Financial reporting at a crossroads. (Commentary).

INTRODUCTION

Today, the institutions responsible for financial reporting in our capital markets are reeling from the fall-out of financial-reporting scandals of colossal proportions. Reports on the collapse of Enron, the bankruptcy of WorldCom, and a growing list of failures and near

failures have exposed massive manipulations of financial reporting by management, inexplicable breakdowns in the independent audit process, astonishing revelations of holes in our financial-reporting standards and practices, and stunning lapses of corporate governance. In this environment, investors and the public have become increasingly skeptical about a system that seems to be out of control. Indeed, financial reporting is once again at a crossroads.

We witnessed high-profile failures in the past and encountered similar questions about the performance of the key players in our financial-reporting system. Clearly, however, the revelations that continue to unfold have had cataclysmic effects that changed the world's view of a system that we often tout as "the best in the world." So severe is the damage that the investing public can be expected, rightly so, to demand answers and meaningful reforms.

SOME CHALLENGING QUESTIONS DEMAND ANSWERS

As we re-examine the partnership between the public and private sectors that has been the basis for oversight of our capital markets, we must confront candidly and honestly some challenging questions:

* Can we believe in and rely on the independent audit?

* Can we believe that our accounting and disclosure standards provide the transparency that is essential to investors and the public?

* Can we rely on self-regulatory systems to ensure audit quality and to root out and discipline substandard performance?

* Can we rely on corporate governance processes--oversight by boards of directors and audit committees--to ride herd on management and to see to it that auditors do their job?

Events have changed how we look at and think about those questions, and the change may last for decades to come. The road ahead seems awesomely challenging. Where do we begin to reform a system that suddenly seems very fragile and perhaps seriously flawed? What are the essential changes that we need to make?

I offer some perspectives and insights drawn from my nearly 40 years in accounting practice and public service and share some thoughts on needed reforms.

SHARED GOALS OF CAPITAL MARKET PARTICIPANTS

I begin with some essential views that I think all who have important roles in and benefit from a vibrant capital market system can embrace--business, government, auditors, standards setters, investment bankers, analysts, and the investing public. We all share a common, linked starting point:

* First, I think all will agree that our capital market system is a national treasure. It is vital to the success of the economy. Indeed, our exceptional standard of living depends on its vitality.

* Accordingly, we share a compelling common interest in assuring the strength and liquidity of our capital markets. We all benefit from the result.

* This compelling common interest must shape our policy goals and guide our thinking as we search for solutions. Other goals and interests must not obstruct our vision.

* Finally, the most critical, yet intangible, ingredient of a successful capital market system is the confidence of investors and the public in the fairness of the markets--confidence that information flowing into the markets is trustworthy and that insiders do not have an unfair information advantage over public investors.

Indeed, the focus of the securities laws is rooted in this view of our capital markets. Historian David M. Kennedy (1999) discusses the events that surrounded the enactment of the securities laws in his Pulitzer Prize-winning book, Freedom From Fear. In describing the formulation of the securities laws, he writes:

For all the complexity of its enabling legislation, the power of the SEC resided principally in just two provisions, both of them ingeniously simple. The first mandated disclosure of detailed information, such as balance sheets, profit and loss statements, and the names and compensation of corporate officers, about firms whose securities were publicly traded. The second required verification of that information by independent auditors using standardized accounting procedures. At a stroke, those measures ended the monopoly...on investment information. (Kennedy 1999, 367)

He goes on to observe:

The SEC's regulations unarguably imposed new reporting requirements on businesses....But they hardly constituted a wholesale assault on the theory or practice of free market capitalism. All to the contrary, the SEC's regulations dramatically improved the economic efficiency of decisions....This was less the reform than it was the rationalization of capitalism, along the lines of capitalism's own claims about how free markets were supposed to work. (Kennedy 1999, 368)

As we look at the issues today, it should be abundantly clear that there is no higher goal for financial reporting than providing useful and reliable information that promotes informed investment decisions and confidence in the system. Sometimes, however, we hear arguments that financial reporting should take into account other policy goals in the name of promoting various economic benefits, including some that advocate the interests of capital users rather than capital providers. That view of the world is based on a curious, upside down logic. The truth is, without investor confidence, arguments about how financial reporting does or does not contribute to economic goals or market efficiency simply are moot-they are a waste of time. If investors do not have confidence or lose confidence in the integrity of the information they receive, then they will flee the markets, and we all will pay a devastating price.

