How to fix a damaged financial reporting system…

Enron’s reported exploitation of financial-reporting rules is a deplorable but all too natural consequence of the erosion of the U.S. financial-reporting system. Until those who set, regulate, and enforce that system place the information needs of investors above the desire by corporate America to curtail disclosure, I believe more such disasters will follow.

Why are financial reporting rules not stronger? At times, under pressure by corporate lobbyists, legislators have inappropriately interfered in standard-setting to get rules based not on the needs of users of financial statements but
on the preferences of issuers. In advocating better disclosure, organizations like our own representing 155,000 investment managers, analysts and other users of financial statements worldwide have been consistently outgunned.

We believe that only an independent Financial Accounting Standards Board, free from undue political pressure, with aggressive enforcement by the Securities and Exchange Commission, can create a financial reporting system
that will regain public confidence.

For the past 20 years, AIMR has advocated that issuers should not be allowed to tailor transactions to get an accounting treatment that suits them. We have repeatedly asked for accounting rules that would require issuers to:

• Report on the balance sheet all assets under their control and all liabilities for which they have responsibility.
• Explain how and why they use derivatives.
• Measure and record compensation expense for employee stock options.
• Recognize all financial assets, liabilities, and derivatives at fair value with changes reported in earnings.
• Conduct and disclose meaningful market-sensitivity analyses or “stress tests” so users can forecast potential risks under changing market conditions.

Despite their best efforts to enact such rules, the FASB and SEC succumbed to political pressure and issuers’ objections. The resulting financial reporting system must be fixed if investors, regardless of their sophistication, are to get the kind of disclosure and transparency they need. AIMR stands ready to support the FASB and SEC to repair that system. But all stakeholders issuers, auditors, standard-setters, regulators, legislators and analysts must
participate.

Corporate managements must:

• Change their attitude toward financial reporting to fulfill not only the letter but the spirit of disclosure and commit to complete transparency.
• Provide financial reports to the benefit rather than the detriment of investors.
• Write financial reports in plain English, free of “boilerplate”, that can be easily understood by the average reader.

Boards of directors must:

• Take responsibility for financial reports and ensure that a high-quality system of internal controls is in place.
• Appoint audit committees that are truly independent, unaffiliated with the company and free of personal relationships with management.
• Appoint audit committees that are accounting-literate – sufficiently knowledgeable of accounting rules to ask management and auditors the right questions and judge the veracity of the answers.

Auditors must:

• Regain their lost independence.
• Not tolerate insurmountable conflicts: internal auditing, internal reporting systems and corporate finance (e.g., creating tax shelters). It is only common sense that auditors cannot independently audit their own work.
• Disclose fully in the client’s annual report any non-audit services they provide (and some services, such as tax preparation, are appropriate).

Credit-rating agencies must:

• Use their privileged information as an early warning of financial distress.
• Place investor needs for appropriate ratings first.
• Monitor rated companies continuously and modify ratings swiftly when circumstances warrant so financial markets will be well served.

The Financial Accounting Standards Board must:

• Take full advantage of the current climate of intolerance for financial shenanigans and revise its agenda to amend key standards on accounting for:

– Employee stock options and other equity compensation
– Financial assets, liabilities and derivatives
– Performance reporting
– Off-balance sheet assets and liabilities.

The Securities and Exchange Commission must:

• Enforce aggressively and consistently all financial reporting rules. No set of financial reporting standards, regardless of quality, is worth anything without effective enforcement.
• Restore essential supplemental SEC disclosure rules, such as the detailed schedules for fixed assets and bad-debt reserves that were recently eliminated.
• Retain redundancies between accounting standards and regulatory requirements that provide failsafe mechanisms for investors.

Congress must:

• Have faith in the private sector’s ability to set high-quality accounting standards.
• Allow the FASB to set accounting standards without undue political interference – interference that is responsible in part for the current state of US accounting affairs.
• Ensure the SEC has sufficient resources for enforcement.
• Put the needs of investors first. Although corporations may be the constituency with the deepest pockets, individual investors go to the polls.

Employers of investment analysts must:

• Recognize that it is in their best interest to reward independent research.
• Encourage analysts to express their views on accounting issues instead of allowing them to be silenced by corporate clients’ opposition.
• Adopt standards that demonstrate to investors a commitment and adherence to independent and objective research and recommendations.

Investment analysts must:

• Demand quality financial reports in order to have a reasonable and adequate basis for their recommendations.
• Ferret out information not contained in the primary financial statements – as taught in the Chartered Financial Analyst® Program for almost 40 years – and adjust valuation models accordingly.
• Play a greater role in supporting improved financial reporting and explaining investors’ needs to standard-setters and regulators worldwide.
• Personally commit to independence and objectivity and adhere to a code of ethics and standards of professional conduct that require them always to place the interests of investing clients first – as all AIMR members and CFA®
candidates are required to do.

Analysts must be supported in their commitment to independence. AIMR, for its part, is developing globally applicable standards so that issuers and institutional clients – not just research analysts and their employers – can promote objective research and recommendations. I am pleased that the SEC and NASD accepted our invitation to observe our deliberations on research objectivity and that several of our recommendations are reflected in the recently issued NASD Proposed Rule on Research Analyst Conflicts of Interest. If we put even a fraction of the creativity and energy into strengthening our financial reporting system that has gone into undermining it, we will all be rewarded – with renewed investor confidence – with greater reliance on financial reporting information – and with the kind of transparency that can only be a long-term benefit for investors in U.S. financial markets.

Thomas A. Bowman, CFA, is president and CEO of AIMR, a global organization of 155,000 investment professionals, including 100,000 who are enrolled as candidates in its Chartered Financial Analyst (CFA®) Program.