Subcommittee on Securities

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

Prepared Testimony of Mr. Michael R. Young
Willkie Farr and Gallagher

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


I am Michael Young of Willkie Farr & Gallagher, and I am delighted to have been asked to participate in these hearings. I say that because I am very much of the view that it is time to take stock of our present system of financial reporting and to acknowledge that it is not optimally serving the needs of financial markets in today's economy.

The fundamental problem is straightforward. On the one hand, we are working with a financial reporting system that was designed during the 1930s. At root, it is a "periodic" system -- that is, a system that was designed to provide financial information only periodically. On the other hand, today's financial markets are not interested in receiving new financial information only periodically. Today's financial markets want immediate financial updates all the time.

The result is a dislocation. It is a dislocation between the real-time demands of today's financial markets and the inability of our creaky, sputtering 1930s-vintage financial reporting system to satisfy those needs. The consequences of this dislocation are exceedingly unfortunate. They include a significant upsurge in reported instances of "accounting irregularities"; the related problem of "earnings management"; operational inefficiencies; unnecessary volatility in securities markets; and an increase in the cost of capital.

That's a summary. Now let me break it down.

A Real-Time World

The departure point is the obvious proposition that today financial markets are operating in a real-time world. If this morning the United States Senate were to announce an event of consequence to world-wide financial markets, we might expect no more than a few minutes to pass before the impact was felt on the New York Stock Exchange.

For that matter, the concept of a real-time financial world has almost infiltrated the very fiber of our culture. I live and work on the West Side of Manhattan and every day I walk past giant screens in Times Square bombarding me with the latest financial market statistics. Most or all of you have probably seen the giant, ever-changing Bloomberg financial screens in New York's Penn Station. While on an airplane the other day I was intrigued to see that now I can even stay plugged into ever-changing financial data while in the air. The air phone on the seat in front of me advertised the availability of real-time financial quotations dependent solely on my willingness to insert my American Express card.

A 1930s Financial Reporting System

This was not anyone's vision of the world when our financial reporting system was designed in the 1930s. The vision of the 1930s assumed that financial market needs would be almost completely satiated by information that was delivered only periodically. The original plan was to make new information available once a year, though that later got increased to once every three months. At bottom, though, the system remains a "periodic" system. It contemplates the publication of financial information only quarterly.

Resulting Dislocations

Therefore a mismatch exists -- a mismatch between financial market needs and financial system capability. Now let me turn to some of the resulting dislocations.

Foremost is the problem of an upsurge in reported instances of "accounting irregularities." That is, by the way, simply a polite way of describing accounting fraud. It is a serious problem and, conservatively estimated, potentially costs shareholders hundreds of millions of dollars per year.

Here is the problem. Under our present system, the main vehicles for the public dissemination of financial information consist of a Form 10-K, which is filed with the SEC annually, and a Form 10-Q, which is filed quarterly. A practical consequence of our laws against inside trading is that, between the quarterly reports, a federally-enforced period of silence exists. Absent unusual circumstances, our present system does not contemplate more frequent financial updates.

Financial markets do not like that at all. Therefore, between quarterly reports, they basically abandon the formal financial reporting system and turn to whatever else happens to be available. Today, that means financial markets turn to the intra-quarterly earnings predictions of Wall Street financial analysts. It is, as a result, the publication of analyst expectations that actually move financial markets. The official data in the Forms 10-Q and 10-K rarely move financial markets unless they fail to fulfill the earlier analyst expectations.

This is, in truth, a miserable system of financial reporting. Analysts are frequently wrong and sometimes no better at predicting the future than the rest of us. Nonetheless, an analyst's earnings prediction -- once published -- can establish an expectation within the financial community which, if not fulfilled by actual earnings at the end of the quarter, can cause a company's stock price to collapse. I have heard it said that there is no pressure on senior executives today as fearsome as the perceived need to report earnings that fulfill analyst expectations. All too often, the tools to fulfill those expectations can include accounting manipulations. In other words, they can include financial fraud.

