[Introductory
note: Commissioner Sommer was graduated from Notre Dame (1949) and
Harvard Law School (1950). Prior to his appointment to the SEC,
Mr. Sommer was a partner of the Cleveland law firm Calfee, Halter,
Calfee, Griswald & Sommer.
Our Distinguished Lecturer is well known to readers
of legal and accounting periodicals, having written extensively
on corporate reorganizations, conglomerate accounting and other
securities laws and accounting topics. He was at various times Chairman,
Federal Regulation of Securities Committee and Member, Committee
on Corporate Laws and Committee on Stock Certificates of the American
Bar Association and of various committees of the Ohio State Bar
Association. Mr. Sommer was a Lecturer at Case-Western Reserve and
has appeared frequently before institutes, forums, symposia and
meetings dealing with securities law, corporation law and accounting
matters.
Commissioner Sommer will discuss the desirability
of presenting financial statements with different degrees of summarization
based upon the differing needs and technical abilities of various
statement users. In considering this matter the requirements of
an increasingly professional group of analysts must be recognized,
along with the needs of the average investor. At the same time legal
and accounting problems arising out of a differential approach must
be explored. The subject is particularly timely since the Commission
has suggested this approach in a number of recent proposals and
the Financial Accounting Standards Board is currently considering
the conceptual framework for accounting and reporting in connection
with its review of the Trueblood Committee report on the objectives
of financial statements.
* The Securities and Exchange Commission, as
a matter of policy, disclaims responsibility for any private publication
or speech by any of its members or employees. The views expressed
here are my own and do not necessarily reflect the views of the
Commission or of my fellow Commissioners.]
On October 4, 1973, the Securities and Exchange Commission issued
Securities Act Release No. 5427 entitled somewhat innocuously, "Notice
of Proposed Amendments to Regulation S-X Providing for Disclosure
of Significant Accounting Policies." This release exposed for
further comment proposed changes in Regulation S-X which would require
increased disclosure concerning the consequences of an issuer opting
for certain accounting principles in preference to others.
The previous exposure for comment of these proposed changes had elicited
the sort of responses one might have expected. Generally, analysts
endorsed the thrust of the proposed changes and issuers endorsed the
objectives but expressed concern about the particulars of implementation
-- and it was to be expected that the re-exposure would elicit another
round of fairly technical comment and suggestions.
However, Securities Act Release No.5427 contained a section that
raised the debate from one over technicalities to one concerning fundamental
disclosure philosophy. This section was entitled "An Approach
to Disclosure." The first paragraph of this section said:
"The proposals set forth in this release are primarily
designed to assist professional analysts who have the respon-sibility
of developing an understanding in depth of corporate activity. They
are not primarily intended to serve the direct needs of the 'average
investor.' Such an investor does not usually have the time to study
or the training necessary to fully understand the data which are called
for herein. It is not appropriate, however, for such data to be unavailable
to the average investor who does wish to devote the time necessary
to consider it. By being included in financial statements filed with
the Commission, therefore, data will become 'data of public record'
and, hence, available to all. Disclosure will not be discriminatory
even though usage will mostly be by professionals. Data of this kind
would not be expected to be sent routinely to all shareholders, although
it would be useful if its availability was mentioned in communications
with shareholders and if management took steps to make it available
on request."
This was the first indication, at least officially, by the Commission
that financial statements might be something other than unitary --
that is, that there might be financial statements for the sophisticated
investor and professional analyst and financial statements for the
average investor. This reminds me, I must confess, of the famous Bill
Mauldin cartoon during the Second World War which showed a brass-laden
officer watching a sunset asking his orderly, "Magnificent! Is
there one for enlisted men?"
This development, reiterated in subsequent releases concerning income
taxes and compensating balances, quickly became a matter of extensive
comment, concern and criticism. I think it is fair to say that few,
if any, voices were raised in support or praise of the Commission's
innovation and, as is not uncommon, the Commission found itself somewhat
alone.
I would suggest that the new direction pointed by the Commission
is a step in the demytholigization, if I may call it that, of the
disclosure process; a step that in one way or another has been called
for by eminent commentators such as Homer Kripke, though I hasten
to add that I am not sure he and his fellow critics would particularly
endorse the particular manner in which the Commission is setting about
accomplishing this demytholigization. This effort recognizes and responds
to such fundamentals, acknowledged by all as the fact that American
business has grown steadily more complex, that such complexity has
been geometrically expanded by conglomerization and the expanding
multinational character of American enterprise, that increasingly
complex accounting rules have been necessitated by changes in the
business scene. It recognizes the rather fundamental fact that investors
come in not 57 varieties, but more accurately, fifty-seven thousand
and more varieties. Some are astute as Warren Buffett of Omaha, Nebraska,
whose exploits are amply described in Supermoney; others are as naive
as the legendary Aunt Jane in Dubuque, Iowa. Some are assisted by
professionals, but retain the final judgment, which may reflect not
only the astute analyses of those they pay handsomely but other considerations
as subjective and, if you will, irrational as those that often animate
horse players. Some have abandoned the individual quest for investment
success and have committed their resources to professionals who, hopefully,
have greater capacity to comprehend this swiftly changing, ever more
complex, business world and interpret it meaningfully and in a way
that leads to profits.
