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• The board of directors™ proposals
• The authorization of a new stock or bond issue
• Corporate management™s conduct with respect to corporate affairs
• The selection of the independent auditing firm

As a result of the stockholders™ voting power, it is essential that the audit com-
mittee develop stockholder profiles. For example, committee members should
identify the number of stockholders and their related stockholdings in order to iso-
late the degree of voting power. Voting power may be concentrated in a family
group. Such a group can greatly influence corporate policies due to its percentage
of stock ownership. Although the board has other demands from its outside con-
stituencies, the audit committee can aid the board through its understanding and
familiarity with investors™ interests and investments in the corporation. In short,
the primary concern of the committee is to give consideration to the stockholders™
interests because of their relationship to corporate policy decisions.
In 1992, Richard C. Breeden, former chairman of the SEC, stated in his annual
report to Congress:

The Commission adopted significant revisions of the proxy rules to facilitate effec-
tive communications among shareholders and between shareholders and their cor-
porations. The reforms will encourage greater participation by shareholders in
corporate governance by removing unnecessary regulatory barriers, reducing the
costs of complying with the proxy rules and improving disclosure.
In addition, the Commission revised its rules to ensure that shareholders receive bet-
ter information about executive compensation. Among other things, the new execu-
tive compensation disclosure rules require new tables that will disclose clearly and
concisely the compensation received by a corporation™s highest paid executives.12
The Commission adopted important amendments to its executive compensation dis-
closure requirements. The amendments are designed to (1) ensure that shareholders
receive comprehensible, relevant, and complete information about compensation
paid to executives upon which to base their voting and investment decisions; and (2)
foster accountability of directors to shareholders by permitting shareholders to vote
on the proposals of other shareholders with regard to executive and director com-
pensation, and thereby advise the board of directors of the shareholders™ assessment
of the compensation policies and practices applied by the board.
After three years of study, two releases for public comment, a two-day public con-
ference, and more than 1,700 public comment letters, the Commission substantially
revised its rules governing proxy solicitations. The revisions were adopted to (1) fa-
cilitate effective communications among shareholders and between shareholders and
their corporations, as well as participation by shareholders in corporate governance,
by removing unnecessary regulatory barriers, (2) reduce the costs of complying with
the proxy rules, (3) improve disclosures to shareholders, and (4) restore a balance be-
tween the free speech rights of shareholders and Congress™ concern that solicitation
of proxy voting authority be conducted on a fair, honest and informed basis.13

Securities and Exchange Commission, 1992 Annual Report, p. viii.
Ibid., p. 53.
102 The External Users of Accounting Information

Recognizing the significance of the financial reporting process and demands
for full disclosure, several investor associations, such as the Investor Responsibility
Research Center (IRRC), the National Investor Relations Institute, and the Associ-
ation for Investment Management and Research, have conducted annual forums
dealing with various issues related to the investing public. For example, Maryellen
F. Andersen, former chair of the board, and Margaret Carroll, former executive di-
rector, of the IRRC, note:

Increasing numbers of corporate officers and directors looked to IRRC to help in-
form their policies and decisions on such diverse questions as assessing environ-
mental liability (through our Environmental Information Service); anticipating
questions at annual meetings, challenging shareholder proposals at the SEC, prepar-
ing responses for the proxy statement, gauging levels of institutional investor inter-
est in key issues and their likely reaction when those issues are raised (through
our Proxy Information Service); and deciding whether or when to enter or re-
enter South Africa (through our South Africa Review Package). Corporations
in other countries, too, began to look to IRRC for many of the same kinds of

In 1998, Arthur Levitt, former SEC chairman, reported that:

[a]n area of great concern to the Commission is inappropriate earnings manage-
ment. While this is not a new problem, it has risen in a market unforgiving of com-
panies that miss Wall Street™s estimates. During the year, our staff issued guidance on
various issues relating to the presentation of earnings per share.”15