RESTORING CONFIDENCE IN INDEPENDENT AUDITS

In the past, the auditing profession responded to challenges to its performance with arguments that, on the whole, audits are effective and that public expectations of the independent audit are unrealistic. As the dialogue continued, attention inevitably turned to the standards that govern financial reporting and auditor performance. After extended debate, some changes were proposed and some were adopted. Responses to the challenges of the 1970s, for example, led to the formation of the SEC Practice Section of the American Institute of Certified Public Accountants, the formation of the Public Oversight Board, and the development of the Peer Review Program. Opinion about whether the changes improved auditor performance or enhanced investor confidence, however, was mixed, and the ensuing periods of peace and adjustment were uneasy. Time and again, investors and the public, who understand little about how audits and auditors work, were left to wonder what the future holds.

Today, in the light of all that has happened, we must find more substantive and lasting remedies. Now is the time to design and implement essential reforms, both through regulatory processes and by re-examining and, if necessary, redefining relationships and reporting responsibilities.

I believe that the road to a more lasting resolution begins with full acknowledgement by the auditing profession of the reality that seems so clear today. Failures in our financial-reporting system are more than aberrations. They seriously undermine the confidence of investors and the public in the institutions that are supposed to protect them. They "poison the well."

Pleas that the vast majority of financial reports are sound, that most audits are effective, and that failures are few miss the point. In capital markets, a single financial-reporting failure can be a disaster in which losses to investors and the public can be, and often are, overwhelming-wiping out decades of hard work, planning, and saving. In that context, debates about how many failures are tolerable are not only not productive, but are also nonsense.

What the Auditing Profession Needs to Do

The urgent challenge is to find ways to restore and maintain confidence in the independent audit. To achieve that goal, I believe that the auditing profession needs to do three things:

1. It will have to embrace a role that is fully consistent with high public expectations. In public capital markets, insiders have more information about the current condition and future prospects of the firm than does the investing public, a phenomenon called "information asymmetry." (1) This leads to problems that academics have labeled "adverse selection" and "moral hazard." An example of the former arises when insiders attempt to sell stock to outsiders. Investors understand that insiders have incentives to overstate the benefits of buying their stock, and unless the insider can credibly signal the value of their company, investors will reduce the amount they are willing to pay for the stock. The latter arises after capital is raised because management has incentives to use capital in ways that are not consistent with the interests of investors. To avoid the "hazard" that managers will exert too little effort on behalf of investors or consume too much of the capital in the form of perks, investors typical ly look to compensation plans that are tied to the financial results of the company.

Theorists demonstrate that the inefficiencies caused by adverse selection and moral hazard can be reduced by having an independent third party attest to the accuracy of information provided by insiders to owners or prospective owners. In this role, independent auditors are expected to balance the scales by assuring public investors that financial reporting provides useful and reliable information that gives them a fair and not misleading portrayal of the economic realities of the business.

2. The auditing profession must tackle fraudulent financial reporting as a distinct issue with a distinct goal--zero tolerance. We understand that, in life, "zero defects" are almost never realized. Nevertheless, the public expects the profession to pursue that end, and with greater energy and more success than in the past.

3. It must accept and support necessary regulatory processes that give comfort to investors and the public that the profession is doing all that it can do to prevent future episodes of failed financial reporting.

Changes Needed in Regulatory Processes

To build confidence in the independent audit, regulatory processes must be truly independent; they need to be open; they need to actively engage, inform, and involve the public; they need to be adequately resourced and empowered to accomplish their mission; and they need to be adaptable to changing conditions. I believe that there are five critical ingredients of an effective regulatory process that can restore and maintain public trust:

1. Timely and thorough investigations of circumstances that may involve fraudulent financial reporting.

2. Objective and fair assessments of the role and performance of auditors.

3. Timely and meaningful discipline of auditors and firms that violate acceptable norms of conduct.

4. Regular oversight and periodic examinations of the policies and performance of independent auditors.

5. Timely and responsive changes in professional standards and guidance when a need for improvements is identified.

I believe that these goals can best be accomplished through an independent statutory regulatory organization operating under the oversight of the Securities and Exchange Commission. This new organization should be empowered to require registration of independent auditors of public companies, establish quality control, independence, and auditing standards applicable to registered independent auditors, conduct continuing inspections of the accounting and auditing practices of registered firms, undertake investigations of possible financial-reporting failures, and conduct proceedings to determine whether disciplinary or remedial actions, including fines, are warranted. To carry out these responsibilities the organization will need appropriate investigative and disciplinary powers. The "Postscript" at the end of this article discusses recent legislative action on these issues.