This is the world that the Securities and Exchange Commission, Congressionally
designated enforcer of broad standards of disclosure, determiner of
what should be disclosed and how is should be disclosed and how it
should be disseminated, confronts: a complex world in which just the
footnotes of the financial statements of a conglomerate -- described
by one commentator as "the most exciting part of the annual report
-- might run a dozen or more pages, with perhaps other pages of notes
following the financial statements of non-consolidated or separately
reporting entities; a world in which there are asserted to be some
thirty million shareholders (a declining number, incidentally), many
of whom find it difficult to balance their checking accounts, some
of whom are as trained and knowledgeable and astute as Mr. Buffett;
a world in which annual reports compete with television, Playboy (and
now Playgirl) and a multitude of other human activities and endeavors
for the attention of investors.
Manny Cohen, a former Chairman of the Commission, would often say
that he had difficulty explaining anything unless he went back to
Genesis. I don't propose to go back quite that far, but I do think
it would be helpful to go back to the genesis, small "g"
if you will, of the federal disclosure system, the Securities Act
of 1933.
Congress in 1933, confronted with indisputable evidence of massive
financial wrongdoing in the 1920's and convinced that much of it stemmed
from the failure of promoters and entrepreneurs to fairly and candidly
inform those whose resources they garnered and used in their endeavors,
adopted the philosophy of the English Companies Act and mandated that
those who sought money from the public through distributions of securities
should, with narrow exceptions, make comprehensive disclosure in connection
with the distribution. Prior to this mandate, multi-million dollar
offerings of large and respected companies were made with no more
disclosure than could be put on a single sheet of paper, and this
disclosure often consisted of little more than an identification of
the issuer, the kind of securities involved in the issue, and a few
financial facts.
Congress' hope, one that many think has proven to have been unduly
optimistic, was that disclosure would in time defeat the schemes of
the predators and restore the integrity of the financial markets.
In Schedule A to the 1933 Act it specified the information prospectuses
and registration statements should contain and gave the Federal Trade
Commission (supplanted in 1934 as the monitor of the disclosure system
by the newly created Securities and Exchange Commission) broad powers
to vary the requirements.
It was apparent from examing Schedule A that financial statements
of integrity loomed large in Congress' thinking. A prospectus was
required to include a balance sheet and income statement certified
by independent public or certified accountants and it was specified
that such statements should show:
"[A]ll the assets of the issuer, the nature and cost
thereof, whenever determinable, in such detail and in such form as
the Commission shall prescribe ... All the liabilities of the issuer
in such detail and such form as the Commission shall prescribe, including
surplus of the issuer showing how and from what sources such surplus
was created ..." "[E]arnings and income, the nature and
source thereof, and the expenses and fixed charges in such detail
and such form as the Commission shall prescribe ... [W]hat the practice
of the issuer has been ... as to the character of the charges, dividends
or other distributions made against its various surplus accounts,
and as to depreciation, depletion, and maintenance charges, in such
detail and form as the Commission shall prescribe, and if stock dividends
or avails from the sale of rights have been credited to income, they
shall be shown separately with a statement of the basis upon which
the credit is computed. Such statement shall also differentiate between
any recurring and nonrecurring income and between any investment and
operating income."
The legislative history of the 1933 Act clearly showed the determination
of Congress that financial statements be honest and reliable. At one
time it was proposed that federal auditors certify the financial statements
of publicly held companies, and only the avowals of the accounting
profession that it could supply the sought for reliability prevented
this development.
In 1934 Congress adopted the Securities Exchange Act of 1934 which
provided the framework for a continuous disclosure system, including
periodic reports to be filed with the Commission and disclosures to
shareholders through proxy statements by companies listed on exchanges.
It should be noted that at this time exchanges, principally the New
York Stock Exchange, had been steadily increasing their pressure for
listed companies to increase the quantum of disclosure to shareholders.
In the 1934 Act, perhaps largely because of the steps which had been
taken by exchanges, Congress did not specify in the detail it had
in the 1933 Act, the kinds of disclosure which should be made, but
rather left to its new creation, the SEC, the task of specifying such
details.
