Special Report: impact of new regulations on Corporate America. (Financial Reporting).

Corporate America is experiencing extraordinarily difficult the stock market's swift and deep downward spiral, corporate and accounting scandals, televised images of handcuffed executives hauled off to jail and the quickly-enacted bipartisan legislation, the Sarbanes-Oxley Act of 2002 (the "Act").

Financial Executive asked Jerry L. Arnold, a frequent contributor, to comment on the impact of the situation from the financial practitioner perspective. Arnold is a professor in the Leventhal School of Accounting at the University of Southern California and the founding director of the USC School of Accounting's SEC and Financial Reporting Institute. He instructs SEC reporting and compliance courses, serves as an expert witness and consults to both large and small corporations. An edited version of his comments follows.

Situation Overview

We are clearly in an unprecedented period, not seen since the Crash of 1929. A broad brush is being applied to all work that conveys information about corporations to the public -- by investors, by the media, by politicians -- which basically says: "don't believe what you read."

I think it is unfortunate, and overstated. It is a widely held perception -- not what I believe to be the facts -- that there is a major systemic problem with the credibility of our reports. We have to deal with the reality that this mindset is permeating the economy and suppressing the markets.

Forty years ago, in 1962, President John F. Kennedy got into the discussion about the Investment Tax Credit and accounting for it. I can't remember an incident since then where a President of the United States has made accounting, reporting and corporate responsibility a centerpiece of his agenda. Until now, that is.

There are several areas where actions are necessary to remedy existing problems and thus create the perception that there's been a floor put under what's being depicted as a bottomless pit of problems.

As an overview, everything now has got to be considered in the context of "we haven't see this before in most of our professional lifetimes." What would be off the table in the past and considered inconceivable is already happening. The Securities and Exchange Commission is the point entity -- adopting the rules, requirements and perspectives that will be pushed within financial statements and, very importantly, beyond the financial statements.

The importance and potential impact of the Act must be considered not only in the context of the following selected topics, but in all aspects of preparing and filing reports with the SEC.

CEO/CFO Certifications

The Act had an immediate impact on CEOs and CFOs of each listed company being required to file periodic reports with the SEC. For starters, the SEC adopted a rule that by August 14 the CEOs and CFOs of 947 companies with revenues of $1.2 billion or more were compelled to sign a concrete certification that says, in essence, "To the best of my knowledge ..." This is key. The Act expanded this requirement to all filing companies and extended its application to future filings; signing an erroneous certification could lead to felony charges.

What CEOs/CFOs are saying is that after performing due diligence, they have determined -- and are stating for public record -- they are not aware of, and to the best of their knowledge, there are no material misstatements or omissions. (Note, this "best of my knowledge" test is not an absolute; the courts will eventually have to interpret precisely what that means.)

It is also important since it's not just saying that generally accepted accounting principles (GAAP) were followed, and this requirement extends beyond the financial statements as it applies to the entire document. This refers to 10Ks, 10-Qs, 8-Ks and proxy statements.

The Changing Role of Audit Committees

A big issue in the revolutionary environment -- corporate governance -- will center on the audit committee, making it more important than ever. It will become a centerpiece for reestablishing the credibility of the reporting system because of its function: oversight. The CEO and CFO have to indicate whether they have discussed their conclusions in regard to the certifications with the audit committee.

While, historically, the role and scope of the audit committee has been on financial statements and footnotes, the CEO/CFO statements are much broader. They relate to all aspects of the filing, thus making it likely that the audit committee will have an increased scope of responsibility: awareness of disclosures, in terms of both completeness and reasonableness throughout the document.

Audit committee members will have to work harder and take their expanded role very seriously. Members will have to be highly compensated, and it is likely that they'll need to engage an expert, or experts, for independent advice on the reasonableness of the accounting treatments that are applied, and the accompanying disclosures.

For this knowledgeable and independent advisor, the committee might look to anyone who is not associated with the organization or that would seem to have a vested interest in the results. Likely candidates include consultants, academics, retired partners of major accounting firms or retired financial executives of other corporations.

Critical accounting policies

The SEC has taken two steps related to what it calls "critical accounting policies," specific accounting policies and estimates that, if applied differently, could have a significant impact on a company's reported operations.

Step one, which was put in place with the 10-K for the year ending Dec. 31,2001, is to have a company identify its critical accounting policies and discuss the possible implications of changing estimates -- either approaching it in a different way or generating a different estimate that would be a change in policy.

Step two, which is more dramatic, is that the SEC has proposed to have companies formalize this analysis of estimates, and to perform a "sensitivity analysis:" What if we changed this estimate by this amount or that amount? What would be the dollar impact on the financial statements? That's proposed, and will probably be adopted in one form or another, for fiscal years ending Dec. 31, 2002 and thereafter.

Accelerated filings

Another area is the acceleration of due dates for filings and the addition of new items. The SEC has proposed expanding the 8-K to cover numerous "new" items.

Among them: entering into a material agreement that's not made in the ordinary course of business, the exit activities including material write-offs and restructuring, any material impairment, a change in a rating agency decision, issuance of a credit watch or a change in company outlook.

Including these items in 8-Ks will generate a lot of additional reporting and a lot of pressure, because the 8-K would be due within two days of the event's occurrence, as would existing 8-K events. Compared to the way it is today, it would make compliance with the 8-K requirements a significant burden.

In the context of immediate reporting, the Act requires that corporate executives report personal purchases or sales of the company's stock to the SEC within two days, unless the SEC concludes that a longer period is necessary. Given the regulatory climate, it's doubtful that the SEC will extend the period.

Another major acceleration proposal relates to Form 10-K and Form 10-Q. The SEC has proposed requiring that Form 10-K be filed within 60 days, rather than the current 90 days after year-end; and it has also proposed requiring that Form 10-Q, the quarterly report, be filed within 30 days, rather than the current 45 days after the quarter end. This proposal represents a one-third reduction from the current time period to prepare these documents.

It's likely that the SEC will adopt most, if not all, of these proposals. The increased time pressure is likely be of special concern to the CEO and CFO as they would experience the squeeze of performing their due diligence prior to signing the certification in two-thirds of the time now permitted.

Impact of changes

A few observations: First, one must keep in mind that in regard to auditor independence, there has always been a dual set of criteria that must be met, that of independence "in fact" and independence "in appearance." We are dealing with a tremendous lack of belief that there is independence in appearance, and in many ways, it doesn't matter whether that's accurate in terms of this free fall of the market. One thing that has to happen is that the firms have to work with the regulators, and there has to be reasonableness involved, such as undertaking some rapid steps that will help jumpstart the confidence.

The auditors are, in fact, doing what they are expected to do: to perform their audits in the interest of shareholders; they are not there merely as tools of management. It's an easy and attractive criticism to say that the auditors are in the pockets of management, but it is just not true, as evidenced by so many of the debates between auditors and management over application of GAAP.

But right now we are in a situation that requires two things:

1) A reassessment as to whether changes in GAAP are needed; and

2) Actions that help reestablish confidence on the part of the public.

Those are not necessarily the same thing, and I'm not a believer of heavy government intervention. I do not believe that is the best way for our capitalistic system to work.