW, Australia
by
Walter P. Schuetze
November 27,
2001
A Memo to National
and International Accounting
and Auditing
Standard Setters
and Securities
Regulators
(A Christmas
Pony)
Chancellor,
Vice-Chancellor, distinguished guests.
Thank you, Chancellor, for those kind introductory words, and thank you
Dean Wolnizer for the invitation to present the RJ Chambers Research Lecture. It is indeed a pleasure for me to be here in
Sydney delivering this lecture. I long
have admired Professor Chambers’ work.
I wish I had met him.
I graduated from The
University of Texas in Austin in the summer of 1957. I went to work on August 1, 1957 for an accounting firm in San
Antonio, Texas by the name of Eaton & Huddle. Tom Holton, one of the partners of Eaton & Huddle, hired
me. After Eaton & Huddle merged
with Peat, Marwick, Mitchell & Co., now KPMG, Tom Holton eventually became
chairman of KPMG. Mr. Holton will attest
that I have been talking about, making speeches about, and generally advocating
and promoting, market value accounting since the late 1950s. By “market value accounting,” I mean
estimated selling price for assets and estimated settlement price for liabilities. Without knowing it, I was sounding like
Chambers in the 1950s, although not so eloquently.
I had not read Chambers until
I joined the Financial Accounting Standards Board. I was at the FASB from March 1973 through June 1976. While I was there, I read Chambers’ book
entitled Accounting, Evaluation and Economic Behavior and discovered
that he and I shared the same view about accounting for assets. Unfortunately, there was no way to get
market value accounting adopted by the FASB in its early days. The climate was just not right. In fact, in 1975, when the FASB issued
Statement 12 on “Accounting for Certain Marketable Securities,” the FASB could
muster only three out of seven votes for mark to market of marketable equity
securities.[1] Similarly, in 1985, in FASB Statement 87 on
“Employers’ Accounting for Pensions,” the mark to market for off-balance-sheet
pension plan assets, mostly stocks and bonds, is smoothed out so as not to
affect employers’ pension plan expense too much in any particular year.
The climate for introducing
market value accounting into financial statements did not change until 1990, in
the aftermath of the savings and loan crisis and the consequent US Government
bailout of insolvent savings and loan associations. On September 10, 1990, the US Securities and Exchange Commission,
in testimony by its chairman before the US Senate’s Committee on Banking,
Housing and Urban Affairs, described how faulty accounting and the consequent
improper measurement of regulatory capital contributed to lax regulatory
oversight of the S&Ls, which ultimately led to the bailout. The Commission in that testimony took the
position that banks and thrifts should mark to market their bond portfolios. At that time, Richard Breeden was chairman
of the SEC. Chairman Breeden is a
lawyer, not an accountant. But, he
strongly believed that thrifts and banks were presenting false pictures of
their financial position and results of operations, and importantly the amounts
of their regulatory capital, through the use of historical cost accounting for
their bond portfolios and through selective timing of sales of bonds so as to
trigger gains but not losses, a practice called “gains trading.”
When I interviewed with
Chairman Breeden for the position of Chief Accountant in December 1991, it
turned out that his and my thoughts on market value accounting were in
sync. At least as far as bond
portfolios were concerned. Chairman
Breeden did not want to go further than the bond portfolio. I wanted to mark all assets to market, but
in the early 1990s, I was glad to start with the bond portfolios of thrifts and
banks. So, in January 1992, I started
as Chief Accountant to the SEC. As it turns
out, I was the Commission’s foot soldier getting thrifts and banks to mark to
market their bond portfolios. Of
course, there was no stopping with depository institutions. Insurance companies and other “float”
companies also had bond portfolios, and they also had to mark to market their
bonds. I was Chief Accountant from
January 1992 to April 1995. I spent a
considerable portion of 1992 and 1993 promoting the Commission’s view that
banks, thrifts, and insurance companies should mark to market their bond
portfolios.
In May 1993, the FASB, in
Statement 115, required that all marketable equity securities be marked to
market. Statement 115 went part of the
way on bonds and requires that trading and held-for-sale bond portfolios be
marked to market, but allows the held-to-maturity bond portfolio to be reported
at cost. (Determining which bond is in
which portfolio is a metaphysical, serendipitous determination that has always
eluded my understanding.) Since 1993,
the accounting for bonds, mortgages, mortgage-backed securities, derivative instruments,
and hedging has become more incredibly complex than I can or want to describe,
but gains trading out of the held-to-maturity portfolio still is possible. However, the FASB is moving forward to
require mark to market on all financial assets and liabilities.