THOUGHTS ON IMPROVING ACCOUNTING STANDARDS AND STANDARDS SETTING

Strengthening the independent audit, though vital, is only part of the needed reform of our financial-reporting system. We also need to critically examine the processes by which our accounting standards are developed and then take action to strengthen these processes. As we have seen, poor accounting standards and guidelines can exact their own toll. They can be extremely costly to investors and the public. We simply cannot tolerate financial-reporting standards that enable those who come to the markets seeking investor capital to "hide the ball."

There seems to be a great deal of finger pointing today about what is wrong with U.S. accounting standards. Some have placed the blame for financial-reporting failures on an accounting model that is out of date. The popular rhetoric asserts that the essential problem is that we are trying to apply an industrial age accounting model to an information age economy. The solutions offered include such things as more timely reporting, reporting that seeks to avoid impenetrable complexity by requiring more understandable disclosures, and a greater recognition in the financial statements of intangible assets. While there are very real problems with our accounting model, and while the ideas that have been offered are intellectually stimulating, they would do little to remedy the challenges presented by an Enron or a WorldCom--cases in which financial reporting apparently was deliberately distorted with the objective of misleading investors and the public about the underlying economic performance of the enterprises.

Additional criticism is beginning to focus on the fact that U.S. standards have become increasingly detailed, and suggestions are made that they should be broader statements of principle, applied with good judgment and respect for the substance of underlying transactions and events. I have sympathy for the desire to break the cycle of the mind-numbingly complex accounting rules that are now the norm, but to do that I think we have to confront realistically the reasons why our standards evolved the way they have, and what is required to avoid the same pitfalls in the future.

What the capital markets need and demand is accounting and disclosure that provide a clear picture of the underlying economics and furnishes information that is comparable among companies and consistently presented over time. The issue and debate should not be about whether accounting standards should be detailed or broad, but rather about what formulation of standards and standards-setting approaches best accomplish the goals to which financial reporting should aspire.

Some Forces That Shape Accounting Standards

To fully appreciate the challenges of improving financial reporting, it is useful to look for a moment at the forces at work in shaping our accounting standards, and to reflect on the obstacles they present (see Revsine 1991). Here are some of the underlying pressures:

* Business managers want standards that provide the greatest flexibility and room for judgment. They want to be able to manage reported results, but yet be able to point to an accounting standard that assures the public that they are following the rules.

* Deal makers and financial intermediaries want standards that permit structuring transactions to achieve desired accounting results--results that could obscure the underlying economics. In that world, creative transaction structures are valuable commodities.

* Auditors are pressured to support standards that their clients will not take issue with, and they often are restrained in their expected support for reporting that is in the best interests of investors and the public.

* Others, including some legislators, too often lose sight of the fundamental importance of an independent and neutral standards-setting process. Without independence and neutrality, standards setters cannot effectively perform their essential service to the investing public.

* Standards setters too often pull their punches, backing away from solutions they believe are best. Perhaps they do this because of a perceived threat to the viability of private sector standards setting, perhaps because of the sometimes withering strains of managing controversial, but needed, change, or perhaps because of a loss of focus on mission and concepts that are supposed to guide their actions.

Effectively meeting the expectations of investors and the public in that environment requires a standards-setting process that has the independence to withstand the myriad of constituent pressures that it inevitably faces and to make the tough decisions that inevitably are required.

We cannot tolerate processes that fall to produce standards that are responsive to critical accounting and financial-reporting issues as they arise in the market place, and that fall to do so on a timely basis. Current rules for accounting for Special Purpose Entities (SPEs), for example, are nonsensical. They can be explained only by accountants to accountants--or more disturbingly, perhaps, by accountants to deal makers. They do not portray accurately the underlying economics of the arrangements. In virtually all of these arrangements, the sponsoring entity retains substantial risks and retains the ability to control substantial benefits associated with the assets and operations transferred to the SPE. Those accounting rules are designed to permit the removal of assets, debt, and operations from the sponsor's financial statements if certain bright-line tests are met, even though meeting those tests has little bearing on the sponsor's ultimate risks and benefits. Thus, we have accounting rules that permit di storted financial reporting when as little as 3 percent of total investment in the SPE comes from outside, at-risk capital. Sometimes even that capital is not truly at risk.

The current approach being pursued by the Financial Accounting Standards Board (FASB) to address the criticism of the current rules does little to bring the accounting and underlying economics in line. It merely moves the bright-line from 3 percent to 10 percent, though even the proposed 10 percent test is framed as a presumption that could be overcome by "persuasive evidence," and adds a few more tweaks that have the effect of changing deal structures, but do little to improve the quality of financial reporting (see FASB 2002).