This scheme of disclosure, I suggest, reflected several assumptions
of varying merit. First, I think it suggested the assumption that
investment decisions, not all perhaps, but certainly a sociologically
significant number, were made on a rational basis. This approach was
reflected in Graham and Dodd's first edition of Security Analysis
published in 1934 which ushered in a new era of fundamental investment
analysis. It was believed that investors would -- and could -- use
the information provided, that they would thereby be impelled to make
sounder decisions, thus avoiding the fraud and over-reachings characteristic
of the twenties.
I would suggest that perhaps underlying the Congressional commitment
to the disclosure philosophy was far more basic assumption, one having
its roots deep in American history and ideology: the belief that the
"common man" had an innate wisdom, a natural capacity for
the absorption of knowledge, an inborn facility for sound judgment
if only he had the facts. This is reflected in many of our popular
sayings; for instance, "let people know and the truth shall make
them free. " It is reflected in our commitment to education and
the assumption, now perhaps discredited, that everyone has the capacity
for the fullness of a classical education. This ideology has its origins,
of course, in Rousseau and many others.
With these assumptions so entrenched, it is not surprising that there
is little in the legislative history of the 1933 and 1934 Acts concerning
the use that people might make of the information Congress wished
them to have, the manner in which investment decisions were made,
the process by which judgments were reached. That the intervening
four decades have done little to change this situation is indicated
in the Report of the Study Group on the Objectives of Financial Statements
in October 1973:
"Users' needs for information, however, are not known
with any degree of certainty. No study has been able to identify precisely
the specific role financial statements play in the economic decision
making process."
The natural consequence of the Congressional mandate for a disclosure
system, the assumption that investors are generally rational, the
conclusion that the quality of investment decisions is related to
the quantity and integrity of disclosure, and the belief that the
"common man" has uncommon wisdom and judgment, has been
a constant pressure for increased disclosure: more information, information
of higher reliability, broader dissemination.
This insistence upon more disclosure and more reliable disclosure
has been particularly pronounced with respect to financial information.
Through the years, to assure reliability, the Commission has steadily
tightened the mandate of auditor independence. There has been steady
expansion of the amount of disclosure. For instance, in 1971 the Commission
required a source and application of funds statement and in 1969 the
Commission first required disclosure of line of business profitability
in 1933 Act prospectuses and later extended this to periodic reports.
One reads the list of the Commission's Accounting Series Releases
and can discern there the rising demands for more and better information.
This expansiveness has been accompanied by rather constant controversy.
The business community, which is the source of the information, has
repeatedly urged restraint for several reasons. It has contended that
frequently the Commission was indifferent to the costs involved in
producing the additional information; that the additional information
was of questionable utility; that analysts always want more without
knowing what to do with what they had; that additional disclosures
would favor competitors at the expense of and to the hardship of the
enterprise's shareholders. The Commission has often given recognition
to these contentions through what must fairly be described as minor
concessions, but the expansion of disclosure has gone forward unremittingly.
While the controversies concerning the particulars of disclosure
have been fought through Commission releases, comments on them, articles
in the Financial Executive and Journal of Accountancy,
a deeper and broader controversy, which had for so long been hidden
on the shelf, has been emerging. In this controversy the issues are
simple: does all this financial disclosure mean anything? Has it a
utility? Has it made a difference? Is the investor better off because
of all of this federally mandated disclosure?
The critics of the whole disclosure system have brought to bear on
the controversy techniques of analysis that are in some instances
novel, at least to the ears of the lawyers and accountants who have
been the principal custodians of the disclosure grails since 1933;
among these has been sophisticated mathematical analysis. In the forefront
of these critics has been Professor George Benston (popularized and
encouraged by Professor Henry J. Manne) who has written that the disclosure
requirements of the Securities Exchange Act of 1934 have had no measurable,
positive effect on the securities traded on the New York Stock Exchange,
that there is little basis for the 1934 Act and no evidence that it
was needed or desirable, and that "certainly there is doubt that
more required disclosure is warranted." Professor Benston uses
an empirical method of analysis in an attempt to prove that the disclosures
mandated by the 1934 Act have not been effective in preventing fraud
and manipulation. Professor Marine has echoed this thought in Barron's:
"As we approach the 40th Anniversary of the Securities
Exchange Act of 1934, honorable men everywhere would do well to reevaluate
the whole field of securities regulation. Instead of constantly repeating
the deadening cliches about fairness, disclosure and fraud, perhaps
some brave Congressman or Senator or even Commissioner of the SEC
will take note of what competent economic scholars are beginning to
say about the field."
Critics of the Benston-Manne analysis have retorted that the mathematical
mode of analysis is not suited to the complexities of the investment
process, that within the parameters of their technique there are insufficiencies,
that disclosure serves purposes beyond that of simply informing investors,
that forty years of steadily stronger securities markets in this country
(recent aberrations excepted) provide some evidence of the values
of disclosure, that the propensity of other countries to emulate our
system indicates convictions of objective observers of the value of
the disclosure system.
