Financial Reporting at a Crossroads

Abstract

INTRODUCTION Today, institutions responsible for financial reporting in our capital markets are reeling from fall-out of financial-reporting scandals of colossal proportions. Reports on collapse of Enron, bankruptcy of WorldCom, and a growing list of failures and near failures have exposed massive manipulations of financial reporting by management, inexplicable breakdowns in independent audit process, astonishing revelations of holes in our financial-reporting standards and practices, and stunning lapses of corporate governance. In this environment, investors and public have become increasingly skeptical about a system that seems to be out of control. Indeed, financial reporting is once again at a crossroads. We witnessed high-profile failures in past and encountered similar questions about performance of key players in our financial-reporting system. Clearly, however, revelations that continue to unfold have had cataclysmic effects that changed world's view of a system that we often tout as the best in world. So severe is damage that investing public can be expected, rightly so, to demand answers and meaningful reforms. SOME CHALLENGING QUESTIONS DEMAND ANSWERS As we re-examine partnership between public and private sectors that has been basis for oversight of our capital markets, we must confront candidly and honestly some challenging questions: * Can we believe in and rely on independent audit? * Can we believe that our accounting and disclosure standards provide transparency that is essential to investors and public? * Can we rely on self-regulatory systems to ensure audit quality and to root out and discipline substandard performance? * Can we rely on corporate governance processes--oversight by boards of directors and audit committees--to ride herd on management and to see to it that auditors do their job? Events have changed how we look at and think about those questions, and change may last for decades to come. The road ahead seems awesomely challenging. Where do we begin to reform a system that suddenly seems very fragile and perhaps seriously flawed? What are essential changes that we need to make? I offer some perspectives and insights drawn from my nearly 40 years in accounting practice and public service and share some thoughts on needed reforms. SHARED GOALS OF CAPITAL MARKET PARTICIPANTS I begin with some essential views that I think all who have important roles in and benefit from a vibrant capital market system can embrace--business, government, auditors, standards setters, investment bankers, analysts, and investing public. We all share a common, linked starting point: * First, I think all will agree that our capital market system is a national treasure. It is vital to success of economy. Indeed, our exceptional standard of living depends on its vitality. * Accordingly, we share a compelling common interest in assuring strength and liquidity of our capital markets. We all benefit from result. * This compelling common interest must shape our policy goals and guide our thinking as we search for solutions. Other goals and interests must not obstruct our vision. * Finally, most critical, yet intangible, ingredient of a successful capital market system is confidence of investors and public in fairness of markets--confidence that information flowing into markets is trustworthy and that insiders do not have an unfair information advantage over public investors. Indeed, focus of securities laws is rooted in this view of our capital markets. Historian David M. Kennedy (1999) discusses events that surrounded enactment of securities laws in his Pulitzer Prize-winning book, Freedom From Fear. …