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March 4, 2002
Representative W. J. "Billy" Tauzin, Chairman
Committee on Energy and Commerce
U.S. House of Representatives
Washington, D.C. 20515-6115
Dear Chairman Tauzin:
Re: Response to your questions (from February 20, 2002), concerning my testimony before your committee (February 6, 2002).
The order of my answers follows your questions.
1. Concerning SEC Chairman Pitt's comments about "current disclosures." In general, the more current and timely the disclosure to capital markets, the more efficient and fair will these markets be. So, I definitely encourage quick and unbiased (e.g., not only good news) disclosure of business events.
This, however, differs from my testimony about a major limitation of the accounting and financial reporting systems-the reflection of past transactions only (with few exceptions). Thus, for example, "unexecuted obligations," such as loss guarantees to special purpose entities, or provisions for future availability of raw materials and other inputs (known as "take-or-pay contracts," or "throughput arrangements"), create obligations which are not reflected as liabilities in the financial reports. (Unexecuted obligations arise from agreements related to future transactions).
In my testimony, I strongly urged accounting standard-setters (SEC, FASB) to expand the scope of financial reports to include most unexecuted obligations. This can be done effectively and expeditiously in my opinion.
2. Response include in (1), above.
3. The issue of intangible (intellectual) assets, which are by and large not reflected in financial reports, is broad and obviously beyond the confines of this response. It is, however, thoroughly presented and analyzed in my recent book-Intangibles: Management, Measurement, and Reporting (Brookings Institution Press, 2001).
For the record I will note that various estimates indicate that intangible assets (e.g., discoveries, patents, brands, unique organizational designs and processes, etc.) currently constitute 60-75 percent of corporate value, on average.
The socially harmful consequences of the failure to account properly for those assets (which are mostly expensed immediately by the accounting system), and disclose their attributes are numerous and very consequential. They include: using intangibles (e.g., in-process R&D) for widespread manipulation of financial information, excessive gains to corporate insiders from trading the stock of their companies, high volatility of stock prices, and not the least-excessive cost of capital to intangibles-intensive companies, hindering innovation and growth. (Elaboration on these social harms can be found in my book, referenced in (1), above, Chapter 4.)
The accounting and financial reporting systems can, and should be significantly modified-for example GAAP rules for asset recognition-to reflect vital information about investments in intangible assets and their consequences. At the minimum, corporations should be required to routinely disclose information on their investment in key intangibles-brands, human resources, information technology, major business processes, and breakdown of R&D-and the consequences of such investments. Investors should be able to assess the desirability and productivity of such investments.
4. Concerning risk exposure. The SEC required in the early 1990s some disclosure by corporations of risk exposure. This was a step in the right direction, but a very modest step which was not pursued vigorously.
A system of "stress tests" should be developed, to reflect the consequences of foreseeable events on the company's operations and economic condition. Thus, for example, a globalized corporation exposed to foreign exchange fluctuations of the Euro or the Yen (relative to the U.S. dollar), should be required to provide information on the consequences of expected changes in the value of these currencies. For example, the consequences of changes of plus/minus 2%, 5%, 10%, relative to the exchange rates at the end of the year. Similarly, a company exposed to interest rate fluctuations, should report the results of "stress tests," reflecting the consequences (gains/losses, changes in assets/liabilities) of expected changes in interest rates of 0.25,0.5,1.0 percents.
Similar risk-related information is currently requires from financial institutions. I favor expansion of such requirements to include non-financial enterprises.
Concerning your questions about secrecy of strategic information, I sincerely doubt that results of stress tests will harm the competitive position of the corporation. To the contrary, I believe that a requirement to publicly report risk exposure will focus the attention of mangers and board members on a vital aspect of operations (i.e., risk) currently neglected in many corporations, as a result of the failure of the accounting system to reflect risk.
5. You are perfectly right that the number of earnings restatements has mushroomed in recent years. New York University Ph.D. candidate, Ms. Min Wu, documented a sharp increase in restatements during 1998-2001 (see attached graph from her dissertation).
The major reasons for the increase in restatements in the late 1990s are: the rise in uncertainty/volatility of the business environment in the late 199s, and the pressure from Wall Street to meet or beat the earnings forecast of financial analysts (the "earnings game"). These reasons led many executives to "manage" their volatile earnings toward meeting the forecasts. Ultimately, however, reality catches up with such managers, leading to restatements, and in extreme cases to bankruptcies.
Restatements of earnings are just a symptom of the futile but pervasive "earnings game" played by managers and analysts to the detriment of investors and the economy. Fundamentally, the earnings game, with its focus on short-term profits and a superficial concept of companies' operations (undue focus on accounting earnings), should stop. This is not an easy task, but expansion of the disclosure of relevant information-a central theme of my testimony-should lessen the adverse impact of the earnings game.
6. Regarding auditors' rotation. I suggest not only a rotation of auditors, but mainly their selection and reappointment by shareholders every five years. (See my testimony). If shareholders are satisfied with the performance of auditors, they will reappoint them. So, auditors will not necessarily be changed every five years. What will happen every five years is a serious examination of auditors' performance, and an opportunity for competitor auditors to publicly bid for the audit engagement.
While I have no reliable cost estimates for the proposed system, I doubt whether it will result in a significant cost increase. I am familiar with the argument that there are some "learning" advantages from repeating the audit over several years, but I am not familiar with any estimates of the magnitude (cost savings) of such learning. The benefits of my proposal in increased auditor diligence, knowing that their performance will be seriously evaluated every few years, and in the occasional dismissal of negligent auditors, will in my opinion far outweigh the additional costs, if any.
7. Regarding consulting activities. I believe that if revenues from non-audit activities will be limited to a reasonable fraction of audit fees (I suggest 25-30 percent), then there will be no need to specify which services should be excluded-a difficult task at best.
8. You ask: "…will there be perverse incentives for the auditing firm to provide a poor opinion of the consulting firm's work…?" I doubt it. In general, auditors don't opine on managerial issues (e.g., effectiveness of operations, quality of the product, etc.), only on the faithful representation of financial reports. Most consulting engagements, in contrast, deal with management issues (e.g., improving information technology, streamlining human resource practices, etc.). Accordingly, I don't see a significant opportunity for auditors to criticize consulting engagements by other firms.
Concluding Comment
The above responses are by necessity brief and hopefully concise. I will be happy to elaborate, in person, on any issue of concern to your legislative activities (within my range of expertise, of course).
My best wishes,
Baruch Lev
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