And there are other more fundamental discussions that reach to the
heart of our disclosure system. Increasing attention is paid to the
so-called "random walk theory" which questions the utility
of the Graham and Dodd kind of fundamental analysis (as indicated
above, a premise of the disclosure system) by asserting that if an
investor simply diversifies his risks he will do as well as the investor
who engaged in extensive research and analysis. Without attempting
extensive analysis of the pros and cons of these somewhat exotic theories,
it does strike me that the random walk theory is grounded on notions
of an efficient market, and an efficient market is one in which all
information of consequence is evenly and fully distributed; hence,
I think even if one is a devotee of the random walk theory, there
is the necessity for an effective information dispensing system, otherwise
the fundamental of the theory, and efficient market, is impossible.
While these intriguing and potentially most significant discussions
continue -- and I think they are extremely important and pose challenging
and difficult problems for those responsible for securities regulation
-- there have been changes in the manner in which investment decisions
are made. For one thing, increasing amounts of investable funds are
in the hands -- and under the control -- of institutions. In 1961
some 430 billion dollars were under the control of institutions; in
1971 this amount had grown to 839 billion, and by now the amount is
surely near a trillion dollars. In 1961 investment companies had 34
billion dollars under management; in 1973, even considering heavy
redemptions, the total was about 73 billion. Institutional trading
currently accounts for approximately 70% of the volume of trading
on the NYSE. A further indication of the nature of this change is
reflected in the membership figures of the Financial Analysts Federation.
At the end of 1950, there were 2,422 members; there are currently
approximately 14,000 members. Increasingly various financial institutions
have offered money management services. Brokerage houses and banks
are actively competing for such business and frequently brokers state
their preference for such activity over customary brokerage services
because of its reliability and persistence as a source of revenues.
There is a constant lowering of the minimum portfolio which advisors
will undertake to manage. The growth of this activity was recognized
in the report of the Commission's Advisory Committee on Small Business
Investment Management Services which, among other things, urged the
Commission to forego tight regulation of so-called "mini-accounts,"
provided certain specified conditions were met.
Thus, the institutionalization of the market has been accompanied
by what I could call, for want of a better term, the quasi-institutionalization
of the market -- the increasing reliance -- in many cases conclusive
reliance -- of individual investors who retain the final decision
with respect to investment decisions upon the advice of professionals.
Perhaps indicative of this increased emergence of quasi-institutionalization
of the market is the concern of the financial analysts themselves
for the quality of their performance and the integrity of their profession.
Several years ago the Financial Analysts Federation commenced a program
of study and qualification which would result in the encomium, "Chartered
Financial Analyst," in the belief that sufficient public repute
would attach to the magic initials "C.F.A." that less reputable
or competent analysts would be driven from the market. While the program
has resulted in the award of this designation to about 3,000 analysts,
it has not, in the minds of many, been sufficient and there have recently
arisen demands for more rigorous regulation, either state or self-regulatory
or federal with perhaps a measure of self-regulation.
The disclosure system has resulted in the availability of tremendous
amounts of information for anyone who wishes to use it. Whenever an
issuer "goes public" for the first time it must file with
the Commission a registration statement containing extensive financial
and non-financial information and much of that must, albeit for the
most part at a somewhat insufficient time before the final investment
decision is made, find its way into the hands of investors. Thereafter,
until the number of its holders of equity securities falls below certain
minimal levels, it must file each quarter with the Commission an abbreviated
income statement, it must file annually a Form 10-K which in effect
updates its registration statement under the 1933 Act, it must file
with the Commission promptly reports of certain important events such
as changes in debt terms that affect the rights of any registered
class of securities, it must furnish to shareholders annual reports
containing certified financial statements, and it must furnish proxy
materials in connection with proxy solicitations (and comparable information
even if it doesn't solicit proxies). And increasingly there are pressures
from exchanges and courts for publicly-held companies to make prompt
public disclosure of important developments, even though the legal
theories relating to such disclosure are in a state of development
and not yet fully articulated.
All of this information, legally mandated, is of course supplemented
in many ways. There are analysts' meetings, increasingly subject to
judicial mandates that important information provided at such meetings
be given wide circulation; there are the interpretations published
by commentators; there are the speeches of company officers. All of
this adds to the fund of information, often approaching torrential
proportions, available to the investor.
I think it would be naive -- and irresponsible -- if, having achieved
this vast outpouring of information and its relatively efficient dissemination,
we concluded that our task was done. That may have been the conviction
that animated Congress in 1933 and 1934, but I say we know more about
the limitations of human beings, we have somewhat more concise, albeit
still quite inexact, notions of how people invest, we have less Rousseauian
confidence in the competence of the common man, to reach that easy
a conclusion.