But that's only the beginning. An additional consequence is the desire on the part of senior executives to avoid earnings shortfalls by, in substance, siphoning off extra earnings when times are good so that they can thereafter be used when times are bad. This takes us to the issue of "earnings management," in which companies -- in order to avoid disappointing the published expectations of Wall Street analysts -- in good times deliberately understate their earnings (for example, by establishing what Arthur Levitt refers to as "cookie jar reserves") and then overstate earnings when times are tougher.

The problems, though, are not limited to the incentive for management to overstate (or understate) financial performance. Another consequence is operational efficiencies, which may result when a company -- faced with the need to generate extra revenue to fulfill analyst expectations at the end of a quarter -- accelerates the pace of its quarter-end operations. These attempts at acceleration may involve, for example, quarter-end discounting, which can have the unfortunate consequence of conditioning customers (e.g., distributors) to postpone purchases to the end of a quarter in hopes of getting a better price. Soon, the expectation begins to feed on itself, and companies can find their assembly lines largely idle in the first month of a quarter, more active in the second month, and then working overtime in the third. That is a costly and inefficient way to run a business.

Notwithstanding all of this, sometimes companies are not successful in reporting earnings that measure up to analyst expectations and, as I suggested a moment ago, financial markets are not bashful about doling out punishment. You may recall that an announcement of a weak outlook by IBM in the fourth quarter of last year resulted in a one-day loss of market value of $39 billion. Three months later, Lucent Technologies' announcement of an anticipated failure to attain analyst expectations (it said it expected to miss them by about 15 cents) translated into a market capital loss almost twice as large -- $64 billion. When Intel preannounced disappointing earnings for the first quarter of 1998, it reportedly triggered a collapse in securities markets around the world.

Hence we have also introduced into the equation extraordinary levels of volatility in securities markets. For everyday investors, volatility means risk. That means that sensible investors want an extra measure of return on their capital investment as compensation. Still another consequence of our 1930s financial reporting system, therefore, is an increase in the cost of capital spread throughout the stock market as a whole.

And all of this is without even getting to a company's incentives to "talk down" analyst expectations to less than actually foreseen, or to the potential incentives by analysts to issue favorable reports owing to preexisting relationships between a company and the analyst's investment bank.

So that's where we are at the moment. The dislocations resulting from our 1930s financial reporting system result in accounting fraud, improper earnings management, operational inefficiency, unnecessary stock market volatility, and an increase in the cost of capital. More broadly, they result in horrific inefficiency in the dissemination of financial information and the operation of financial markets.

A New Financial Reporting System

An understanding of the problem suggests a solution that is almost self-evident. That solution would involve an evolution of financial reporting beyond the periodic system of the 1930s into a system that provides the real-time information financial markets seek. The practical consequence would be the elimination of the period of silence between quarterly reports and the substantial reduction, if not elimination, of the role of analyst expectations in driving stock price.

To some extent, implementation of a real-time financial reporting system would be almost remarkably straightforward. In its crudest form, it could simply involve the daily publication of revenue (or other available measure of financial performance) on a company's website.

That is not, however, to suggest an absence of obstacles to such an evolution. Those obstacles would include the need for acceptance by the SEC and self-regulatory organizations of website disclosure as public dissemination of information, a significant upgrade of corporate management information systems to increase the reliability of real-time financial information, continued work by the AICPA on enhancing the systems to provide assurance as to the reliability of real-time financial information, a willingness by corporate executives to summon the courage to report financial information more frequently in our highly-litigious business environment, and the formulation of risk management systems so that the legal liability would not be unacceptable.

None of these barriers, however, should prove insurmountable. The opportunities for enhanced efficiency in financial markets, enhanced operations, diminished volatility in securities markets, and a decrease in the cost of capital are too important to allow our system of financial reporting to remain tethered to an era no longer completely relevant to today's financial market needs.

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