Few people know that to the
extent that we have mark to market accounting today, the credit for that
belongs to the Securities and Exchange Commission, and primarily to Chairman
Breeden. Incidentally, none of those
commissioners in 1990 was an accountant.
(To my knowledge, only one accountant, Mr. James Needham, has served as
a commissioner since the Commission was established in 1934. Most, but not all, of the commissioners have
been lawyers. An exception is Arthur
Levitt, the immediate past chairman, who is not an attorney. Chairman Levitt, prior to his appointment to the SEC, was head of
the American Stock Exchange.)
When the SEC endorsed mark to
market on bonds in 1990, the banking, thrift, and insurance companies community
had to be dragged, kicking and screaming, into the world of relevant, mark to
market accounting. In a sense, the FASB
was also dragged along by the SEC because none of the FASB’s constituencies was
in favor of mark to market, and the FASB itself was not out in front leading
the charge for mark to market. But,
come around it did, and now the FASB is moving forward on mark to market for
all financial assets and liabilities.
I think that it is now time
for the SEC, the FASB, and the reconstituted International Accounting Standards
Board, to extend mark to market to the rest of the balance sheet—to all assets
and liabilities. Why do I say
that? Well, to begin with, there is no
question that mark to market produces relevant information that investors and
creditors can use to make investment decisions. Not only is the information relevant, its quality is
undisputed. The two ideas—relevance of
information and quality--go hand in glove.
There is no relevance to a datum called cost or cost minus
amortization—it is just a number, a number having no information content. The “quality” of the datum called cost or
cost minus amortization for assets such as inventory, factories, mines, oil and
gas reserves, salmon farms, machinery and equipment, copyrights, and patents is
indisputably awful; worse, it can be and often is misleading. We have seen many situations in the USA, and
I’m sure you have seen them in Australia as well, where corporations have been
reporting earnings and an excess of assets over liabilities using our current
generally accepted accounting principles just before going bust. We now have the case where after the tragic
events of September 11 some US airlines are teetering on the brink of
bankruptcy and the market prices of their aircraft have fallen into the cellar.
Yet the historical cost of those aircraft continues on the airlines’ balance
sheets because, under the FASB’s rule in Statement 121 and now Statement 144 of
looking to the undiscounted future cash flows from the aircraft, the carrying
amount of the aircraft is not impaired.
What an awful rule. Historical
cost of assets and representations as assets of FASB-approved junk such as
goodwill, deferred income taxes and tax benefits of operating loss
carryforwards, and capitalized direct-response advertising costs have misled
investors for years. I will have more
on quality later.
The second reason to adopt
mark to market for all assets and liabilities is to go back to basics—to go
back to first principles—and to simplify the accounting. First, we need a definition of assets that
we can all understand. The FASB’s
definition of assets in paragraph 25 of its Concepts Statement 6 is as
follows: “Assets are probable future
economic benefits obtained or controlled by a particular entity as a result of
past transactions or events.” That is followed
by six paragraphs of about six hundred words explaining the definition. There are 330,000 members of the American
Institute of Certified Public Accountants.
It is my experience that a very large majority of those CPAs does not
understand the FASB’s definition of an asset.
I have seen litigation involving alleged fraudulent financial statements
because of improper asset and income recognition where both parties to the
litigation and both of their expert witnesses, in their briefs and at trial,
quoted the very same words from the FASB’s Concepts Statements saying that a
debit balance on the balance sheet was, or was not, a fit and proper asset
under the FASB’s definition. The judge
has not yet decided the case even though three years have gone by.
Not only do most practicing
accountants not understand the FASB’s language about assets, ordinary folk are
mystified by that babble. The financial
statements that are produced as a result of all of the FASB’s rules, which now
is a veritable mountain of rules, are impenetrable. Go to the internet and look at the financial statements and
related notes to the financial statements of US companies in their annual
reports. There are pages and pages of
jargon, understandable to a few highly indoctrinated accountants but not most
investors and other ordinary folk. This
is not just my opinion. The new
chairman of the SEC, Mr. Harvey Pitt, is quoted in the November 5, 2001 issue
of Business Week, at page 92, as saying that quarterly and annual
reports are “…not always capable of being deciphered by sophisticated experts,
much less ordinary investors.”
