"THE NUMBERS GAME"

Remarks by Chairman Arthur Levitt Securities

and Exchange Commission

Delivered at the NYU Center for Law and Business

New York, NY

September 28, 1998

Thank you very much. Dean Daly, Dean Sexton and to everyone

gathered this evening, thank you for welcoming me tonight. I am

honored to be here on such an auspicious evening for both NYU

and Bill Allen.

The creation of the Center for Law and Business recognizes an

important truth: we cannot continue to view the worlds of business

and law as parallel but separate universes. And NYU could not have

selected a more qualified or thoughtful individual than Bill as its first

director. His leadership of the Delaware Court of Chancery --

acknowledged as the nation's most influential arbiter of corporate

law -- confirmed his reputation as a great thinker who effortlessly

bridges the worlds of law and business. I've heard from friends on

Wall Street that it's a far less stressful experience to hear Bill

lecture in front of a classroom than from his former seat on the

bench.

Seven months ago, I expressed concerns about selective

disclosure. Through conference calls or embargoed press releases,

analysts and institutional investors often hear about material news

before it is made public. In the interval, there is a great deal of

unusual trading. The practice had been going on for a long time.

And, while everyone was aware of it, and most were extremely

uncomfortable with it, few spoke out. As the investor's advocate,

the SEC did and we will continue to do so.

Well, today, I'd like to talk to you about another widespread, but too

little-challenged custom: earnings management. This process has

evolved over the years into what can best be characterized as a

game among market participants. A game that, if not addressed

soon, will have adverse consequences for America's financial

reporting system. A game that runs counter to the very principles

behind our market's strength and success.

Increasingly, I have become concerned that the motivation to meet

Wall Street earnings expectations may be overriding common

sense business practices. Too many corporate managers, auditors,

and analysts are participants in a game of nods and winks. In the

zeal to satisfy consensus earnings estimates and project a smooth

earnings path, wishful thinking may be winning the day over faithful

representation.

As a result, I fear that we are witnessing an erosion in the quality of

earnings, and therefore, the quality of financial reporting. Managing

may be giving way to manipulation; Integrity may be losing out to

illusion.

Many in corporate America are just as frustrated and concerned

about this trend as we, at the SEC, are. They know how difficult it

is to hold the line on good practices when their competitors operate

in the gray area between legitimacy and outright fraud.

A gray area where the accounting is being perverted; where

managers are cutting corners; and, where earnings reports reflect

the desires of management rather than the underlying financial

performance of the company.

Tonight, I want to talk about why integrity in financial reporting is

under stress and explore five of the more common accounting

gimmicks we've been seeing. Finally, I will outline a framework for a

financial community response to this situation.

This necessary response involves improving both our accounting

and disclosure rules, as well as the oversight and function of

outside auditors and board audit committees. I am also calling

upon a broad spectrum of capital market participants, from

corporate management to Wall Street analysts to investors, to

stand together and re-energize the touchstone of our financial

reporting system: transparency and comparability.

This is a financial community problem. It can't be solved by a

government mandate: it demands a financial community response.

The Role of Financial Reporting in Our Economy

Today, America's capital markets are the envy of the world. Our

efficiency, liquidity and resiliency stand second to none. Our

position, no doubt, has benefited from the opportunity and potential

of the global economy. At the same time, however, this increasing

interconnectedness has made us more susceptible to economic

and financial weakness half a world away.

The significance of transparent, timely and reliable financial

statements and its importance to investor protection has never

been more apparent. The current financial situations in Asia and

Russia are stark examples of this new reality. These markets are

learning a painful lesson taught many times before: investors panic

as a result of unexpected or unquantifiable bad news.

If a company fails to provide meaningful disclosure to investors

about where it has been, where it is and where it is going, a

damaging pattern ensues. The bond between shareholders and the

company is shaken; investors grow anxious; prices fluctuate for no

discernible reasons; and the trust that is the bedrock of our capital

markets is severely tested.

