On Dec. 6, 2010, Securities and Exchange Commission Chair Mary Schapiro spoke to several thousand assembled accountants at the annual SEC/Public Company Accounting Oversight Board/American Institute of CPAs conference in Washington, D.C. By tradition, the chair's annual remarks are usually not very newsworthy because they mainly assure the profession that the chair understands that accountants and accounting issues are important to securities regulation.

Her speech was quite different because it had a very important section that the media has unfortunately given only scant attention, probably because they didn't comprehend what she was saying.

Specifically, we think her words lay down a challenge that should rock all accountants because they suggest that the old paradigm is inadequate and that a new paradigm is essential for overcoming the serious problems that led to the financial markets' collapse in 2008. Of course, this kind of talk resonated with the two of us because we've advocated that change for years.

 

THE OLD PARADIGM

As we see it, and we believe our stance is aligned with Mary's, financial accounting has devolved to existing primarily for its own sake. That is, accountants act as if only they know what's best. Accordingly, they believe that they and they alone can identify and frame financial reporting issues and then resolve them. Unfortunately, this inward focus has led to an obsession with the "supply side," which means they are concerned about their own problems, their own convenience and, frankly, their own skins.

One main outcome of this worldview is elevating the role of standards to providing final answers to every question. Financial accountants seem to think that standards define acceptable practice and that complying with them will eliminate all problems for everyone. A recent manifestation of this conventional perspective is the misbegotten drive to create a single set of international reporting standards to be applied all over the world. Ironically, another is the opposite move in the U.S. to create separate standards for private companies. We're not at all surprised by these paradoxically incompatible efforts. Both grow out of self-focused supply-side thinking where each sub-group of accountants seeks to preserve its own monopoly kingdom.

The fly in this ointment is that standards actually don't work very well.

 

SCHAPIRO'S HESITATION

Mary's speech shows that she doesn't subscribe to this accountant-centered paradigm. As we'll describe in detail later, she laid some real challenges on the audience that reflect much broader concerns about these issues:

Can accounting standards effectively protect the markets?

Do existing accounting standards actually produce useful financial reports?

Could better accounting practices produce more useful financial reports?

She confronted the entire profession by encouraging all to stop and ask why we do what we do and whether we're fulfilling our social role.

 

SCHAPIRO'S FRAMEWORK

The following points from her text provide insight into her perceptions about financial reporting and accounting.

Objective: When she said, "A robust rule-making agenda ... is the cornerstone of our efforts to restore faith in our financial markets," she identified her objective as the SEC chair to be building much more trust in the markets so that risk can be diminished and otherwise managed.

Obstacle: She claimed that faith and trust have been lost because of "investor skepticism that springs from a decade ... marked by restatements, misleading 'window dressing' in quarterly reports and 'off-balance-sheet' exposures that prevent them from making fully informed investment decisions." In other words, she has met the enemy, and the enemy appears to include accountants to the extent that they have not helped prevent these toxic practices and even may have promoted them.

Desired outcome: Mary described her vision for "functioning capital markets" in which investors have the "ability to get an unvarnished assessment of a company's financial condition." She went on to say, "The foundation of successful markets is accurate and transparent financial reporting." In our words, the information should be relevant, representationally faithful and accessible. But current GAAP (and IFRS) will not get us there.

Needed action: Knowing that some corporate managers and chief financial officers can be hard for auditors to deal with when composing useful reports, Mary said the key is "pushing back to assure yourself that investors can rely on those numbers." She basically told the assembled auditors that they have to stand firm in defense of investors' needs.

Expectation: Citing our own code of ethics, she challenged accountants to "discharge your duties 'with integrity, objectivity, due professional care and a genuine interest in service to the public.'" Her decision to refer to this principle may reveal that she's wondering how many actually remember its near-sacred charge.

Enforcement: While Mary knows that rigorous enforcement is necessary, she also knows it is not nearly sufficient for restoring faith and trust. Specifically, she said: "Enforcement actions are cold comfort for investors who lost their savings after relying on misrepresentations or half-truths." What she didn't have to say is that enforcement efforts will never prevent or uncover all misdeeds. Something more is needed.

 

CHALLENGING QUESTIONS

We've lamented that the only question auditors ask right before signing their opinions is, "Do these statements comply with GAAP?" We've speculated things would be quite different if they asked these two questions instead: "Are these statements useful? What can be done to make them more useful?"

Therefore, we really sat up and paid notice when the SEC chair proposed questions that were obviously not mere rhetorical devices. It seems she wants accountants to integrate them into the new paradigm she believes should replace the old. Specifically, she posed these four challenges:

"Could I be doing more to ensure that the information is accurate?"

"Are the results I am reporting an exercise in wishful thinking or a true portrait of actual results?"

"Do I understand the company I am auditing well enough to recognize red flags, and have I taken all appropriate steps to respond to them?"

"Even if the numbers reported are accurate, do they convey a fair picture, or is there a need for additional disclosure?"

It's clear what she's getting at: The old way of thinking and acting is not good enough and the new way needs to replace it. While standards are better than nothing, they are not much better than nothing if those who implement them treat them only as maximums and game them, or permit their clients to do so, by producing false rosy pictures with the futile goal of tricking the markets. Instead, accountants need to ensure that financial statements are useful, even as useful as they can be. That goal can be reached only with perfect awareness of their importance and by applying great diligence in their construction.

 

THE MARKETS NEED ACCOUNTANTS

In our January column ("'For the benefit of' or 'to the benefit of:' What's the difference?"), we pointed out that capital markets work to accountants' benefit but do not exist for our benefit. Rather, we have a franchise to provide useful information, and meeting that obligation rewards us with a good living and the satisfaction of doing important work.

We think Mary is reminding our profession about that point. If we don't collectively step up and deliver, the markets will flounder and even founder, and, perish the thought, turn somewhere else for better information.

 

ACCOUNTANTS NEED THE MARKETS

It is obviously in accountants' collective self-interest to see that these bad things don't happen. To make that point more memorable, we'll paraphrase a common bit of advice: "If the markets ain't happy, then nobody's happy."

Thus, it follows that we collectively have to rise to the Schapiro challenge or we won't survive. In hearing that challenge, some will respond like the practitioner who recently wrote a letter to the editor complaining about our criticism of systematic depreciation in our December column. His engrained paradigm, reinforced by years of successful practice, has clearly stymied his inclination to perceive that something might be wrong with GAAP. Thus, we speculate that it will be hard for him to change.

In a strange irony, today's clients could be paying out far more than what they get in return, while accountants are earning far less than they could if they were to ask Mary's questions and then take the right steps to bring more quality into their products.

On the other hand, we harbor the profound hope that first a few practitioners and then many will rise to the challenges we and the SEC chair have envisioned and start delivering fully useful depictions of the truth that will enable the markets to accomplish all they're supposed to.

We don't think her challenge could be stated any more clearly. How many times will it have to be repeated before it is met?

 

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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