Thank you, Mr. Chairman. Senator Gramm. Members of the Committee. My name is Walter P. Schuetze. My brief resume is attached hereto.
Just a few comments about my experience and background. I was on the staff and a partner with the public accounting firm KPMG and its predecessor firms for more than thirty years. I was one of the charter members of the Financial Accounting Standards Board from April 1973 through June 1976. I was a member and chair of the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants in the 1980s. I was Chief Accountant to the Securities and Exchange Commission from January 1992 through March 1995 and Chief Accountant of the SEC’s Division of Enforcement from November 1997 through mid-February 2000.
I need to mention that although I am retired, I am a consultant to the Securities and Exchange Commission and several other entities under consulting contracts. In addition, I have one remaining tie with my former firm KPMG in that I am an insured under a group life insurance contract obtained and administered by that firm; I pay the premium attributable to me. The views I express here today are my personal views.
I appreciate very much the opportunity to testify here today. Your letter of January 16, 2002 inviting me to testify at this hearing says, "A number of high-profile business failures in recent years, including, most recently, the collapse of Enron Corp., have involved significant accounting irregularities, and the February 26 hearing will examine the issues raised by those failures for financial reporting by public companies, accounting standards, and oversight of the accounting profession. You should feel free to address those issues as you see fit. The committee would also appreciate any recommendations you may have about ways to deal with the issues you discuss." I indeed have a major recommendation, which I will get to at the conclusion of my remarks.
The public’s confidence in financial reports of and by Corporate America, and in the audits of those financial reports by the public accounting profession, has been shaken badly by the recent surprise collapse of Enron, by recent restatements of financial statements by the likes of Enron, Waste Management, Sunbeam, Cendant, Livent, and MicroStrategy, and by the SEC’s assertion of fraud by Arthur Andersen in connection with its audits of Waste Management’s financial statements in the 1990s, which Andersen did not admit or deny in a settled SEC action last summer. The public’s confidence needs to be regained and restored. If that confidence is not regained and restored, the result will be that investors will bid down the price of stocks and bonds issued by both US and foreign corporations; we have seen evidence of that phenomenon in recent weeks. That is an investor’s natural response to increased risk or the perception of increased risk. This will reduce the market capitalization of corporations, which in turn will negatively affect capital formation, job creation and job maintenance, and ultimately our standard of living. So, we are concerned today with a very important matter.
You will hear or have heard many suggestions for improvement to our system of financial reporting and audits of those financial reports. Some will say that auditor independence rules need to be strengthened. That external auditors should not be allowed to do consulting work and other non-audit work for their audit clients. That external audit firms should be rotated every five years or so. That external auditors should be prohibited from taking executive positions with their corporate clients for a number of years after they have been associated with the audit firm doing the audit unless the firm resigns as auditor. That peer reviews of auditors’ work need to be improved and done more frequently if not continuously. That auditors should be engaged by the stock exchanges and paid from fees paid to the exchanges by listed companies. That the oversight of auditors needs to be strengthened. That punishment of wayward auditors needs to be more certain and swift. In that regard, Chairman Pitt of the SEC has proposed that there be a new Public Accountability Board overseeing the external audit function; this Board would, as I understand it, have investigative and disciplinary powers. And so on and on. In my opinion, those suggestions, even if legislated by Congress and signed by the President, will not fix the underlying problem.
The underlying problem is a technical accounting problem. The problem is rooted in our rules for financial reporting. Those financial reporting rules need deep and fundamental reform. Unless we change those rules, nothing will change. The problems will persist. Today’s crisis as portrayed by the surprise collapse of Enron is the same kind of crisis that arose in the 1970s when Penn Central surprisingly collapsed and in the 1980s when hundreds of savings and loan associations collapsed, which precipitated the S&L bailout by the Federal government. Similar crises have arisen in Australia, Canada, Great Britain, and South Africa. There will be more of these crises unless the underlying rules are changed.
Under our current financial reporting rules promulgated by the Financial Accounting Standards Board, management of the reporting corporation controls and determines the amounts reported in the financial statements for most assets. For example, if management concludes, based on its own subjective estimates, that the cost of an asset—say equipment--will be recovered from future cash flows from operations without regard to the time value of money or risk, no write down is required even when it is known that the current market price of the asset is less than the cost of the asset. The external auditor cannot require that the reported amount of an asset be written down to its estimated selling price; the external auditor cannot even require the corporation to determine the estimated selling price of the asset and disclose that price in its financial statements. So, when it comes time to sell assets to pay debts, there often are surprise losses that investors then see for the first time. Management also makes similar assessments in determining the amount of inventory obsolescence, the allowance for bad debts, and whether declines in the values of investments below cost are "other than temporary."
Under our current accounting rules, corporate management often records sales and trade receivables at 100 cents on the dollar even though a bank or a factor would pay only pennies on the dollar for those trade receivables. We saw that phenomenon in the past few years in the telecom rage where sales and receivables were recorded followed several months later by write offs of the receivables. On another front, we currently are seeing swaps of assets and the recognition of gains in what is effectively a barter transaction, even though the fair value of what was exchanged is apparently negligible.