Using the FASB’s definition of
an asset, a thing that most of us call a truck is not that which is the
asset. The asset is the economic
benefit, whatever that is, that will arise from using the truck to haul lumber
or coal or bread. Using the FASB’s
definition, the truck is an abstraction.
I think that we should define assets by reference to real things, not
abstractions. I think that we should
define assets as follows: Cash, claims
to cash, for example, accounts and notes receivable, and things that can be
sold for cash, for example, a truck.
I’ll bet this audience understands my definition of an asset.
The FASB’s definition of a
liability in paragraph 35 of Concepts Statement 6 is as murky as its definition
of an asset, to wit: “Liabilities are
probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to
other entities in the future as a result of past transactions or events.” That paragraph is followed by five
paragraphs of more than seven hundred words that explain the definition. Included in those five paragraphs is a
sentence that says liabilities include, in addition to legal obligations,
“equitable or constructive obligations,” but does not define what those
are. Most accountants do not
understand, at the margin, what the FASB’s definition of a liability means,
leading to great diversity in practice.
In practice, if the management of a corporation says that it has a
liability under a so-called restructuring plan, a liability may be, but need
not be, booked. In practice, year-end
bonuses to employees are sometimes, but not always, booked as liabilities as
the year progresses even though there is no contractual obligation to pay the
bonuses. We are seeing in 2001 that
many US corporations are not going to pay bonuses or are going to pay reduced
amounts of bonuses. (See the Wall
Street Journal, October 2, 2001, p. B1.)
(I doubt that there is much disclosure in financial statements about
those liability reversals.) In
corporate acquisitions, liabilities are booked if the acquiring corporation
declares that it will pay out cash for this or that even though there is no
contractual requirement to pay cash; no liability is booked if the corporation
makes no declaration. Consequently,
liability recognition, and the amount thereof, is subject to great management
discretion and abuse.
I think that liabilities
should be defined as follows: Cash
outflows required by negotiable instruments, by contracts, by law or
regulation, and by court-entered judgments and agreements with claimants. I’ll bet this audience understands my
definition of liabilities. Nothing
murky about it.
The third reason to adopt mark
to market for all balance sheet items is to stop—to stop dead in its
tracks--earnings management. Earnings
management is a scourge in the USA. The
disease called earnings management is pandemic. I am not being shrill or alarmist when I say that I think that it
threatens the very soul of financial reporting. What we get under our present reporting system is earnings as
determined by management, not as determined by transactions and economic events
and conditions that actually happened and exist. Many people, indeed many accountants, are fond of saying that
financial statements should portray economic reality. But, in fact, except for the financial statements of investment
companies (mutual funds) and broker/dealers where all assets are marked to
market every evening at the close of business, today’s financial statements
come nowhere close to achieving that goal because, except for stocks, and bonds
in some cases, non-cash assets are not marked to market.
In the spring of 1998, a
national business magazine in the USA—Forbes--had the following banner
on its cover: “Pick a Number, Any Number.”
That was followed by articles in the national press, such as USA
Today, about “Abracadabra Accounting,” “Hocus Pocus Accounting,” and the
like. The gist of these articles was
that the accounting numbers were being managed or manipulated by corporations
and certified as being OK by their external auditors. This national outrage moved Chairman Levitt of the SEC into
action. On September 28, 1998, Chairman
Levitt gave a speech entitled “The Numbers Game.” (That speech is available at www.sec.gov.) In that speech, he gave examples of ways
that corporations are managing their earnings—big bath restructuring charges,
creative acquisition accounting, cookie jar reserves, improper revenue
recognition, and abuse of materiality.
(I would point out that under our current accounting rules there are
dozens of ways to manage earnings.
Chairman Levitt gave only a few examples.) Chairman Levitt made numerous suggestions for improvement. The upshot of that speech was (1) the SEC’s
staff produced Staff Accounting Bulletins on restructuring charges, revenue
recognition, materiality, and banks’ loan loss allowances, (2) the New York
Stock Exchange and the NASDAQ charged a blue-ribbon panel chaired by two
prominent business leaders, Mr. Ira Millstein and Mr. John Whitehead, with
making recommendations about corporate audit committees, and (3) the Public
Oversight Board of the American Institute of CPAs charged the Panel on Audit
Effectiveness chaired by Mr. Shaun O’Malley, formerly the CEO of
PricewaterhouseCoopers, with making recommendations about improving the
effectiveness of external audits.
