Michael Lange

The SEC's Reality GAAP
by Michael G. Lange

More companies than ever before are putting out pro forma results that are not audited and in most cases do not comply with generally accepted accounting principals ("GAAP"). They are management's presentation of "our business as we'd like it to be," in the words of Securities and Exchange Commissioner Isaac Hunt, Jr. As Hunt notes: "The growing use of pro forma earnings has undoubtedly been fueled by management's desire to paint a rosier picture than GAAP might otherwise allow."

Of course, there is nothing new about management trying to make bad results look good. Soon, however, they may get help from a surprising source - the SEC itself. The agency is now a "kindler, gentler place," says new Chairman Harvey Pitt.

While Pitt is critical of pro forma results, he views them as "indicative of the need to rethink our current [disclosure] system." To his mind, managers are not trying to put one over on investors. Pro forma earnings reflect a "legitimate desire by companies to demystify mandated financial statement disclosures and to encourage shareholders to focus on what management believes are the most salient details to be gleaned from their company's financials."

As any good magician knows, sleight-of-hand tricks require making the audience look the wrong way. That is easy with financials, since companies typically announce their pro forma results in news releases weeks in advance of filing detailed disclosures with the SEC. Thus, for several weeks, all investors have are the releases, which focus on what managers consider the "most salient details."

And the SEC doesn't seem to think you are really reading those long disclosures anyway. As Pitt says: "Investors anxious for current, simplified and comprehensible financial reporting are today more likely to rely upon a company's 'pro forma' disclosures than the same company's meticulously prepared, mandated GAAP disclosures."

It is time to "step back and rethink our financial disclosure model," Pitt says. "Because our current system focuses principally on so called 'objective' numbers and disclosure, it does not provide nearly enough useful information to investors …" Management must be "encouraged to disclose trend information more broadly" and to give investors "more information about intangibles."

Of course, these same managers can't be up all night worrying if their emphasis and gloss will get them sued. They need protection from what Pitt calls a "hyperactive litigation environment," and he seems ready to give it to them. Pitt has announced a new SEC enforcement policy in which companies "discovering" securities violations can expect reduced penalties - or no punishment at all - in return for cooperating with the agency. To further insulate them from the "specter of liability" he might also try to give them protection from irate shareholders, as the agency did with Regulation FD, which expressly bars shareholders from suing companies to enforce the rule.

Pitt does not seem at all concerned about the strong corporate trend towards manipulation of earnings and eroding accounting standards. However, the accounting scandal now engulfing Enron is but one of many accounting debacles over the past few years at companies including Sunbeam, Cendant, Waste Management, Xerox and Lucent Technologies.

A recent study by Enron's own auditors, Arthur Andersen, found that the number of companies forced to restate their financial results due to accounting improprieties has been soaring. Researchers counted 723 restatements from 1997 through 2000. An astonishing 233 restatements were recorded last year alone, double the number in 1997 and more than five times the 10-year average of 46 per year from 1988 through 1997.

Arthur Andersen knows about restatements all too well. Just this month, it agreed to pay $20 million to settle a lawsuit involving Waste Management that accused the firm of professional malpractice. That is on top of the $7 million fine it paid to settle an SEC inquiry involving the company's books. And earlier this year, Arthur Andersen shelled out $110 million to settle an accounting fraud lawsuit involving its work for Sunbeam.

Accurate financial reporting is the bedrock of our financial markets. With the quality of financial reporting so clearly eroding, the SEC should be shoring up this bedrock by vigorously enforcing GAAP, not questioning the continued relevance of the "objective" information it provides in today's securities markets.

Michael G. Lange is a partner with Berman DeValerio Pease Tabacco Burt & Pucillo, a law firm that represents investors in shareholder class actions nationwide.