Chairman Levitt Announces Action Plan to Improve Quality of Corporate Financial Reporting

Washington, D.C., September 28, 1998 – In a major address on the state of accounting delivered today at New York University, Securities and Exchange Commission Chairman Arthur Levitt expressed concern that the quality of financial reporting in corporate America is eroding and he presented an action plan that calls on the entire financial community to remedy the problem.

Chairman Levitt said, "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."

He added, "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."

Suspect Accounting Practice and the Pressure to "Make Your Numbers"

Chairman Levitt cited five accounting practices that companies employ to manage their earnings: "big bath" restructuring charges, creative acquisition accounting, "cookie jar reserves," "immaterial" misapplications of accounting principles, and the premature recognition of revenue.

Chairman Levitt outlined the pattern that 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. Companies' ability to do this depends on achievable earnings targets from analysts. And analysts need constant guidance from companies to frame those expectations. Auditors, who want to retain their clients, are under pressure not to stand in the way.

Action Plan

Specifically, Chairman Levitt called for the following actions:

• SEC will formulate and augment new and existing accounting rules and interpretations covering revenue recognition, restructuring reserves, materiality, and disclosure;
• NYSE and NASD will sponsor a "blue ribbon" panel to improve audit committee performance
• to be co-chaired by John Whitehead and Ira Millstein;
• FASB will prioritize current standard setting projects, particularly those relating to the definition of "constructive" liability;
• The AICPA's Auditing Standards Board will give greater guidance heightening auditors' scrutiny of problematic accounting practices during audits;
• The Public Oversight Board has a proposal to create a panel to review the effectiveness of recent changes in the audit process;
• The SEC Enforcement Division and Corporation Finance Division will vigorously identify and pursue accounting fraud;
• Corporate management and Wall Street need to undergo a wholesale cultural change, rewarding those who practice greater transparency and punishing those who don't.