The Millstein and Whitehead
Blue Ribbon Committee issued its report on February 8, 1999. (The report is available at
www.nyse.com.) Among the Committee’s
recommendations are that (1) there be a discussion between the audit committee
and the external auditor about the quality of the company’s accounting and (2)
that the audit committee represent in the company’s annual report that, based
on discussion with management and the external auditor, the company’s financial
statements are fairly presented in conformity with generally accepted
accounting principles. The second
recommendation attracted massive, negative comment from the corporate and legal
communities. Commentators stated that
audit committee members are not accountants and do not have the expertise to
determine whether the company’s financial statements conform to generally
accepted accounting principles. When
the SEC adopted its revised rules on audit committees on December 22, 1999 (See
SEC Release No. 34.42266 at www.sec.gov), the SEC did not adopt that recommendation. Instead, the SEC merely required that the
audit committee state, in the annual report, that, after discussion with the
external auditor, the audit committee “…recommended to the Board of Directors
that the audited financial statements be included in the Annual Report…,”
thereby implicitly acknowledging that members of audit committees don’t know
whether the financial statements comply with generally accepted accounting
principles.
The recommendation that the
audit committee discuss with the external auditor the quality of the company’s
accounting has been acted on by the auditing profession in the USA. In December 1999, the AICPA’s Auditing
Standards Board issued Statement on Auditing Standards No. 90, “Audit Committee
Communications,” which requires, as to public companies, that the auditor “…
discuss with the audit committee the auditor’s judgments about the quality, not
just the acceptability, of the company’s accounting principles as applied in
its financial reporting.” I would like
to be a fly on the wall when such discussions take place in the corporate
boardroom. I can just imagine the
auditor saying to his/her client, “My firm has audited your financial
statements. My firm is prepared to
report without qualification that your financial statements have been prepared
in conformity with generally accepted accounting principles, but my grade on
the quality of your financial statements is C-.” In my opinion, this requirement by the Auditing Standards Board
is worse than a joke. It is farcical. The large auditing firms have hundreds, some
thousands, of partners in the USA and still more worldwide. There are no objective standards by which
the individual partner in San Francisco, Sydney, Seoul, Singapore, or
Southhampton can make a judgment about the quality of a client’s
accounting. Following the Auditing
Standards Board’s rule, opinions about the quality of clients’ accounting would
be based on the idiosyncratic judgments of hundreds or thousands of individual
partners. The practical upshot will be
that every client’s grade on quality will be an A. There are two reasons for that.
First, given the highly competitive nature of the public accounting
business, few if any audit partners are going to jeopardize a client
relationship by telling the client that its accounting is not of high
quality. The second reason is that the
accounting rules under which financial statements are prepared allow the
management to use its judgment in preparing those financial statements, and the
auditor has no basis on which to make a different judgment except personal
preference.[2]
The O’Malley Panel issued its
255-page report on August 31, 2000.
(That report may be viewed at www.pobauditpanel.org.) The Panel’s major recommendations are as
follows:
Auditors
should perform some “forensic-type” procedures on every audit to enhance the
prospects of detecting material financial statement fraud.
The Auditing
Standards Board should make auditing and quality control standards more
specific and definitive…
Audit firms
should put more emphasis on the performance of high quality audits in
communications from top management, performance evaluations, training, and
compensation and promotion decisions.
The Public
Oversight Board (“POB”) of the AICPA, the AICPA, the SEC Practice Section
(“SECPS”) of the AICPA, and the SEC should agree on a unified system of
governance for the [auditing] profession under a strengthened Public Oversight
Board that would oversee standard setting (for auditing, independence and
quality control), monitoring, discipline and special reviews.
The SECPS
should strengthen the peer review process, including requiring annual reviews
for the largest firms, and the POB should increase its oversight of those
reviews.
The SECPS
should strengthen its disciplinary process.
Audit
committees should pre-approve non-audit services that exceed a threshold
amount…
The
International Federation of Accountants should establish an international
self-regulatory system for the international auditing profession.
