PONDERING FINANCIAL REPORTING.

• Author: Peirce, Hester M.
• Position: 2018 Leet Business Law Symposium: Fiduciary Duty, Corporate Goals, and Shareholder Activism

Thank you for the opportunity to be here today. I will begin with my standard disclaimer. The views I express today are my own and do not necessarily represent the views of the Commission or my fellow Commissioners.

It is a real honor to be back at Case Western Reserve University a quarter of a century after graduating. As a wide-eyed freshman, I lived just down the street in the North Side dorms. I took the LSAT right here in the law school. On nice days, I used to study out in front of the art museum, where I could gaze at the statue of Rodin's The Thinker for inspiration in my own thinking. This statue is one of the approximately ten large versions created during the master's lifetime under his watch. (1) The museum acquired the statue in 1917, coincidentally the year Rodin died. (2)

As you may know, the Cleveland version of The Thinker is not fully intact. The Thinker arrived whole and enjoyed more than fifty years of uninterrupted thought. (3) Then, in the middle of a March night in 1970, someone placed a bomb underneath the statue's base. (4) The Thinker has continued to ponder for another almost fifty years, but the bombing literally knocked the legs out from under him and surely affected his thinking in some form or fashion.

Today, I want to talk to you about an attempt to knock the legs out from under many years of thinking regarding financial reporting and securities disclosure by public companies. Specifically, I want to talk with you about the role that financial reporting plays in giving investors a window into the companies they own. Recently, some people have suggested that financial reporting should perform other functions too. (5) I contend that we need to be very careful in making changes to something that is so central to the functioning of our economy.

To understand its importance, it may be helpful to start with a quick outline of the financial reporting process itself. It is probably worth throwing in some history as well.

Financial reporting is not, new. For as long as investors have been investing in enterprises, one imagines they wanted insight into how their money was being used. Double-entry bookkeeping, or debits and credits, began over five hundred years ago. (6) Later, during the Industrial Revolution, railroad companies found they needed a coherent system for presenting their operations to prospective investors, which paved the way for the development of financial reporting. (7) Other companies then began to follow suit. (8) Soon the need for a reliable financial accounting and reporting framework became evident. The framework would have to pull together existing practices and provide a uniform set of standards for companies so that investors could readily understand the financial statements of various companies.

Generally Accepted Accounting Principles (GAAP), which were built on time-tested standards, brought that much-needed uniformity to financial accounting and reporting. By using GAAP, companies can produce financial reports that are consistent, which allows investors to compare and analyze different companies. The Financial Accounting Standards Board (FASB), which was created in 1973, (9) maintains the standards under authority given to it by the SEC. (10) GAAP are not static, so the FASB's work is ongoing as it adjusts standards to allow for better, more comparable financial reporting.

Having skimmed the surface of a bit of the history, we can now dive into the process of financial reporting itself. The primary actor is the company. As the SEC's Chief Accountant, Wes Bricker, has noted, "high-quality financial reporting starts with companies." (11) As a first step before reporting begins, the company creates the reporting environment through the development of appropriate internal controls. These company policies dictate how the company will make its decisions, who has the authority to act on behalf of the company, how these decisions and transactions are documented, and what checks ensure that the company adheres to its own policies. A company that maintains insufficient controls will have difficulty presenting its financial condition accurately to investors. Equally troubling, the company's managers will have difficulty understanding its own financial condition, which makes management tough. Additionally, the company will be at the mercy of wrongdoers within its ranks if it lacks the proper controls to flag questionable activity. Federal securities laws now require these controls, but even without such a statutory mandate, only a foolhardy company would operate without controls. (12)

Having controls in place is just a start. The company must document the controls and all authorized transactions in its books and records. (13) This documentation forms the backbone of the actual financial reporting process. For companies subject to the U.S. federal securities laws, the responsibility for maintaining books and records in reasonable detail is assigned to the companies themselves. (14) Again, even without a statutory mandate, this arrangement makes sense; companies are in the best position to maintain their own books and records. These books and records are the building blocks of financial statements that are "comparable, verifiable, timely, and understandable by investors and others." (15)

Although financial reporting starts with companies, a number of outside parties also have a role in the process. People reading the financial reports might not be inclined to trust them simply because companies say they have implemented internal controls and complied with GAAP. An independent third party--the independent auditors-must review the company's financial statements and issue an opinion. (16) Auditors add credibility to financial reports by performing procedures to determine whether the financial reports are presented fairly in accordance with GAAP. For an audit to be effective it must be objective and performed by auditors who are "ethical, independent, skeptical, and who apply the diligence necessary to meet professional and regulatory standards." (17) These auditors are overseen by the Public Company Accounting Oversight Board (PCAOB), which was established to develop standards to ensure these objectives are met in public-company audits. (18) Even before the establishment of the PCAOB after the Enron and WorldCom debacles, auditors were subject to professional standards, which helped investors to trust the auditors' work. (19)

Because of their position as the last check on a company's financiais, auditors often serve as attractive scapegoats when a company runs off the rails. (20) When a company has been poorly run and subsequently collapses, however, we should look first to management, not the auditors. While the auditors perform a vital function, their role is limited to ensuring that the financial statements are free of material misstatements. They do not assess whether a company is well-run, nor is it their job to ferret out every instance of negligence or malfeasance.

A recent example from the United Kingdom serves to illustrate the point. In January 2018, Carillion, a British facilities management and construction services firm, was forced to liquidate with 29 million [pounds sterling] in cash and 1.3 billion [pounds sterling] in debt. (21) The liquidation came shortly after the company announced an 845 million [pounds sterling] write-down on unprofitable, longterm construction projects, the value of which declined at the same time that the company's debt increased significantly. (22) Carillion's collapse left many wondering how a failure of this magnitude could go unnoticed for so long. In response to public outcry, politicians turned their sights on...