The Pressure to "Make Your Numbers"

While the problem of earnings management is not new, it has

swelled in a market that is unforgiving of companies that miss their

estimates. I recently read of one major U.S. company, that failed to

meet its so-called "numbers" by one penny, and lost more than six

percent of its stock value in one day.

I believe that almost everyone in the financial community shares

responsibility for fostering a climate in which earnings management

is on the rise and the quality of financial reporting is on the decline.

Corporate management isn't operating in a vacuum. In fact, the

different pressures and expectations placed by, and on, various

participants in the financial community appear to be almost

self-perpetuating.

This is the pattern earnings management creates: companies try to

meet or beat Wall Street earnings projections in order to grow

market capitalization and increase the value of stock options. Their

ability to do this depends on achieving the earnings expectations of

analysts. And analysts seek constant guidance from companies to

frame those expectations. Auditors, who want to retain their clients,

are under pressure not to stand in the way.

Accounting Hocus-Pocus

Our accounting principles weren't meant to be a straitjacket.

Accountants are wise enough to know they cannot anticipate every

business structure, or every new and innovative transaction, so they

develop principles that allow for flexibility to adapt to changing

circumstances. That's why the highest standards of objectivity,

integrity and judgment can't be the exception. They must be the

rule.

Flexibility in accounting allows it to keep pace with business

innovations. Abuses such as earnings management occur when

people exploit this pliancy. Trickery is employed to obscure actual

financial volatility. This, in turn, masks the true consequences of

management's decisions. These practices aren't limited to smaller

companies struggling to gain investor interest. It's also happening in

companies whose products we know and admire.

So what are these illusions? Five of the more popular ones I want to

discuss today are "big bath" restructuring charges, creative

acquisition accounting, "cookie jar reserves," "immaterial"

misapplications of accounting principles, and the premature

recognition of revenue.

"Big Bath" Charges

Let me first deal with "Big Bath" restructuring charges.

Companies remain competitive by regularly assessing the

efficiency and profitability of their operations. Problems arise,

however, when we see large charges associated with companies

restructuring. These charges help companies "clean up" their

balance sheet -- giving them a so-called "big bath."

Why are companies tempted to overstate these charges? When

earnings take a major hit, the theory goes Wall Street will look

beyond a one-time loss and focus only on future earnings.

And if these charges are conservatively estimated with a little extra

cushioning, that so-called conservative estimate is miraculously

reborn as income when estimates change or future earnings fall

short.

When a company decides to restructure, management and

employees, investors and creditors, customers and suppliers all

want to understand the expected effects. We need, of course, to

ensure that financial reporting provides this information. But this

should not lead to flushing all the associated costs -- and maybe a

little extra -- through the financial statements.

Creative Acquisition Accounting

Let me turn now to the second gimmick.

In recent years, whole industries have been remade through

consolidations, acquisitions and spin-offs. Some acquirers,

particularly those using stock as an acquisition currency, have

used this environment as an opportunity to engage in another form

of "creative" accounting. I call it "merger magic."

I am not talking tonight about the pooling versus purchase problem.

Some companies have no choice but to use purchase accounting --

which can result in lower future earnings. But that's a result some

companies are unwilling to tolerate.

So what do they do? They classify an ever-growing portion of the

acquisition price as "in-process" Research and Development, so --

you guessed it -- the amount can be written off in a "one-time"

charge -- removing any future earnings drag. Equally troubling is the

creation of large liabilities for future operating expenses to protect

future earnings -- all under the mask of an acquisition.

Miscellaneous "Cookie Jar Reserves"

A third illusion played by some companies is using unrealistic

assumptions to estimate liabilities for such items as sales returns,

loan losses or warranty costs. In doing so, they stash accruals in

cookie jars during the good times and reach into them when

needed in the bad times.

I'm reminded of one U.S. company who took a large one-time loss

to earnings to reimburse franchisees for equipment. That

equipment, however, which included literally the kitchen sink, had

yet to be bought. And, at the same time, they announced that

future earnings would grow an impressive 15 percent per year.