More broadly, outdated rules governing consolidation and off-balance-sheet financing have become recipes for masking a company's true economic risks and obligations. Today, companies are able to finesse the consolidation rules and, thereby, manage the financial results they present to investors. For example, unconsolidated entities are used to park equity-method losses off the income statement, to create the appearance that transactions with affiliated entities are bona fide transactions with third parties, to permit the netting of losses on securities investments with gains on other securities investments, and to hold indirectly risky assets that regulators forbid regulated entities to hold directly. The FASB has studied consolidation issues for years, and yet it has done little more than tinker around the edges.

The Need for Action

We have a right to insist that the FASB develop and promulgate accounting rules that are clearly responsive to the underlying economics of transactions and events. It is not acceptable to sit by while financial market innovations outstrip the development of that guidance.

We need to re-energize our standards-setting processes and the commitment of capital market participants to support a fully effective, independent standards setter. If the public-private sector partnership for improving financial reporting is to continue, we need to renew and strengthen our commitment to the needs of investors and the public. Of critical importance is the urgent need for those with the greatest stake in transparent financial reporting--buy-side analysts, those who invest for retirees and manage their funds, and other institutional investors--to take a more active role in the standards-setting and rule-making processes.

We should provide independent funding for the FASB--funding that does not depend on contributions from constituents that have a stake in the outcome of the process. We also need a more independent governance process to replace the current Financial Accounting Foundation board. The leadership for these changes should come from visionaries of unquestioned objectivity and demonstrated commitment to the goals of high-quality financial reporting and the public interest. Perhaps the needed reforms could be best developed and implemented under the auspices of an independent commission made up of leaders of the corporate governance movement, heads of investment funds and retirement systems responsible for managing and investing the nation's savings and pension assets, academic leaders grounded in business and economics, and former leaders of institutions responsible for capital market regulation.

REFORMING CORPORATE GOVERNANCE

Effective oversight by boards of directors is at the heart of the financial-reporting processes that serve and protect the interests of investors and the public. Without effective oversight, important checks on management's integrity, judgment, and performance are compromised. Without effective oversight, critical safeguards of the rigor and objectivity of the independent audit are weakened. As we have witnessed, failures of corporate governance can be devastating, and the investing public is asking, "Can we rely on corporate governance processes--oversight by boards of directors and audit committees--to ride herd on management and see to it that auditors do their jobs?"

We wanted to believe that Enron is an anomaly--that the governance failures are isolated to this case--but we now know they are not. While Enron has become a "poster child" for a system out of control, the underlying concerns about the diligence of boards of directors and audit committees reach far more broadly into our corporate and capital market culture. We now see clearly that without diligent, probing directors and audit committees, and without dispassionate independent auditors, the quality of financial reporting can be systematically undermined. Without adequate checks that must come from effective governance, conflicts of interest can go unchallenged.

One of the most practical and effective first steps in reforming the financial-reporting system is to immediately revisit and rewrite our corporate governance policies and guidelines to clearly break the bonds between management and the independent auditor, and to unmistakably spell out the responsibilities of boards of directors and audit committees to shareholders and the investing public. Management should be the subject of, not the manager of, the independent audit relationship and process. The ultimate responsibility for full and fair disclosure to shareholders, and the direct responsibility for the independent audit relationship and the quality of the audit process, should be clearly fixed with the board of directors and its audit committee. All members of the audit committee should be independent directors.

Ensuring a relationship with the independent auditor that best protects audit quality may require further measures such as periodic rotation of auditing firms, limitations on hiring personnel from the independent auditing firm, and further restrictions on nonauditing services that independent auditors provide to audit clients. As we confront those issues, it is important to keep in mind that investor confidence is influenced by both the fact and the appearance of the independence of the auditor. At the end of the day, governance of the financial-reporting process should provide comfort to the investing public that the financial statements they receive were subjected to an effective and truly independent audit.

MOVING FORWARD

Financial reporting is again at a crossroads. As we re-examine the partnership between the public and private sectors that is the basis for oversight of our capital markets, we must confront candidly and honestly some challenging questions. Are we willing to fulfill, with commitment and enthusiasm, our clear responsibilities to serve investors and the public? Are we willing to exercise discipline to assure that we faithfully fulfill that commitment? Are we willing to be spirited participants in regulatory and governance processes that are essential to provide comfort to investors that our capital markets can be trusted? Only clear affirmative answers to these questions can assure that the partnership will continue and flourish.

At the outset, I suggested that our common interest in preserving and maintaining healthy capital markets far outweighs the concerns or goals of any particular group or special interest. We have to keep focusing on that fundamental tenet and on the goals of preserving confidence in our capital markets and restoring confidence in our financial-reporting and disclosure system. Only a continuing commitment to that goal guarantees that we will continue to enjoy the best capital markets in the world.