All of the above has led critics of the present disclosure system like
Homer Kripke to criticize what he rather pungently calls "The Myth
of the Informed Layman." Professor Kripke said in his article bearing
that title:
[T]he Commission has misconceived its market. It has never
admitted any hypothesis other than that the prospectus is intended
for the man in the street, the unsophisticated lay investor. My theme
is that the theory that the prospectus can be and is used by the lay
investor is a myth. It is largely responsible for the fact that the
securities prospectus is fairly close to worthless. "
In another article, Professor Kripke has said simply: "My conclusion
is that the goal of financial accounting should be to provide the
most useful information for serious securities investors, financial
analysts and money managers who serve investors, and for economists."
His conclusion, and that of others, is that we should do away with
the nonsense of trying to make prospectuses and other disclosure documents
simple and understandable for the layman (it is a prerequisite under
Rule 460 that a prospectus be reasonably concise and readable so as
to facilitate an understanding of the information contained in the
prospectus and periodically the Commission urges issuers to make their
documents more readily understandable) and recognize that the only
ones able today to cope with the complexities of American business
and the concomitant complexities of disclosure about American business
are the sophisticated, knowledgeable, informed professionals to whom
the non-professionals increasingly turn for help in making their investment
decisions.
This approach has much appeal. The Commission could multiply the
requirements of disclosure with no concern for easy comprehensibility;
it would be possible, for instance, to perhaps mandate new kinds of
mathematical and economic disclosure, including sophisticated projections
and other forward looking information, which would mystify the average
investor but make sense to the trained analyst familiar with sophisticated
research methodology. Certainly an express abandonment of the small
investor would open the door for far more sophisticated disclosure
techniques.
And yet there lingers the mythos and the fact: the mythos, that Americans
can make up their own minds, that they have a competence to decide
their own political fate and a fortiori their financial fate;
the fact that, notwithstanding the increasing dependence upon professionals,
there are still many investors who do make their own decisions, who
do try to cope with the data provided to them, who are unwilling to
surrender their judgment. And there is the fact that often we hear
of such investors who regularly outperform the professionals despite
their apparently limited expertise.
This "common man" concept has been expressed repeatedly
in Commission rules and determinations and court decisions relating
to standards of materiality. For instance, Rule 405 of the Commission
defines materiality as "those matters as to which an average
prudent investor is reasonably to be informed before purchasing the
security registered."
Similarly, in SEC v. Texas Gulf Sulphur Co. the Court of Appeals
for the Second Circuit used as one of its criteria of materiality
this:
"[W]hether a reasonable man would attach importance
... in determining his choice of action in the transaction in question..."
The standard of materiality is thus that which means something to
the "ordinary prudent investor" -- not the expert, but the
ordinary prudent investor. This notion has been almost reduced
to a statistical criterion. In Feit v. Leasco Data Processing Equipment
Corp., Judge Weinstein, in speaking of materiality, said:
"A fair summary of the rules stated in terms of probability
is that a fact is proved to be material when it is more probable than
not that a significant number of traders would have wanted to know
it before deciding to deal in the security at the time and price in
question..."
The varying purposes of and audiences for disclosure have not gone
unrecognized. In the Commission's "Disclosure Policy Study"
(the "Wheat Report") it was said:
"By and large, the Commission has responded to the
various needs for disclosure in pragmatic fashion. Thus, where an
issue of securities possessed unusually speculative elements, it was
felt that special efforts should be made to call these factors to
the attention of the ordinary investor -- hence the development of
the 'introductory statement' to the prospectus. By contrast, the detailed
financial information required by the schedules to the Form 10-K report
could be intended only for the skillful analyst. Indeed, it was recognized
from the beginning that a fully effective disclosure policy would
require the reporting of complicated business facts that would have
little meaning for the average investor. Such disclosures reach average
investors through a process of filtration in which intermediaries
(brokers, bankers, investment advisers, publishers of investment advisory
literature, and occasionally lawyers) play a vital role."
In an article recently published by the Hastings Law Journal, Alison
Gray Anderson has perceptively described the efforts of the Commission
to both protect the small investor and serve the needs of the professional
and the sophisticated investor, and suggests that perhaps the Commission
is today according less primacy to the protective role.
Given this background, it is rather surprising that the idea that
there should be "differential disclosure" has met with such
dismay and dissent. After all in matters of news we are accustomed
to "differential disclosure." The man who wants simply,
shall I say, notification watches the eleven o'clock news; the one
who wants more, say enough to handle a conversation on current events
intelligently after a couple of martinis at a cocktail party, reads
Time or Newsweek; the person seeking perhaps more detail
and some interpretation goes to the New York Times or the Washington
Post; while the real student reads the Congressional Record, official
releases of governmental agencies, and the myriad of other materials
available.