"Materiality"

Let me turn now to the fourth gimmick -- the abuse of materiality --

a word that captures the attention of both attorneys and

accountants. Materiality is another way we build flexibility into

financial reporting. Using the logic of diminishing returns, some

items may be so insignificant that they are not worth measuring

and reporting with exact precision.

But some companies misuse the concept of materiality. They

intentionally record errors within a defined percentage ceiling. They

then try to excuse that fib by arguing that the effect on the bottom

line is too small to matter. If that's the case, why do they work so

hard to create these errors? Maybe because the effect can matter,

especially if it picks up that last penny of the consensus estimate.

When either management or the outside auditors are questioned

about these clear violations of GAAP, they answer sheepishly, "It

doesn't matter. It's immaterial."

In markets where missing an earnings projection by a penny can

result in a loss of millions of dollars in market capitalization, I have

a hard time accepting that some of these so-called non-events

simply don't matter.

Revenue Recognition

Lastly, companies try to boost earnings by manipulating the

recognition of revenue. Think about a bottle of fine wine. You

wouldn't pop the cork on that bottle before it was ready. But some

companies are doing this with their revenue -- recognizing it before

a sale is complete, before the product is delivered to a customer, or

at a time when the customer still has options to terminate, void or

delay the sale.

Action Plan

Since U.S. capital market supremacy is based on the reliability and

transparency of financial statements, this is a financial community

problem that calls for timely financial community action.

Therefore, I am calling for immediate and coordinated action:

technical rule changes by the regulators and standard setters to

improve the transparency of financial statements; enhanced

oversight of the financial reporting process by those entrusted as

the shareholders' guardians; and nothing less than a fundamental

cultural change on the part of corporate management as well as the

whole financial community.

This action plan represents a cooperative public-private sector

effort. It is essential that we work together to assure credibility and

transparency. Our nine-point program calls for both regulators and

the regulated to not only maintain, but increase public confidence

which has made our markets the envy of the world. I believe this

problem calls for immediate action that includes the following

specific steps:

Improving the Accounting Framework

First, I have instructed the SEC staff to require well- detailed

disclosures about the impact of changes in accounting

assumptions. This should include a supplement to the financial

statement showing beginning and ending balances as well as

activity in between, including any adjustments. This will, I believe,

enable the market to better understand the nature and effects of the

restructuring liabilities and other loss accruals.

Second, we are challenging the profession, through the AICPA, to

clarify the ground rules for auditing of purchased R&D. We also are

requesting that they augment existing guidance on restructurings,

large acquisition write-offs, and revenue recognition practices. It's

time for the accounting profession to better qualify for auditors

what's acceptable and what's not.

Third, I reject the notion that the concept of materiality can be used

to excuse deliberate misstatements of performance. I know of one

Fortune 500 company who had recorded a significant accounting

error, and whose auditors told them so. But they still used a

materiality ceiling of six percent earnings to justify the error. I have

asked the SEC staff to focus on this problem and publish guidance

that emphasizes the need to consider qualitative, not just

quantitative factors of earnings. Materiality is not a bright line cutoff

of three or five percent. It requires consideration of all relevant

factors that could impact an investor's decision.

Fourth, SEC staff will immediately consider interpretive accounting

guidance on the do's and don'ts of revenue recognition. The staff will

also determine whether recently published standards for the

software industry can be applied to other service companies.

Fifth, I am asking private sector standard setters to take action

where current standards and guidance are inadequate. I encourage

a prompt resolution of the FASB's projects, currently underway,

that should bring greater clarity to the definition of a liability.

Sixth, the SEC's review and enforcement teams will reinforce these

regulatory initiatives. We will formally target reviews of public

companies that announce restructuring liability reserves, major

write-offs or other practices that appear to manage earnings.

Likewise, our enforcement team will continue to root out and

aggressively act on abuses of the financial reporting process.

Improved Outside Auditing in the Financial Reporting

Process

Seventh, I don't think it should surprise anyone here that recent

headlines of accounting failures have led some people to question

the thoroughness of audits. I need not remind auditors they are the

public's watchdog in the financial reporting process. We rely on

auditors to put something like the good housekeeping seal of

approval on the information investors receive. The integrity of that

information must take priority over a desire for cost efficiencies or

competitive advantage in the audit process. High quality auditing

requires well-trained, well-focused and well-supervised auditors.

