New Yardsticks for Investors

SEC chief Harvey Pitt is determined to overhaul the nation's outdated system of financial reporting

At his Senate confirmation hearings in July, Securities & Exchange Commission Chairman Harvey L. Pitt pledged to set a new tone of cooperation between the agency and the markets and companies it regulates. Now he has started backing up his words with potentially the biggest shakeup in securities regulation since the SEC's birth in the depths of the Depression.

The new accounting for the 21st century could deliver big payoffs: more accurate stock valuations and less volatility in stock markets for investors, and cheaper capital for companies. "This will be transformative," says Brookings Institution economist Robert Litan.

Pitt is determined to break the stranglehold of earnings reports on the market's pysche. Quarterly and annual reports are "static...often stale," and "not always capable of being deciphered by sophisticated experts, much less ordinary investors," Pitt told the American Institute of Certified Public Accountants. So he wants to throw the doors open for companies to augment today's earnings and asset numbers with far more information on their future trends and strengths.

The most radical change could be in the treatment of so-called "intangibles"--assets such as brands, patents, and staff know-how. Intangibles are crucial to today's successful businesses, but they're left off balance sheets now unless companies are bought or sold. Pitt also wants to encourage companies to issue current numbers, along the lines of weekly auto production or retailers' monthly sales, that give frequent updates on how businesses are performing.

Many companies love Pitt's ideas. New Economy and knowledge-based enterprises could present what they consider to be a fairer and more accurate view of themselves and where they're headed. "We need to reach beyond the quarterly reports to provide more timely information and more context about future prospects," says David L. Shedlarz, chief financial officer for Pfizer Inc.

POLICY REVERSAL. Already, some companies report nontraditional measures: 3M Co., for example, highlights "innovation revenues," the 35% of its sales resulting from products introduced in the last four years. Under Pitt's plan, companies wouldn't be required to report such numbers--but laggards would feel the heat from analysts and investors. "There's tremendous value in giving the market guidance, so that estimates of what your stock is worth aren't all over the map," says Cary Klafter, director of corporate affairs for chipmaker Intel Corp.

Investors could gain, too. Overlooking intangibles handicaps shareholders, says New York University accounting professor Baruch Lev. His research shows that insiders who buy and sell stocks at research-intensive companies collect capital gains three times larger than executives at other companies. Insiders capitalize on the fact that they know more than other investors about how R&D is paying off, Lev says.

Economists, accountants, and corporate executives have produced reams of research on potential new measures. What's been lacking is a push from the SEC. "It's a massive project, and somebody has to get it rolling," says Robert K. Herdman, Pitt's new chief accountant. "We're intent on getting it done."

Although their implementation will be complex, Pitt's ideas share a common theme: Encouraging companies to volunteer better information that will help investors. His emphasis on carrots over sticks is a reversal from his predecessor, Arthur Levitt Jr. Faced with a runaway bull market, Levitt crusaded against the numbers games played by companies striving to hit targets for quarterly earnings. Ultimately, he went to war with accountants, whom he felt were turning a blind eye to financial shenanigans.

By contrast, Pitt, a longtime top defense lawyer for individuals and companies fighting the SEC, is reaching out with initiatives long sought by two groups of key Levitt antagonists. The day after he announced his accounting push, the SEC gave securities lawyers a road map that their corporate clients can follow when they uncover accounting or securities-law violations. Companies that cooperate with SEC probes, the agency said, can hope to avoid enforcement lawsuits.

Like Levitt, Pitt decries the current mania for pro forma earnings--figures that purport to demonstrate how a company's core business is faring by rearranging the official numbers or leaving out extraordinary expenses. But the trend, he says, carries an important message: "Investors [are] anxious for current, simplified, and comprehensible financial reporting."

PUFF? The trouble is that Pitt's push to address that issue could create a whole new set of problems. While companies want credit for their intangibles, accountants still have no agreed way of measuring them. Corporate America would balk at new reporting mandates--but the voluntary disclosures Pitt favors could invite companies to highlight favorable trends and downplay the bad. And firms say they need better protection from lawsuits before they'll give more predictive information--a possible license to mislead the market, according to critics.

Pitt's SEC thinks it can clear those hurdles. First, it doesn't plan to scrap GAAP--the generally accepted accounting principles that govern official financials. Instead, it hopes to improve GAAP by adding intangibles--a challenge that the Financial Accounting Standards Board will consider taking up in December. "We'll never be able to quantify every asset," says Edmund L. Jenkins, FASB's chairman, "but we need to help investors understand which are crucial to the value of corporations."

MINEFIELDS. To further its campaign, the SEC is likely to soon issue a white paper. Its goal: encourage auditors, companies, and investor groups to develop a consensus, by industry, on how to define the extra data--market share, say, or return on research spending--that serves shareholders best. Then, analyst and investor pressure will force companies to provide numbers consistently.

Emphasizing voluntary disclosure will help the SEC negotiate political minefields. Congress has encouraged the agency to look at New Economy measures. But a flood of new reporting rules would boost companies' costs and raise political opposition--a risk that Pitt is unlikely to take. Besides, voluntary and experimental programs can get rolling quickly--well within Pitt's likely five-year term--while the SEC's ponderous rulemaking could drag out much longer.

But he still faces tough foes. Pitt, a fan of the 1995 law that gave companies a safe harbor for forward-looking statements, will need to ask Congress to give companies even broader protection--possibly setting Corporate America against trial lawyers and investor advocates.

Whatever the headaches, Pitt is determined to push ahead with reforms. If he succeeds, the New Economy will get the new accounting its proponents have long wanted.

By Mike McNamee in Washington

    Before it's here, it's on the Bloomberg Terminal.