POSTSCRIPT

On July 30, 2002 President Bush signed into law the Sarbanes-Oxley Act of 2002 (P.L.107-240). This Act provides for a series of far-reaching changes in the oversight and regulation of financial reporting in our capital markets. A description of some of the key provisions of the Act follows:

Public Company Accounting Oversight Board: Title I of the Act creates a new Public Company Accounting Oversight Board to oversee audits of public companies. Accounting firms that audit public companies must register with the Board. The Board may, subject to review by the Securities and Exchange Commission:

* establish, adopt, or modify auditing, quality control, ethics, and independence standards for public company audits.

* inspect accounting firms.

* investigate potential violations of applicable rules relating to audits.

* impose sanctions if those violations are established.

The Board has authority only over audits of public companies. It has no jurisdiction over the work of accountants auditing other companies.

Accounting Standards: The Act amends the Securities Act of 1933 specifically to allow the SEC to recognize as "generally accepted" (for purposes of the securities laws) accounting principles established by a private entity that is funded as outlined in the bill and that has adopted procedures, including acting by majority vote, to ensure prompt consideration of necessary changes to the body of generally accepted accounting principles. (2) These provisions are, of course, meant to apply to the FASB. The Act also asks the SEC to conduct a study concerning the adoption of what the bill refers to as a "principles-based accounting system" and to report to the House Financial Services Committee and the Senate Banking Committee within one year on the results of that study.

Independent Funding: Under the provisions of the Act, public companies are required to pay "accounting support fees" to support the annual budgets of the new oversight Board and the FASB. The FASB will continue to set its own budget, and the new Board's budget will be subject to approval by the SEC. Amounts payable by public companies to either body will generally be allocated among and charged to individual companies based on relative average annual monthly market capitalization for the 12 months prior to the year to which the support fee relates. Both the Board and the FASB are permitted to differentiate among various classes of public companies in allocating fees.

Corporate Responsibility: The Act contains provisions relating to the responsibility of senior corporate managers and directors for a public company's financial disclosures. It requires audit committees to be directly responsible for the appointment, compensation, and oversight of a public company's independent auditors, and requires those auditors to report directly to the audit committee. Auditors must include in that reporting, in a timely manner:

* the critical accounting policies and practices used in the company's financial statements.

* all alternative accounting treatments within GAAP that were discussed with management.

* any accounting disagreements between the auditor and management.

* other material written communications between the auditor and management.

To strengthen the independence of the audit committee itself, the Act bars audit committee members from accepting consulting fees from, or being affiliated persons of, the company or the company's subsidiaries, other than in the member's capacity as a member of the board of directors or any board committee. Finally, the Act requires the chief executive officer and the chief financial officer of public companies to certify the accuracy and completeness of the company's financial statements in periodic reports filed with the SEC. Moreover, in the company's annual report, they must certify the sufficiency of the company's system of internal controls with respect to financial reporting.

We will struggle for a while to understand and assess fully the implications of these reforms and how they will impact the institutions responsible for financial reporting--management, auditors, standards setters, boards of directors, academe, and the investing public. Although new regulatory and oversight structures and responsibilities will provide new tools to help address the abuses that brought us to the "crossroads," laws and regulations alone cannot assure that abuses will not recur. Only diligence and commitment to professionalism and ethical behavior supported by effective governance and regulatory oversight can assure lasting improvements.

(1.) For more on information asymmetry, see Scott (2003).

(2.) Simple majority is intended, and is to apply to voting by the FASB in promulgating its official pronouncements; it is not expected to affect the process for issuing EITF consensuses and the like.

REFERENCES

Financial Accounting Standards Board (FASB). 2002. Consolidation of Certain Special Purpose Entities, An Interpretation of ARB No. 51. Exposure Draft of Proposed Interpretation. June 28. Norwalk, CT: FASB.

Kennedy, D. M. 1999. Freedom From Fear, The American People in Depression and War, 1929-1945. New York, NY: Oxford University Press.

Revsine, L. 1991. The selective financial misrepresentation hypothesis. Accounting Horizons 5 (December): 16-23.

Scott, W. R. 2003. Financial Accounting Theory. Third edition. Toronto, Canada: Prentice Hall.

Michael H. Sutton is an independent consultant on accounting and auditing regulation and related professional issues.

Editor's Note: Mr. Sutton was Chief Accountant of the Securities and Exchange Commission from June 1995 to January 1998. This article is based on Mr. Sutton's testimony before the Senate Committee on Banking, Housing, and Urban Affairs on February 26, 2002 and before the Permanent Subcommittee on Investigations of the Senate Committee on Governmental Affairs on May 7, 2002.