There are as many capacities to understand and cope with information,
and willingness and desire to do so, perhaps as there are investors;
consequently, it is impossible to design a single disclosure system
that perfectly matches the needs and capacities of each person. Consequently,
as in most things in life, we must categorize, recognizing that the
fit will be crude in most cases, but better than the kind of procrustean
achievement that would dictate a single set of requirements for everyone
simply on the grounds, somewhat Steinian, that an investor is an investor
is an investor.
Once one concludes that a disclosure system should at least be bifurcated,
if not refined more precisely, then I think the problem is much more
complex than simply quantity. It is not enough to say simply, "Now
that we recognize that the skilled professional can use well more
sophisticated information than the amateur, we will simply give him
more information." There is at the minimum a correlative necessity
to process and prepare the information for use by the "average"
investor (to use a wholly inadequate term) in a manner that will make
it useable and useful; it is a matter of presentation, as well as
quantity. There is also the problem where and how the respective disclosures
are made. If that directed to the professional is so interlaced with
that intended for the amateur, then it may well have the effect of
causing the unsophisticated investor to back off in fear and confusion.
Attention must be paid to the fact that professionals have access
to information that would not be available to the small investor;
for instance, analysts frequently seek out filings with the Commission
-- in many cases they receive "microfiche" copies routinely,
while small investors would hardly know where to begin in seeking
out this information, although the Commission's recent proposal that
corporations make the Form 10-K available on request is designed to
partially remedy this problem. Thus there are problems of mode of
presentation and dissemination as well as those of quantity and complexity
of information that must be faced.
Undoubtedly the part of the Commission's approach to differential
disclosure which has troubled most, particularly those in the accounting
profession, is the requirement of the Commission that this differential
disclosure be accomplished through the financial statements of the
enterprise. Securities Act Release No.5427 indicated that the extensive
additional information which would be required by the proposed amendment
of Rule 3-08 of Regulation S-X should be a part of the financial statements
filed with the Commission but would not necessarily have to be part
of the financial statements furnished to investors at large. The release
said, "By being included in financial statements filed with the
Commission ... data will become 'data of public record' and, hence,
available to all." The same concept is embodied in Accounting
Series Release No. 148. In Accounting Series Release No.149 pertaining
to income tax expense the distinction is most clearly indicated:
"The Commission has concluded that the benefits of
the disclosure are sufficient to require its presentation in financial
statements filed with the Commission but it recognizes that the detailed
disclosure required herein will be primarily of interest to professional
analysts ... and may not be required in financial statements designed
for the average investor ..."
Two facets of this concept trouble accountants. First, the term "financial
statements" has traditionally had a unitary connotation; there
is one set of numbers and notes that constitutes the financial
statements of the enterprise; the notion that there should be two
or more financial statements is alien. It might be noted that there
is, in a different context, increasing suggestion that there may be
the necessity for more than one set of financial statements to properly
convey necessary financial information concerning an enterprise. In
a paper prepared for the Tenth International Congress of Accountants,
Robert Trueblood said,
"Today, however, many more groups are expressing a
need for enterprise financial information. And, as always, users of
financial statements ask for more information, in more depth. The
interests of different user groups vary some-what, and their information
needs sometimes conflict. General purpose financial statements simply
cannot be expanded to cover all legitimate information requirements.
"To meet the diverse information requirements of all those who
have a legitimate need for enterprise information, a new reporting
method must be developed. The core-statement satellite-report concept
is a suggested solution.
"The core statement would present financial position, net earnings,
and equity status -- as those terms are understood in an economic
sense. Ultimately, the core statement would be accepted as the common
denominator, by all users, in all countries. The information needs
of particular user groups would be served with satellite reports,
tailored to their specific needs."
This is hardly a new idea. George O. May, one of the giants of the
accounting profession, as long ago as 1937 suggested that a single
set of statements could no more serve the diverse needs of investors
than a single utensil could satisfy the need of table silver. He expressed
the notion in an article appropriately entitled, "Eating Peas
with Your Knife," in which he discussed
"the inefficiency, if not the danger, entailed in
the use of accounts for purposes for which they were not designed,
and for which they are not appropriate ... [I]t should be obvious
that it is not possible to get one form of account or one statement
which will serve equally well the purposes of regulation, taxation,
annual reporting and a security issue. Yet this does not seem to be
at all generally appreciated."
The second concern of auditors derives from concern over leaving
out of financial statements on which they issue an opinion information
and data which at least some investors consider important. Is this
inconsistent with the opinion that the statements have been prepared
in accordance with generally accepted accounting principles? It is
fundamental -- and so expressed in accounting literature -- that certified
financial statements may not omit anything material to the fair presentation
of the information. Do financial statements omitting the information
which would be required in filed financial statements by the proposed
revisions of Rule 3-08 and the information now required by Accounting
Series Releases Nos. 147 and 148 "present fairly" in accordance
with generally accepted accounting principles?