As I understand it, the
Auditing Standards Board and other AICPA entities are working on the Panel’s
recommendations. And, I have no doubt
that the SEC’s staff is watching over their shoulders to make sure that all of
the details are implemented to the SEC’s staff’s satisfaction. Maybe the number of financial statement
frauds that the SEC periodically has to investigate and address through
enforcement actions will be reduced if more “forensic-type” audit work is done
by external auditors as recommended by the Panel. But, the earnings management game won’t stop even if every one of
the Panel’s recommendations is implemented immediately. And, the dismaying, surprise corporate
collapses--such as HIH Insurance here in Australia--that happen about once a
month won’t stop even if every one of the Panel’s recommendations is
implemented immediately.
There have been similar
panels, committees, and even Royal Commissions in the past, all with more or
less similar recommendations. We now
have O’Malley. We had the Kirk Panel in
the 90s. We had Treadway about fifteen
years ago. We had the Cohen Commission
in the late 70s. We had Metcalf. Canada had MacDonald. Great Britain had Cadbury. Australia has had similar committees, I’m
sure. In the 1970s, we in the USA
introduced peer reviews of audit firms.
Concurring audit partner reviews also now are a requirement in the USA. We have the AICPA’s Quality Control Inquiry
Committee looking into external auditor performance when financial statements
are restated. We have the AICPA’s
Public Oversight Board, breathing hard, looking over everyone’s shoulder. All for naught. What we have is layers on top of layers on top of layers of
regulation. After O’Malley, we no doubt
will have another layer of regulation.
We had the AICPA’s Committee
on Accounting Procedure writing the accounting rules from 1939 to 1959. That didn’t work and that committee was
replaced by the AICPA’s Accounting Principles Board, which wrote the accounting
rules until 1973. In 1973, the
Accounting Principles Board was replaced, with great hope and fanfare, by the
Financial Accounting Standards Board.[3] Things were supposed to get better. But, nothing has changed. Earnings management continues to flower.
Corporations today continue to
manipulate their earnings without objection from their external auditors. SEC Commissioner Hunt in a speech on October
26, 2001 discussed earnings management.
(See www.sec.gov.) Business
Week, in the July 23, 2001 issue on page 71 reports, “In today’s financial
climate, auditor’s reports have about as much credibility as buy
recommendations from Wall Street analysts.”
The June 2001 issue of the Harvard Business Review has a
twelve-page article entitled “The Earnings Game: Everyone Plays, Nobody
Wins.” On Friday night, October 19,
2001, on a TV program called “Wall Street Week,” I heard and saw a prominent
Wall Street investment manager say something along the following lines: “Corporations
are writing off assets right and left in the quarter ended September 30,
2001. Comparative earnings statements
in 2002 will be wonderful.” His
implication was that the write downs are arbitrary. The Levy Institute Forecasting Center, in a Special Research
Report dated September 2001, describes in twenty-three pages of detail “Two
Decades of Overstated Corporate Earnings,” which its chairman, Mr. David Levy,
previewed on TV on CNBC on October 24, 2001.
Business Week, in the October 15, 2001 issue on pages 46 and 47,
says: “Brace yourself for what may be the ugliest quarter ever for corporate
earnings. For years, companies used
every trick in the book to make their results look better than they really
were. Now, many will be taking the
opposite tack: loading costs and charges onto their income statements in an
all-out effort to make an already horrid year look even worse. To make next year’s results look stronger
companies may load losses into 2001 by: slashing values of physical assets,
which will cut depreciation charges in the future; overestimating likely bad
debts, thus boosting future profits when customers pay up; and charging
impending restructuring costs immediately, so as to benefit if they’re less
than expected.”
It’s not just in Business
Week and the Harvard Business Review. I see it in Forbes. I see it in Barron’s. I read the earnings reports of corporations
on their websites and in the Wall Street Journal, and I see the earnings
management. It is going on in bright
daylight, and not behind closed doors.
Everyone on Wall Street knows it is going on. The Stock Exchanges know it is going on. The SEC knows it is going on. Every sell-side security analyst knows it is
going on. Every institutional investor
knows it is going on. But, the
individual investor who is not part of the Wall Street in-the-know crowd
doesn’t know it is going on. John and
Jane Q. Public don’t know it is going on.
