Subcommittee on Securities

Hearing on Adapting a 1930's Financial Reporting Model to the 21st Century

Prepared Testimony of Mr. Robert K. Elliott
American Institute of Certified Public Accountants

10:00 a.m., Wednesday, July 19, 2000 - Dirksen 538

Thank you, Chairman Grams, for permitting me to testify today on adapting our current financial reporting model to the needs of the twenty-first century. This issue is of great importance to the continued strength of the American economy and therefore to American citizens.

There are many ingredients to a globally successful national economy. The economy must rest on enforceable property rights, the rule of law, an educated workforce, and markets that can express demand and react to supply, to name a few of these ingredients. Another is effective capital allocation.

Capital should be deployed where it can be most productive. At the root of productive investment is information. Those with capital cannot select the most productive companies unless they have information that lets them pick winners. The success of our capital markets has very much been based on informative, reliable financial reporting—often referred to as "transparency." It has helped us redeploy capital from old-line industrial companies to high-tech, new-economy companies.

Germany has historically had low transparency because capital is predominantly deployed by banks. Japan has historically had low transparency because capital has been deployed by keiretsus. Both have been formidable competitors, but they did not have the advantage in capital allocation that has enabled America to become so effective in hi-tech ventures of all sorts.

Today, transparency is more widely recognized as an economic advantage than it ever was before. A movement is afoot in many countries to improve their corporate reporting, and it is abetted by the desire to harmonize accounting across borders. In these circumstances, if we are to maintain our advantage in capital effectiveness, we must move to the next plateau of transparency.

Unfortunately the current accounting model is somewhat out of date. It is very much based on the assumption that profitability depends on physical assets, like plant and machinery; on raw materials, like coal, iron ore, sheet metal, electrical wire, and plastic; in other words, on the tangible inputs needed to produce tangible products. This is the accounting model of the industrial age.

But we are no longer in the industrial age. We still have elements of it, of course, and we always will, but we have moved deeply into the information age. We now have information companies, companies that do research and produce findings that they hope to profit from. Manufacturing companies are no longer rooted solely or predominantly in the physical. The role of intellectual inputs that ultimately lead to sales has multiplied enormously. The range of these inputs runs from patentable ideas to marketing, process design, computer programs, know-how, brand names, work-force expertise and training, quality controls, executive strategy, and organizational mechanisms to generate both quality improvements and innovation. All of these things can add to corporate revenues.

Yet most of these kinds of things are not recognized by the accounting model. Important work is in progress by scholars like Baruch Lev, who is also scheduled to appear here. Baruch’s contributions have been great. I am among his admirers. But looked at nationally, our country’s effort is far from what is needed. As a country, we are not addressing this issue in a manner commensurate with its importance to investors, the economy, and our future.

The same is true when you look at the frequency of reporting, what is called timeliness. The relative absence of up-to-date information with which to assess corporate earning capacity helps explain the volatility of today’s share prices. Timely information has always been prized, but the pace of change in corporate dynamics and earnings capabilities has made it much more important. Corporate diversification, alliances of all sorts, the rate and depth of economic change, and transnational relationships have enormously changed the risks facing modern corporations. Meanwhile, the use of the Internet for economic communications has been exploding. Real-time disclosure of selected financial information — that is, information that can be useful to investors without creating competitive disadvantage to companies — on the Internet is clearly foreseeable. In these circumstances, the annual and quarterly reporting regime is not only on its way to becoming less and less useful, it is on its way to becoming a dinosaur, an organism that has outlived its environment.

Just the slightest acquaintance with the Internet tells you of its possibilities. Add to that the fact that the accounting software employed by companies is increasingly powerful. Cisco Systems, for example, has a system in place to "close its books" — traditionally a process measured in weeks — in mere hours. This kind of thing tells me that the capabilities for more rapid disclosure are coming into being. In fact, some are already on the scene. We can expect that as Internet disclosure grows, software will be produced to help investors analyze data provided over the Internet. Sophisticated investors will purchase the analytical software of their choice, and some will develop or adapt analytical software tailored to their specific needs. Other investors will rely on intermediaries, just as they do today, but what will be available to these investors will be vastly more diverse than what is available today.