Except for inventories and marketable securities, none of these asset amounts in the financial statements—trade receivables, commercial and consumer loans receivable, real estate loans, oil and gas reserves, mineral deposits, pipelines, plant, equipment, investments--is subjected to the test of what the cash market price of the asset is. Yet, we know that most individual investors, and, in my experience, even many sophisticated institutional investors, believe that the reported amounts of assets in corporate balance sheets represent the current market prices of those assets; nothing could be farther from the truth.
And under the FASB’s definition of an asset, corporations report as assets things that have no market price whatsoever; examples are goodwill, direct response advertising costs, deferred income taxes, future tax benefits of operating loss carry forwards, costs of raising debt capital, and interest costs for debt said to relate to acquisition of fixed assets. I call these non-real assets. Today’s corporate balance sheets are laden with these non-real assets; this is the kind of stuff that allows stock prices to soar when in fact the corporate balance sheet is bloated with hot air. Of course, when it comes time to pay bills or make contributions to employees’ pension plans, this stuff is worthless.
The same goes for liabilities. Corporate management determines the reported amount of liabilities for such things as warranties, guarantees, commitments, environmental remediation, and restructurings. Again, this is as per the FASB’s accounting rules.
The upshot is that earnings management abounds. Earnings management is like dirt; it is everywhere. SEC commissioners have made speeches decrying earnings management. Business Week, Forbes, Barron’s, the New York Times, the Wall Street Journal, and the Harvard Business Review carry hand-wringing articles about earnings management. Earnings management is talked about matter-of-factly on Wall Street Week and on Bloomberg TV, CNBC, CNNfn, and MSNBC. Earnings management is a scourge in this country. Earnings management is common in other countries as well because their accounting rules, and the accounting rules promulgated by the International Accounting Standards Board, are much the same as ours.
We need to put a stop to earnings management. But, until we take control of the reported numbers out of the hands of corporate management, we will not stop earnings management and there will be more Enrons, Waste Managements, Livents, Cendants, MicroStrategys, and Sunbeams. How do we take control of the reported numbers out of the hands of corporate management? We do it by requiring that the reported numbers for assets and liabilities, including guarantees and commitments, be based on estimated current market prices--current cash selling prices for assets and current cash settlement prices for liabilities. And by requiring that those prices come from, or be corroborated by, competent, qualified, expert persons or entities that are not affiliated with, and do not have economic ties to, the reporting corporate entity. And by requiring that the names of the persons or entities furnishing those prices, and the consents to use their names, be included in the annual reports and quarterly reports of the reporting corporate entity so that investors can see who furnished the prices.
Let me give you an example of what I am talking about. Pre-September 11, 2001, the major airlines, to the extent that they own aircraft instead of leasing them, had on their balance sheets aircraft at the cost of acquiring those aircraft from Airbus and Boeing. Let’s say that cost was 100 million dollars per aircraft. The market prices of those aircraft fell into the basement post-September 11 to about 50 million dollars per aircraft and remain there today although prices have recovered somewhat. Yet, under the FASB’s rules, those airlines continue to report those aircraft on their balance sheets at 100 million dollars and are not even required to disclose that the aircraft are worth only 50 million dollars. Under mark to market accounting, the aircraft would be reported at 50 million dollars on the airlines’ balance sheets, not 100 million dollars.
I could give you many more examples, but I will add just one more. In the late 1970s, this country was experiencing great inflation. The Federal Reserve Board raised short-term interest rates dramatically. Long-term rates shot up. As a consequence, the market value of previously acquired residential mortgage loans and government bonds held by savings and loan associations declined drastically. But, the regulations of the Federal Home Loan Bank Board and the FASB’s accounting rules said that it was OK for the mortgage loans and bonds to be reported at their historical cost. Consequently, the S&Ls appeared solvent but really were not. This mirage allowed the S&Ls to keep their doors open and in so doing they incurred huge operating losses because their cost of funds far exceeded their interest income on loans and bonds in their portfolios. Some of the S&Ls decided to double down by investing in risky real estate projects, also accounted for at historical cost, and proceeded to lose still greater amounts, which losses were also hidden on the balance sheet under the historical cost label. (The Federal Home Loan Bank Board even went so far as to allow S&Ls to capitalize and report as assets losses on sales of assets, but the FASB said no to that procedure.) Of course, when the Federal government had to bail out the insolvent S&Ls in the 1980s, the Federal government paid for the losses that were hidden in the balance sheet under the historical cost label and the operating losses that had been incurred while the S&Ls kept their doors open because of faulty accounting. Had mark to market accounting been in place and had the Federal Home Loan Bank Board computed regulatory capital based on the market value of the S&Ls’ mortgage loans, government bonds, and real estate projects, the S&L hole would not have gotten nearly as deep as it ultimately did.