As I look at some of the failures today, I can't help but wonder if the

staff in the trenches of the profession have the training and

supervision they need to ensure that audits are being done right.

We cannot permit thorough audits to be sacrificed for re-engineered

approaches that are efficient, but less effective. I have just proposed

that the Public Oversight Board form a group of all the major

constituencies to review the way audits are performed and assess

the impact of recent trends on the public interest.

Strengthening the Audit Committee Process

And, finally, qualified, committed, independent and tough-minded

audit committees represent the most reliable guardians of the

public interest. Sadly, stories abound of audit committees whose

members lack expertise in the basic principles of financial reporting

as well as the mandate to ask probing questions. In fact, I've heard

of one audit committee that convenes only twice a year before the

regular board meeting for 15 minutes and whose duties are limited

to a perfunctory presentation.

Compare that situation with the audit committee which meets

twelve times a year before each board meeting; where every

member has a financial background; where there are no personal

ties to the chairman or the company; where they have their own

advisers; where they ask tough questions of management and

outside auditors; and where, ultimately, the investor interest is

being served.

The SEC stands ready to take appropriate action if that interest is

not protected. But, a private sector response that empowers audit

committees and obviates the need for public sector dictates seems

the wisest choice. I am pleased to announce that the financial

community has agreed to accept this challenge.

As part eight of this comprehensive effort to address earnings

management, the New York Stock Exchange and the National

Association of Securities Dealers have agreed to sponsor a "blue-

ribbon" panel to be headed by John Whitehead, former Deputy

Secretary of State and retired senior partner of Goldman, Sachs,

and Ira Millstein, a lawyer and noted corporate governance expert.

Within the next 90 days, this distinguished group will develop a

series of far-ranging recommendations intended to empower audit

committees and function as the ultimate guardian of investor

interests and corporate accountability. They are going to examine

how we can get the right people to do the right things and ask the

right questions.

Need for a Cultural Change

Finally, I'm challenging corporate management and Wall Street to

re-examine our current environment. I believe we need to embrace

nothing less than a cultural change. For corporate managers,

remember, the integrity of the numbers in the financial reporting

system is directly related to the long-term interests of a

corporation. While the temptations are great, and the pressures

strong, illusions in numbers are only that -- -ephemeral, and

ultimately self-destructive.

To Wall Street, I say, look beyond the latest quarter. Punish those

who rely on deception, rather than the practice of openness and

transparency.

Conclusion

Some may conclude that this debate is nothing more than an

argument over numbers and legalistic terms. I couldn't disagree

more.

Numbers in the abstract are just that -- numbers. But relying on the

numbers in a financial report are livelihoods, interests and

ultimately, stories: a single mother who works two jobs so she can

save enough to give her kids a good education; a father who labored

at the same company for his entire adult life and now just wants to

enjoy time with his grandchildren; a young couple who dreams of

starting their own business. These are the stories of American

investors.

Our mandate and our obligations are clear. We must rededicate

ourselves to a fundamental principle: markets exist through the

grace of investors.

Today, American markets enjoy the confidence of the world. How

many half-truths, and how much accounting sleight-of-hand, will it

take to tarnish that faith?

As a former businessman, I experienced all kinds of markets, dealt

with a variety of trends, fads, fears, and irrational exuberances. I

learned that some habits die hard. But, more than anything else, I

learned that progress doesn't happen overnight and it's not

sustained through short cuts or obfuscation. It's induced, rather, by

asking hard questions and accepting difficult answers.

For the sake of our markets; for the sake of a globalized economy

which depends so much on the reliability of America's financial

system; for the sake of investors; and for the sake of a larger

commitment not only to each other, but to ourselves, I ask that we

join together to reinforce the values that have guided our capital

markets to unparalleled supremacy. Together, through vigilance and

trust, I know, we can succeed.

Thank you.

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