Maybe members of Congress don’t know it is going on. The external auditors can’t stop it. Even if the external auditors were US
Federal government auditors, whose independence would be unquestionably pure,
they could not stop it because the accounting rules allow for earnings
management. External auditors have no
ground on which to stand to stop it because of the way the accounting rules are
constructed. The Stock Exchanges can’t
stop it. Because the accounting rules
allow for earnings management, the SEC can’t stop it through its Division of
Corporation Finance, which reviews and clears registration statements and other
filings by issuers of securities. The
SEC’s Office of Chief Accountant and Division of Enforcement can’t stop it
because the accounting rules allow it.
I could not stop it when I was Chief Accountant at the SEC.
I have been in this business
since August 1, 1957. I think that I
have seen every side and dimension of this problem. In my opinion, the only way that earnings management will be
stopped is as follows: The SEC, or the
SEC and FASB, or the SEC and FASB and IASB, must change the accounting
rules. The SEC must make deep and
fundamental changes to the system.
Unless and until the SEC requires that assets be reported at estimated
selling prices, which of course means that only things that have a market price
could be represented as assets, nothing will change. Unless and until the SEC requires that liabilities be reported at
estimated settlement prices, nothing will change. Unless and until the SEC requires that reported asset and
liability amounts be based on estimated selling and settlement prices and that
external auditors get evidence about those selling and settlement prices from
persons or entities outside the reporting enterprise, nothing will change.
So long as management controls
the numbers, nothing will change. For
example, so long as management decides on the amount of inventory obsolescence,
the amount of bad debts, or the amount of the warranty liability, nothing will
change. So long as management decides
on the assumed rate of return on pension plan assets, nothing will change. So long as management decides on the
estimated useful lives and salvage values of capital assets without regard to
the selling prices of those assets as determined by the marketplace, nothing
will change. So long as management
decides on what will be future, undiscounted cash flows from capital assets,
and can change those numbers at will in determining whether the carrying
amounts of capital assets are impaired, nothing will change. So long as management is allowed to recognize
liabilities for restructuring the business whenever management wants to, and in
an amount determined solely by management, nothing will change.
The reported numbers for
assets and liabilities must be such that they can be verified by external
auditors (and by regulators and courts) by reference to sources outside the
enterprise. By reference to competent
evidence.[4] The SEC must make deep and fundamental
change to the system. Only by requiring
that assets and liabilities have a reference point in the marketplace and that
the amounts representing those assets and liabilities be verifiable by
reference to sources, competent sources[5],
outside the enterprise, will we be able to produce financial statements that
include reliable numbers. As a
practical matter, neither the FASB nor the IASB can accomplish such deep and
fundamental change on its own. Or even
together. Only the SEC can accomplish
such change. And, only if such change
is made will the financial statements be of high quality.
This idea that financial
statements be of high quality, or that accounting standards be of high quality,
has attracted a lot of attention recently.
The term, “high quality,” is on everyone’s lips. It is high sounding. The IASB’s website says that the IASB, “…is
committed to developing, in the public interest, a single set of high quality,
understandable and enforceable accounting standards that require transparent
and comparable information in general purpose financial statements.” The US House of Representatives’
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises, on June 7, 2001, held a hearing on “Promotion of International
Capital Flows through Accounting Standards.”
Representatives Baker, Oxley, LaFalce, Kanjorski, and Mascara made
“Opening Statements.” Mr. Paul Volcker,
Chairman of the Trustees of the IASB, Mr. Philip Ameen, VP & Comptroller of
General Electric, representing Financial Executives International, and Mr.
Robert Elliott, a KPMG partner representing the AICPA, testified before the
Subcommittee about international accounting standards. By my count, the US Representatives, Mr.
Volcker, Mr. Ameen, and Mr. Elliott, in their prepared remarks, used the term
“high quality” no fewer than twenty-three times. Sometimes high quality standards, sometimes high quality
financial statements, and sometimes high quality information. Mr. Lynn Turner, the SEC’s Chief Accountant
from mid-1998 to mid-2001, used the term frequently in his speeches when
describing financial statements prepared under FASB standards and when he
described what he hopes will result under IASB standards. But, I can’t tell what it is that these
people are describing. These people
obviously are not describing what Chairman Levitt described in his September
1998 speech, what Commissioner Hunt described in his speech on October 26,
2001, and what Chairman Pitt meant when he said quarterly and annual reports
are indecipherable by ordinary investors.
