On September 28, 1998, Chairman of the U. S. Securities and Exchange Commission Arthur Levitt sounded the call to arms in the financial community. Levitt asked for, immediate and coordinated action... to assure credibility and transparency of financial reporting. Levitt's speech emphasized the importance of clear financial reporting to those gathered at New York University.
Reporting which has bowed to the pressures and tricks of earnings management. Levitt specifically addresses five of the most popular tricks used by firms to smooth earnings. Secondly, Levitt outlines an eight part action plan to recover the integrity of financial reporting in the U. S.
market place. What are the basic objectives of financial reporting? Generally accepted accounting principles provide information that identifies, measures, and communicates financial information about economic entities to reasonably knowledgeable users. Information that is a source of decision making for a wide array of users, most importantly, by investors and creditors. Investors and creditors who are responsible for effective allocation of capital in our economy. If financial reporting becomes obscure and indecipherable, society loses the benefits of effective capital allocation.
Nothing illustrates the importance of transparent information better than the pre-1930's era of anything goes accounting. An era that left a chasm of misinformation in the market. A chasm that was a contributing factor to the market collapse of 1929 and the years of economic depression. An entire society suffered the repercussions of misinformation.
Families, and retirees depend on the credibility of financial reporting for their futures and livelihoods. Levitt describes financial reporting as, a bond between the company and the investor which if damaged can have disastrous, long-lasting consequences. Once again, the bond is being tested. Tested by a financial community fixated on consensus earnings estimates. The pressure to achieve consensus estimates has never been so intense. The market demands consistency and punishes those who come up short.
Eric Benhamou, former CEO of 3 COM Corporation, learned this hard lesson over a few short weeks in 1996. Benhamou and shareholders lost $7 billion in market value when 3 COM failed to achieve expectations. The pressures are a tangled web of expectations, and conflicts of interest which Levitt describes as almost self-perpetuating. With pressures mounting, the answer from U. S. managers has been earnings management with a mix of managed expectations..