January 2002
The Futility of Selective Regulatory Reviews of Financial Statements
by Neil Mohindra
In the wake of Enron's financial distress, the Securities and Exchange Commission (SEC) and US Congress are both examining what went wrong at the company, which reported that its profits for a five-year period were almost $US 600 million lower than previously reported shortly before entering bankruptcy protection. These probes should include a re-evaluation of programs not only don't work, but potentially create false impressions about the level of investor protection.
In the financial press, fingers have been pointed at a number of potential culprits including Enron's governance, its auditors, and the accounting rules themselves. One direction that hasn't been receiving significant attention is the review of financial statements filed with regulators as part of continuous disclosure. While the SEC thoroughly reviews the statements of companies when they initially publicly list, continuous filings of financial statements are reviewed in-depth only on a selective basis. The SEC has a confidential set of selection criteria through which it chooses public companies for reviews. These reviews include examining whether a company adheres to generally accepted accounting principles (GAAP)—the same ground covered by public auditors.
Recently, Canadian regulators have become more aggressive in reviewing continuous disclosure documents including financial statements. The British Columbia Securities Commission (BCSC) set up a program in 1998 that covers financial statements and other disclosures such as material change reports, press releases, and websites. The Ontario Securities Commission (OSC) followed suit in 2000 with its "Continuous Disclosure (CD) Review Program," which replaced a smaller scale financial statement review program.
Under the new OSC program, issuers with a head office in Ontario are subject to a CD review, on average, once every four years. How often an individual company is reviewed will be determined, as in the US, by selective review criteria. A full CD review covers all CD documents (e.g. annual reports, press releases, quarterly financial statements, websites) in the same depth as a prospectus review. In addition to full reviews, the program includes issue-oriented reviews, limited reviews, and insider trading report reviews. An OSC Staff Notice on the program indicates that the OSC is participating on a Canadian Securities Administrators (CSA) Committee working towards ensuring that all reporting issuers in Canada, including foreign regulators, are treated equitably. Reviewing whether financial statements have been prepared according to GAAP is a significant part of both the OSC and BCSC programs.
The shift towards greater scrutiny of continuous disclosure is in response to the Toronto Stock Exchange Committee on Corporate Disclosure's Final Report (the Allen Report) released in 1997. The report concluded that there was a sufficient degree of non-compliance with the current rules to cause concern, and recommended the creation of a limited statutory regime for continuous disclosure violations. The report also included a set of "Additional Recommendations" which included that Annual Information Forms (AIFs) and material change reports should equate to prospectus level quality of disclosure, and AIFs should be reviewed at least once every five years.
Canadian securities regulators have taken other steps to improve the quality of continuous disclosure including requirements for audit committees to review financial statements, and requirements for boards to sign off on annual financial statements. In addition, the regulators' umbrella group, the CSA, has been exploring setting up a civil liability regime for continuous disclosure.
The Ontario Securities Commission's 2001 Notice of Statement of Priorities notes the OSC's intention to continue pouring resources into reviewing continuous disclosure documents. The real motivation for doing so might be that the OSC shares concerns that have been raised in the US over the quality of public audits and the independence of auditors. In a 1999 speech, David Brown, Chair of the OSC, notes that "Concurrent with an apparent erosion in the quality of financial reporting, public accounting firms have been emphasizing their transformation into professional services firms in which auditing is a shrinking part of their business."1
A recent report by Kroll Associates commissioned by the Canadian Institute of Chartered Accountants suggests the OSC's concerns may, in fact, have been exaggerated. Surveys revealed that 74 percent of the business community rates the overall quality of audited Canadian financial statements at 4 or greater on a five-point scale. In addition, over 86 percent of the business community thought audited statements had improved (44%) in quality or had not changed (42%) over the past year. Both the business community and retail investors ranked regulators lowest in contributing to the creditability of a public company's financial statements. Executive management was ranked the highest, followed by boards and external auditors.
Securities regulators might conclude that the Enron fiasco shows that more resources should be ploughed into reviews of continuous financial statements. This would be a waste of resources for both the regulators and the public companies that must bear the compliance costs. Selectively duplicating the efforts of public auditors does not prevent Enrons from happening, but merely creates investor confusion (as opposed to confidence) since investors have no idea if a public company's financial statements have been thoroughly reviewed recently by securities regulators or not. In Canada's case, the potential for confusion is even greater because regulators in different provinces may have different interpretations of how to apply Canadian GAAP. The wastefulness of this exercise could become even more significant if the CSA proceeds with allowing Canadian issuers to use US or international GAAP for filings as outlined in a recent CSA concept paper. Each provincial securities regulator would then need expertise in three different sets of accounting standards.
Regulators need to resolve their concerns over the quality of auditing with public auditors themselves, taking into consideration the effectiveness of civil liability regimes and oversight and disciplinary practices. Selectively duplicating their work is counter-productive.
Note
1 "Public Accounting at a Crossroads." Remarks of David A. Brown Q.C., Chair, Ontario Securities Commission to the Business Leaders' Luncheon; the Institute of Chartered Accountants of Ontario, June 8, 1999. Available electronically at http://www. osc.gov.on.ca/en/About/News/speeches.html.
References
British Columbia Securities Commission (BCSC) (2000). Continuous Disclosure Review Program, Staff Report (April). Available electronically at: http://www.bcsc.bc.ca/industryinfo/default.asp.
Canadian Securities Administrators (CSA) (2001). Financial Reporting in Canada's Capital Markets. Discussion Paper 52-401 (Mar. 16). Available electronically at: http://www.albertasecurities.com/.
Canadian Securities Administrators (CSA) (2000). Proposal for a Statutory Civil Remedy for Investors in the Secondary Market and Response to the Proposed Change to the Definitions of "Material Fact" and "Material Change." Notice 53-302 (Nov. 3). Available electronically at: http://www. osc.gov.on.ca/en/Regulation/Rulemaking/Notices/csanotices/csa_list.html.
Enron (2001). "Enron Provides Additional Information about Related Party and Off-Balance Sheet Transactions; Company to Restate Earnings for 1997-2001." Press Release (Nov. 8). Available electronically at: http://www.enron.com/corp/pressroom/releases/2001/ene/78-SECReleaseLtr.html.
Kroll Associates (2001). Protecting the Public Interest; the Role of the Chartered Accountanc y Profession. Available electronically at: http://www.cica.ca/cica/cicawebsite.nsf/
Ontario Securities Commission (OSC) (2000). Implementation of Reporting Issuer Continuous Disclosure Review Program, Corporate Finance Branch. Staff Notice 51-703 (June 16). Available electronically at: http://www.osc.gov.on.ca/en/Regulation/Rulemaking/Notices/staffnotices/51-703sn_20000616.html
Ontario Securities Commission (OSC) (2001a). Notice of Statement of Priorities For Financial Year to end March 31, 2002 (June 29). Available electronically at: http://www.osc.gov.on.ca/en/About/who_what.html
Ontario Securities Commission (OSC) (2001b). Continuous Disclosure Review Program Report—November 2001. Staff Notice 51-706. Available electronically at: http://www.osc.gov.on.ca/en/Regulation/Rulemaking/Notices/staffnotices/ staffnotice_list.html.
Securities and Exchange Commission (SEC) (1997). Responsible Corporate Disclosure: A Search for Balance, TSE Committee on Corporate Disclosure Final Report. Public Inquiry (March).
Neil Mohindra (neilm@fraserinstitute.ca) is a Senior Economist with The Fraser Institute specializing in financial sector regulation. He has a MBA from McGill University.
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