These people obviously are not describing what I see in the Harvard
Business Review, Business Week, Forbes, and Barron’s
about earnings management. To me, these
people sound like my seven-year old granddaughter who is wishing that Santa
Claus will bring her a pony on Christmas morning.
What is that we want for
investors when we say “high quality financial statements” or “high quality
information?” I’ll tell you what I
want. I want financial statement
amounts (numbers) that are relevant and reliable. Historical costs of assets and historical proceeds of liabilities
are not relevant to an investor for purpose of making an investment decision—or
to any business person wanting to make a decision about an asset or a
liability. Only current selling prices
for assets and current settlement prices for liabilities are relevant. The only reliable measures of those prices
are those that come from the marketplace, from persons or entities unrelated to
the reporting enterprise. Selling
prices of assets and settlement prices of liabilities can be verified by
external auditors by reference to marketplace sources. If the SEC requires that assets and
liabilities be measured, and be verified by external auditors, by reference to
selling and settlement prices that exist in the marketplace, and requires
disclosure of the names of persons or entities that furnished those prices, the
resulting financial statements will be of high quality. And that standard, unlike what we have
today, will be enforceable by external auditors, regulators, and ultimately the
courts.
There is a new chairman, Mr.
Harvey Pitt, and a new Chief Accountant, Mr. Robert Herdman, at the SEC. Mr. Pitt made a speech on October 22, 2001
(see www.sec.gov) before the governing council of the AICPA, wherein he spoke
of “…simplifying financial disclosures to make accounting statements useful to,
and utilizable by, ordinary investors” and that “we [SEC] may need to
reconsider whether our accounting principles provide a realistic picture of
corporate performance.” The SEC’s press
release on September 19, 2001 (see www.sec.gov)
announcing Mr. Herdman’s appointment as Chief Accountant says, “Mr. Herdman
will lead us [SEC] in revising and modernizing our accounting and financial
disclosure system.” Those words are
promising. Maybe Mr. Pitt and Mr.
Herdman will surprise investors with the equivalent of a pony on Christmas
morning—that is, high quality financial statements.
[END]
Postscript on December 9,
2001: After I presented this lecture, I
received in the mail a brochure advertising a two-day course entitled “How to
Manage Earnings in Conformance with GAAP.”
“This Intensive Two-day, Skill-based Workshop Features over 50
Illustrations, Applications and Case Studies to Make GAAP Work for Your Company
or Client.” “Earn 16 Hours of A&A
CPE Credit and CLE Credit.” This course
is sponsored by the National Center for Continuing Education, 967 Briarcliff
Dr., Tallahassee, Fla 32308, and costs $995.
I rest my case about earnings management being a disease.
###
Walter P. Schuetze, now retired, was Chief
Accountant to the Securities and Exchange Commission and Chief Accountant of
the Commission’s Division of Enforcement, a charter member of the Financial
Accounting Standards Board, a member and chair of the Accounting Standards
Executive Committee of the American Institute of Certified Public Accountants,
and a practitioner of public accountancy with the firm of KPMG LLP.
[1] FASB Statement 12, issued in 1975 and now superseded by Statement 115, required lower of cost or market accounting for the portfolio of marketable equity securities held, which is awful accounting. In Statement 12, I wanted to require mark to market for every security in the portfolio as did two other Board members, Messrs. Litke and Sprouse, who dissented to the issuance of Statement 12. But, because we needed five votes to issue a standard and because our constituents were telling us that practice was so diverse that a standard, some standard, was necessary, I bit my tongue and signed the document without dissenting.
[2] For an excellent discussion and analysis of why the presence of audit committees cannot and will not improve the quality and reliability of today’s financial statements, see “Are Audit Committees Red Herrings?” by P. W. Wolnizer, Abacus, Vol. 31, No. 1, March 1995, pp.45—66.
[3] I know. I was a charter member of the FASB. My wife and I were present at the FASB’s inauguration dinner in the spring of 1973. Mr. Reginald Jones, the chairman of General Electric, delivered the inaugural address. He held out great hope for the FASB.
[4] This style of auditing—obtaining competent evidence—is exactly what P. W. Wolnizer describes and recommends in his book Auditing as Independent Authentication, Sydney University Press, 1987.
[5] The SEC should require (a) disclosure, either by the reporting enterprise or the external auditor, of the names of the persons or entities that furnished the selling and settlement prices and (b) the consent of those persons or entities to the use and disclosure of their names.