I will frankly confess these are genuine concerns expressed by the
accounting profession and they are deserving of careful and close
analysis. The concerns of the profession are, of course, compounded
by the increasing incidence of litigation involving members of the
profession and the still expanding limits of Rule l0b-5, which, among
other provisions, makes it a violation of the Rule to omit anything
necessary to make statements made not misleading.
Of course, differences between the financial information filed with
the Commission in a Form 10-K and that furnished to shareholders is
not completely without precedent. Rule 14a-3 provides that certain
of the particulars contained in Form 10-K financial statements may
be summarized or omitted in those contained in the annual report and
it is quite common to do this. Furthermore, there is no explicit requirement
that the financial statements contained in the Form 10-K be the same
as those in the annual report, although Rule 14a-3 under the 1934
Act does require in the event of divergence explanation of the reason
for it. Also there are required in the Form 10-K certain technical
compliance notes (e.g., concerning stock options) which generally
do not appear in the financial statements in reports to shareholders.
And Form 10-K, as well as part II of the most used registration forms
under the 1933 Act, requires the filing of schedules which are covered
by the auditor's report in addition to the financial statements.
I would suggest that the concerns of the accounting profession are
perhaps needlessly grave.
First, any omission of information which is identified by the Commission
as necessary in filed statements but not in those circulated to the
investors in general would be in reliance upon Commission rule. Section
23(a) of the 1934 Act provides: "No provision of this title imposing
any liability shall apply to any act done or omitted in good faith
in conformity with any rule or regulation of the Commission."
Thus I think the liability concern should be abated. Further than
that, the Commission in Section 13(b) of the 1934 Act is given the
power to prescribe:
[I]n regard to reports made pursuant to this title, the
form or forms in which the required information shall be set forth,
the items or details to be shown in the balance sheet and the earning
statement, and the methods to be followed in the preparation of reports,
in the appraisal or valuation of assets and liabilities, in the determination
of depreciation and depletion, in the differentiation of recurring
and nonrecurring income, in the differentiation of investment and
operating income ..."
That the inclusion of the additional information in filings with
the Commission is pursuant to Commission rule is clear; that such
information may be omitted from the financial statements in annual
reports is less clear. However, the explicit permission in Rule 14a-3
to "omit such details or employ such condensation as may be deemed
suitable to management", combined with the clear benediction
of the Commission for the omission of such information, would seem
clearly to insulate auditors from liability. If there remain, however,
doubts of this, then perhaps the Commission should remove the uncertainty
through the rule-making process.
While the Commission has traditionally deferred to the accounting
profession with respect to the orderly development of accounting principles,
nonetheless it has been fully recognized through the years that the
Commission has broad power over the contents of financial statements
and it has on occasions, such as accounting for the investment credit,
exercised that power when it felt it necessary to do so. If the Commission
has the power to determine the content of financial statements, then
I would suggest that it has the power to classify financial
statements and determine that financial statements used for this purpose
have such and such contents, but that other financial statements intended
for a different audience or use have other or additional contents.
And again, the Commission having made such a determination, and an
auditor having relied upon such determination by the Commission, it
is difficult to see wherein the danger of liability lies.
Apart from narrow legal considerations such as those discussed above,
does the mandating of additional information in financial statements
filed with the Commission do a wrong to the small investor -- is he
misted, is he denied information which he is entitled to have?
I would suggest he is not. At the present time the accounting process
consists of summarization, judicious omission, careful selection of
items which are of use to those using financial statements; certainly
no one would suggest that there should be furnished to anyone outside
a corporation the full financial data that is available, e.g., the
amount of each receivable, each payable, the particulars concerning
each category of inventory, and so on. The entire process of financial
presentation is founded upon selection, summarization, condensation.
Conventionally this is done according to prescribed standards which
have their roots in deeper principles -- founded on assumptions --
concerning what information is useful to the users of financial statements.
The profession has just engaged in a most challenging study of this
entire matter in an effort to find what information is useful to users
of financial statement. Until that report is fleshed out, the profession
will continue to use the conventional standards embodied in generally
accepted accounting principles as presently articulated.
Those standards of presentation, I submit, are founded upon assumptions
with regard to the identity of users. I would suggest that those assumptions
are not sacred, or embedded in stone, or engraved on bronze. All that
differential disclosure is suggesting is that there be explicit recognition
of the fact that implicit in the standards governing presentations
are assumptions concerning users and that there be developed a further
recognition that among those users are many who have need for and
ability to use effectively this additional information.