Various members of Congress have said in recent hearings about Enron that a corporation’s balance sheet must present the corporation’s true economic financial condition. A corporation’s true economic financial condition cannot be seen when assets are reported at their historical cost amounts. The only objective way that the true economic financial condition of a corporation can be portrayed is to mark to market all of the corporation’s assets and liabilities. Recall my earlier example about the cost of aircraft being 100 million dollars and the current market value being 50 million dollars. Mr. Chairman and Members of the Committee: Is there any question that the 50 million dollars presents the true economic financial condition and the 100 million dollars does not? Moreover, following today’s FASB’s accounting rules produces financial statements that are understandable only to the very few accountants who have memorized the FASB’s mountain of rules. Indecipherable is the word Chairman’s Pitt has used in recent speeches. On the other hand, marking to market will produce financial statements that investors, members of Congress, and my sister, who also happens to be an investor, can understand.
The various proposals that have been made to cure Enronitis will not cure the problem. I liken our current accounting system to bridges built from timber, which bridges keep collapsing under the weight of eighteen-wheelers. The public demands that expert consulting engineers be called in to oversee the building of replacement bridges. But the replacement timber bridges keep collapsing under the weight of eighteen-wheelers. More expert consulting engineers will not make the timber bridges any stronger. What needs to be done to fix the problem is build bridges with concrete and steel. The same goes with accounting. In the 1970s, after the surprise collapse of Penn Central, the auditing profession instituted peer reviews—where one auditing firm reviews the work and quality controls of another auditing firm. In the 1970s, auditing firms also instituted concurring partner reviews where a second audit partner within the public accounting firm looks over the shoulder of the engagement audit partner responsible for the audit. These procedures have been ineffectual as shown by the dozens of Enrons, Waste Managements, Sunbeams, MicroStrategys, Cendants, and Livents that have occurred since then. Coincidentally, the Financial Accounting Standards Board also came on the scene in 1970s; it was going to write accounting standards that would bring forth financial statements based on concepts. What happened was that the FASB wrote a mountain of rules that produce financial statements that nobody understands and that can be and are gamed by corporate management. What all of that amounted to was continuing to build timber bridges that keep collapsing under the weight of eighteen-wheelers. We need to stop building timber bridges. We need to build concrete and steel bridges. We need to mark to market all assets and liabilities.
Now, you may ask—how much will concrete and steel bridges cost? Can we afford to build concrete and steel bridges? My response is that we cannot afford not to build concrete and steel bridges. How much of the cost of the S&L bailout was attributable to faulty accounting; the amount is unknowable but no doubt was huge. How much does an Enron or Cendant or Waste Management or MicroStrategy or Sunbeam cost? The answer for investors is billions, and that does not count the human anguish when working employees lose their jobs, their 401-k assets, and their medical insurance, and retired employees lose their cash retirement benefits and medical insurance. By some estimates, Enron alone cost 60--70 billion dollars in terms of market capitalization that disappeared in just a few months. Waste Management, Sunbeam, Cendant, Livent, MicroStrategy, and the others also cost billions in terms of market capitalization that disappeared when their earnings management games were exposed. And, these costs do not include the immeasurable cost of lost confidence by investors in financial reports and the consequent negative effect on the cost of capital and market efficiency.
By my estimate, annual external audit fees in the United States for our 16,000 public companies, 7,000 mutual funds, and 7,000 broker/dealers total about 12 billion dollars. Let’s say that 4 billion dollars is attributable to mutual funds and broker/dealers. (Incidentally, mutual funds and broker/dealers already mark to market their assets every day at the close of business, and we have very few problems with fraudulent financial statements being issued by those entities. Mark to market works and is effective.) That leaves 8 billion dollars attributable to the 16,000 public companies. Assume that the 8 billion dollars would be doubled or even tripled if the 16,000 public companies had to get competent, outside valuation experts (and not the public accountants because they are not competent valuation experts) to determine the estimated cash market prices of their assets and liabilities. We are then looking at an additional annual cost of 16--24 billion dollars. If we prevented just one Enron per year by requiring mark to market accounting, we easily would pay for that additional cost. And, when considered in relation to the total market capitalization of the US corporate stock and bond markets of more than 20 trillion dollars, 16—24 billion dollars is indeed a small price to pay.
The question arises: Who should mandate mark to market accounting? I recommend that there be a sense of the Congress resolution that corporate balance sheets must present the reporting corporation’s true economic financial condition through mark to market accounting for the corporation’s assets and liabilities. I recommend that Congress leave implementation to the SEC, much the way it is done today by the SEC for broker/dealers and mutual funds. There will be many implementation issues, so the SEC will need more staff and money.
My testimony today is a summary of a lengthy article that I wrote about the definition of assets and liabilities, earnings management, and mark to market accounting that was published last year in Abacus, a University of Sydney publication, and which was the basis for the RJ Chambers Research Lecture that I presented last year at the University of Sydney. That article and lecture are attached hereto.
I will be pleased to answer the Committee’s questions.
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