Give Us Disclosure, Not Audits

Shorn of its legislative language and maze of regulation, the Sarbanes-Oxley Act, the sweeping corporate-reform law passed last summer, has one principal effect--to enshrine the GAAP audited financial statement as the central financial disclosure of publicly traded companies. The act was crafted in haste and under political pressure, and it shows.

The deficiency associated with audited financial statements is not their accuracy--as Congress seemed to think--but their adequacy. Instead of rushing to enact something--anything--in response to a falling stock market and several egregious cases of financial statement manipulation, Congress should have taken steps to diminish the importance of audited financial statements by emphasizing other forms of disclosure.

However, by creating a special agency to regulate auditing, and focusing the attention of the Securities and Exchange Commission on the importance of audited financial statements, Congress was fighting the last war.

Contrary to what Congress seemed to believe, there is no such thing as a statement of income under generally accepted accounting principles, or GAAP, that is inherently "correct," or that can be made "more correct" by a better audit. All such statements--quite legitimately and necessarily--are the product of management's opinion about a vast number of events and circumstances that may or may not arise in the future. Thus, while better and more expensive auditing may improve auditors' chances of stumbling upon actual fraud, it will not improve the "accuracy" of financial statements.

Financial statements are prepared by the company's management, not its auditors. Auditors are not capable of making the judgments that management must make during this process. The most they can do is question management estimates, and then only if these seem unreasonable.

That financial statements are inherently malleable should be obvious to anyone who follows the securities markets. The economy moves up and down, interest rates, exchange rates and raw materials costs fluctuate, consumer preferences change constantly, and foreign competition and competition for U.S. companies operating overseas is highly variable. Yet the earnings of many companies did not show significant volatility during the boom years of the late 1990s. Instead, their results grew steadily from year to year, frequently hitting to the penny the forecast for quarterly earnings per share made by the sell-side analysts.

In fact, what seems to have been occurring was a game in which analysts and investors were testing the quality of a company's stated earnings by determining whether management could hit its targets. If it could, that meant that the company's earnings were probably growing, although not necessarily as stated. If it could not, the company had apparently run out of ways to improve its results, suggesting that its earnings had fallen dramatically. This odd game of inferences created the strange market phenomenon in which companies that missed their earnings targets by a penny or two saw 20 percent or 30 percent declines in their share prices.

The problem isn't the earnings game. It's that profitability in GAAP terms is largely an estimate. Excessive reliance on GAAP thus does more harm than good. The real cure should have been changes in the securities laws and enforcement so that other kinds of financial and nonfinancial disclosure could gain traction.

A better way to address the malleability of audited financial statements is to rely to a greater extent on the company's cash results than on its GAAP earnings. As Wall Streeters have always noted, "Earnings are an opinion, but cash is a fact." As Warren Buffett put it, "You just want to estimate a company's cash flows over time, discount them back and buy for less than that."

A desire to re-establish the importance of cash flows is one of the underlying reasons for the president's effort to eliminate the double taxation of dividends. To the extent that companies pay out cash in dividends, they will be demonstrating that they are truly making profits; to the extent that they do not, their investors should be on guard. Although GAAP financial reports contain a statement of cash flow, it is not detailed enough to enable non-professionals to make their own cash-flow projections. The SEC could remedy this by pressing for greater and more useful cash-flow disclosure.

Another urgently needed reform is some way of measuring the success of companies that rely on intangible assets to create value. Intangible assets are knowledge assets such as patents, pharmaceutical designs, computer software, customer relationships and intellectual capital. It's been estimated that 80 percent of the assets of the Fortune 500 consist of intangible assets. The value of these assets can not be captured by GAAP accounting, which is cost-based and relies on the purchase of productive assets at a market price to create a balance sheet value. Intangible assets tend to be produced through the skills of people whose salaries are written off as expenses and do not appear on GAAP balance sheets.

To estimate the value of knowledge companies, then, many commentators and accounting theorists have been recommending the development of new indicators and metrics that will give investors a better picture of how companies are doing and what their prospects are. These indicators are sometimes called "value drivers," and consist of facts about the company's business and intangible assets that provide part of the picture of what will make it successful. Examples of value drivers are employee retention rates, customer turnover rates, product development cycle time, employee and customer acquisition costs, new product success rates, and reject rates. Needless to say, the Sarbanes-Oxley focus on audited GAAP financial statements sets back the development of these indicators.

The objective of the SEC should be to ensure that investors get the most useful information possible. GAAP financial statements do not meet this test by themselves, especially in an economy increasingly dominated by intangible assets. To fulfill its mandate, the SEC should encourage new forms of disclosure and not be misled by the Sarbanes-Oxley Act into a exclusive focus on improving the audit process.

Peter J. Wallison, a resident fellow at AEI, was general counsel of the Treasury and counsel to President Reagan.

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