A necessary correlative of expanding the detailed information available
to the professional and the skilled investor is the necessity of more
and better summarization of data and sounder interpretation of it
by management. The interpretation of financial data is a complex business
in which relatively few investors are skilled. The best source of
meaningful interpretation of data is management. As a consequence
the Commission has increasingly required that the documents furnished
to or made available to investors contain interpretations of the data
presented; financial disclosure should not be a contest between management
and owners of the enterprise to see whether the investor can uncover
the significance of the raw figures. For many years, for instance,
the Commission has included in the instructions to the use of Form
S-1 a requirement that:
[T]he information set forth in prospectus should be presented
in clear, concise, understandable fashion."
The Commission articulated this increased concern with understandable
presentation to the small investor in Securities Act Release No. 5427
under the same heading where the needs of sophisticated investors
are discussed:
"While analysts' requirements are of great importance,
the needs of individual investor must also be served. If this investor
is to remain an active participant in the securities markets, he must
be confident that he is receiving data in a fashion which he can understand
and which does not mislead him as to the operations or position of
the firm. He should not be presumed to possess a depth of accounting
or analytical knowledge in order to obtain a reasonable picture of
the results of an enterprise's activities. The needs of the average
investor can only be met by developing a better process of analytical
summarization where information shown in detail in financial statements
is selectively presented in an interpretive fashion so that the most
significant elements are highlighted in relatively simple form. Since
those elements which are most significant vary from enterprise to
enterprise and from period to period, no fixed rules can be established
as to the specific elements to be included in such an analytical summarization."
In proposed Guide 22 pertaining to 1933 Act filings, which would
also become Guide 1 with respect to 1934 Act filings, the Commission
stated:
"Securities Act Guide 22 and Exchange Act Guide 1,
if amended and adopted as proposed herein, would require an introductory
narrative explanation of the Summary of Earnings and Summary of Operations
whenever clarification is needed to enable investors to appraise the
quality of earnings. Investors should understand the extent to which
accounting changes, as well as changes in business activity, have
affected the comparability of year to year data and should be in a
position to assess the source and probability of recurrence of net
income (or loss). Thus, whenever there are material changes in the
amount and source of revenues and expenses, including tax expenses,
or changes in accounting principles or methods or their application
that have a material effect on net income, or if whenever management
believes that historical earnings are not indicative of present or
future earnings, an appropriate analysis and explanation would be
required."
As a further indication of the dynamics of the process of determining
which information should be available where and to whom, the Commission
has proposed to transport large segments of information heretofore
previously contained only in filings with the Commission into the
annual reports circulated to shareholders, including preeminently
the information concerning the sales and profitability of lines of
business. With the continuing diversity of American enterprise, the
Commission concluded that this information is material to a larger
group than simply those who have ready access and opportunity to use
the filings with the Commission and hence should be available more
readily in the investment market place.
Do these developing practices favor the professional investor and
the analysts' clients over the average investor? The easy answer,
of course, is that the information will be available for anyone who
wants to extract it from the Commission's files; but that is too glib.
The fact is, of course, that the professional investor and the analysts'
clients have significant advantages now deriving from their skills,
their access to publications interpreting data, their ability to secure,
quite legally, background information from management through interviews
and attendance at analysts' meetings; there is no way that the Commission,
or Congress for that matter, can legislate or mandate equality of
wisdom and skill among investors.
But even that, I would suggest, is too easy an answer. The fact
is that the Commission believes that this program will not enhance
the advantage of the professional, substantial as it is now, but will
in the final analysis give the small investor a better shot at knowledgeable
investment than he has now. I would emphasize that fully as important
a part of this approach as the increase in data filed with the Commission
is the requirement for better summarization of data and management
analysis. These requirements will afford the investor access to more
of the kinds of information with which he can deal most effectively.
It will hopefully lead him away from simplistic analyses centered
on earnings or cash flow per share and into deeper awareness of the
complexity of enterprise and the investment process.
If it has the collateral effect of pressing more investors into the
offices of the professionals, I would suggest that is not a bad result
either -- provided the Congress, the Commission and the profession
combine to develop an adequate program to exclude from the ranks of
professional analysts those lacking integrity or expertise. More and
more Americans are realizing that the investment process is hazardous,
uncertain, and, like surgery or trial advocacy, demands more than
ordinary intelligence. To the extent that these advances by the Commission
give better tools to the analysts in their work, I would suggest all
investors are the beneficiaries.
In summary, I would suggest that "differential disclosure"
is a new tool, with roots firmly in the past as well as in a greater
present perceptiveness concerning the investment process and the nature
of investors, by which the disclosure process can become more useful
and more meaningful to investors and their advisors. It recognizes
the capacity of many to deal with complexity and the inability of
still others, who nonetheless are essential to the investment process,
to match the formers' skills and expertise, but who nonetheless must
be the beneficiaries of the process if we are not to abort and abandon
the purposes of the Congress in enacting the scheme of federal securities
laws which we have. Like any experiment, we must watch carefully its
workings and assess realistically its achievements and failures. I
believe it will succeed.
