Subcommittee on Securities

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

Supplemental Testimony of Mr. Peter J. Wallison
Resident Fellow
American Enterprise Institute

At the July 19 hearing on adapting a 1930's financial reporting model to the 21st Century, Chairman Grams asked that each of the witnesses submit supplemental material with suggestions for how the problems identified at the hearing could be addressed. My prepared testimony contained the proposal which I have expanded below.

As I indicated in my prepared testimony, the problem here is that conventional GAAP financial statements are becoming less and less relevant to investors as companies rely increasingly on intangible assets as the source of their value. Conventional accounting has no accepted means for placing a value on internally generated intangible assets, and there is no prospect that such a means can be developed.

Accordingly, if investors are to have sufficient information with which to make informed judgments about companies--judgments that are necessary for the proper allocation of capital in our economy--companies must be persuaded to supplement their financial statements with other disclosures.

There are three forms this information might take: (i) indicators or measures that are derived from financial or operating information, such as ratios or compilations; (ii) raw financial data--possibly made available over the Internet in real time; and (iii) raw non-financial or operating data--also made available in real time. Raw financial and operating data is generally the data companies themselves use to record or monitor their operations, such as daily sales or numbers of employees engaged in various operating functions.

Currently, there is very little interest among companies in disclosing this kind of information. Although some studies have shown that companies can lower their capital costs through increasing the quality of their disclosure, it appears that companies are either not convinced of this or still believe that the costs to them would be greater than the benefits. Companies generally cite two concerns--that providing more data will assist their competitors and that it may lead to legal liability when viewed by investors with hindsight.

To address the legal liability issue, some have proposed the creation of a so-called "safe harbor" for such disclosures. I don't think this is a fruitful approach. The debate over the most recent safe harbor language--which sought to encourage forward-looking disclosures--demonstrates, I think, that an effort to develop statutory language for something as imprecise as indicators and raw financial and operating data would ultimately prove fruitless.

However, it may be possible to structure the indicators themselves--and to call for the disclosure of raw financial and operating data--in such a way as not to implicate the anti-manipulation provisions of the securities laws. We won't really know until we have actually looked at the indicators and considered the kinds of raw data that would be made available.

Accordingly, the only practical way to kick-start this process is to enlist the SEC. The Commission has enormous convening power, and requests from the SEC are taken seriously in the corporate community. If the SEC were to begin pressing companies, analysts and accounting experts to develop solutions to this problem, progress will be made.

I don't think that public statements from the SEC would be enough; the chairman must convene meetings of companies, analysts and members of the accounting profession, tell them what he wants, and designate members of his staff to follow up. Once the corporate and financial communities are engaged in this process, ideas will come forward, objections will be raised and examined, and the there will be forward movement. At this point, of course, there is no substantial activity.

In theory, the SEC should be the most aggressive agency in promoting developments in this area. Its responsibilities, after all, include seeing to it that investors have the most useful information that companies can provide. However, as I noted in my prepared statement, the SEC has thus far shown no significant interest in this subject. It may be that one of its advisory committees is reviewing this among a number of other issues, but regrettably advisory committees are frequently ways of temporizing rather than instruments for finding a solution.

In my view, the Securities Subcommittee should insist that the SEC give priority to this issue, and by holding relatively frequent hearings at which the SEC is asked to update the Subcommittee, it may be possible to raise this issue among the Commission's bureaucratic priorities.

The Subcommittee and its staff (and the staff of the full Committee who worked on this hearing) deserve commendation and thanks for taking the time to consider an issue well before it has become a crisis. However, the fact that the growing irrelevance of conventional accounting statements has not yet been recognized by the media as a serious problem will tend to reduce the attention it receives from the SEC. Yet, given the long lead time necessary to develop disclosure mechanisms, it is important to get started promptly.

My recommendation, therefore, is that the Subcommittee follow up its excellent work in giving high level attention to this issue by maintaining steady pressure on the SEC to pursue some workable solutions.

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