The capabilities I have been describing will allow a frequency and richness of disclosure that is more helpful to investors, because it is more closely aligned with the pace of change in corporate prospects.

It is widely understood that corporate prospects don’t just vary annually or quarterly. What is not widely understood is that the capabilities to help investors obtain more timely information are being assembled. We owe it to investors and to the economy to make sure we adapt without great delay. But again I have to conclude that too little is being done nationally to understand what is needed to adapt. We need richer and more timely disclosure. It should be nonfinancial as well as financial.

Some of you may know of the AICPA Special Committee on Financial Reporting, the so-called "Jenkins Committee." It described investor information needs that go far beyond what is required by the current financial reporting model. In fact, to capture the idea of reporting nonfinancial information, the Jenkins report adopted the broader term "business reporting." The report was based on research to determine investors’ needs. There was no doubt that their needs were not being fully met. The Special Committee produced an accounting model as well. It is hard to believe that the report was produced six years ago and so little has been done in response. If investors’ needs were not being met six years ago, they are likely being met even less well today.

To summarize this theme: If we are going to modernize the accounting model, we must focus on these things:

n First, a broader "bandwidth" of information, such as was heralded by the AICPA’s Jenkins Committee.

n Second, different distribution channels, namely, the Internet.

n And third, increased reporting frequency, ultimately, on-line, real-time reporting.

However, there is also a fourth imperative. It is new audit strategies and technologies. The changes and needs I have been describing are full of import for the accounting profession. They present us with the classic dualism of challenges and opportunities. In an ideal world, companies would be producing the new disclosures with the desired frequency over the Internet; auditors would be providing contemporaneous assurance that the information was reliable; investors’ would benefit from better decision making information; productive corporations would benefit from a lower cost of capital; and the economy would be growing with more stability and promise, even than now.

But there is another way of viewing this scenario. The disclosures could be produced, and auditors could find themselves inadequately prepared to provide assurance to investors about the information’s reliability.

The technology of auditing must change. Auditors in this new world would be reporting primarily on information systems. They would be focusing heavily on preventive controls and providing assurance that the quality of the information systems was sufficient to produce reliable information. The transition is going to require capital investments, and they must come from audit firms that are now thinly capitalized, say, as compared to a modern corporation. The transition is also going to demand personnel of the highest caliber. The skills and other qualifications of these high caliber people will be demanded by other industries too, because the qualifications include expertise in information technology and being on the cutting edge of modern business practices. Thus there is going to be even more competition for talented college graduates, and the capacity to provide challenging opportunities and to reward them will do much to determine whether the auditing profession gets the personnel it needs.

It is for those reasons, among others, that the twenty-first century accounting profession requires a broad scope of practice. There has been a decline in the number of students choosing accounting programs. This comes at a time when there is universal agreement about the need for top-notch personnel at accounting firms for the sake of audit quality. The range of careers from a broad scope of services is an attraction to college graduates, and nonaudit services can supply personnel for particular audit tasks. It stands to reason that any unjustified restrictions on the profession’s services will damage the quality of auditing and thereby the public interest.

That brings me to the current regulatory structure. The SEC was established to administer statutes written before the invention of the digital computer, the Internet, on-line trading, on-line exchanges, on-line offering of securities, and the quantum jump in the globalization of the capital markets. Its regulatory mindset reflects its origins. It has not encouraged innovation in business reporting. To the contrary, discouragement comes closer to describing its influence. It has a financial-statement, rather than a business-reporting, outlook. At this moment the SEC is attempting to erect a barrier to nonaudit services analogous to the Glass-Steagall Act in the financial services industry, an Act which has recently been dismantled by Congress.

In conclusion, I maintain that Congress should carefully consider the need to modernize the business reporting model, where the responsibilities lie, whether there have been delinquencies, current conditions that may affect accounting firms’ long-term viability, and what best serves the public interest. The resolution of these issues is essential to the national interest in being globally competitive. I can assure you that the American accounting profession wants, as I know you do, to assure that this future comes about for the benefit of shareholders, consumers, and, indeed, all American citizens.

Thank you for your attention.

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