Likewise, in 1999, Levitt stated that:

[a]n area of continued concern to the Commission is inappropriate earnings man-
agement. Abusive earnings management involves the use of various forms of gim-
mickry to distort a company™s true financial performance in order to achieve a
desired result. Staff Accounting Bulletin 99 reemphasizes that the exclusive reliance
on any percentage or numerical threshold in assessing materiality for financial re-
porting has no basis in the accounting literature or in the law. The staff also issued
two other bulletins to provide guidance on the criteria necessary to recognize re-
structuring liabilities and asset impairments and the conditions prerequisite to rec-
ognizing revenue.16

More recently, the SEC reported the initiation of these enforcement actions:17

Investor Responsibility Research Center, Annual Report 1992 (Washington, DC:IRRC, 1992), p. 3.
Securities and Exchange Commission, 1998 Annual Report (Washington, DC: U.S. Government
Printing Office, 1998), p. vi.
Securities and Exchange Commission, 1999 Annual Report (Washington, DC: U.S. Government
Printing Office, 1999), p. vi. For further discussion, see Chapter 5.
Securities and Exchange Commission, 2002 Annual Report (Washington, DC: U.S. Government
Printing Office, 2002), p.2.
The Investors 103

FY98 FY99 FY00 FY01 FY02
Civil Injunctive Actions 214 198 223 205 270
Administrative Proceedings 248 298 244 248 280
Contempt Proceedings 15 29 36 31 47
Reports of Investigation 0 0 0 0 1
Total 477 525 503 484 598

Recall in Chapter 1 the discussion about the erosion of the quality of financial
reporting and the quality of earnings. Stockholders and potential investors realize
that if a company does not meet or beat Wall Street expectations, then investors
will punish the market price of company™s stock. Consequently, management has
an incentive to manage current and expected earnings because net income is used
to measure earnings per share and return on equity as well as the value of man-
agement™s stock options. Therefore, the quality of earnings may be affected by
management™s choice of accounting methods and estimates, including nonoperat-
ing items on the income statement.
For further discussion, the reader may wish to revisit Arthur Levitt™s nine-
point action plan in Chapter 1.
As a case in point, the SEC reported:

In the Matter of W.R. Grace & Co. Former senior management of W.R. Grace & Co.
and its main health care subsidiary, National Medical Care, Inc., falsely reported re-
sults of operations and made false and misleading statements in press releases and at
teleconferences with analysts. The managers deferred reporting income, by improp-
erly increasing or establishing reserves, to bring reported earnings into line with tar-
geted earnings. Grace consented to the entry of a cease and desist order, and agreed
to establish a $1 million fund for programs to further awareness and education about
financial statements and generally accepted accounting principles.18

This case illustrates management™s use of “cookie jar reserves” whereby man-
agement makes unrealistic assumptions to estimate liabilities, which in turn can be
reduced in the future to increase net income.

The Need for Accounting Information
As the principal constituency of the corporation, investors make decisions based
on financial accounting information. Such data is essentially discretionary, since
it is predicated on management™s judgment. Although regulatory agencies, such as
the SEC, can dictate the form and content of their reports, the investors must rely
on corporate management. Moreover, investors must not only evaluate the effec-
tiveness of management but also decide whether to increase or decrease their
stockholding based on management™s financial accounting representations.

Securities and Exchange Commission, 1999 Annual Report, p. 5. For further discussion, see Securi-
ties and Exchange Commission, In the Matter of W.R. Grace & Co., Release No. 34-41578, Account-
ing and Auditing Enforcement Release No. 1140 (June 30, 1999). See also Ann Davis, “SEC Case
Claims Profit ˜Management™ by Grace, Wall Street Journal. April 7, 1999, p. C1.
104 The External Users of Accounting Information

More important, because of its stewardship accountability, corporate manage-
ment must periodically communicate its financial accounting information to its
constituencies. The corporate financial statements are the principal reports that are
used to communicate accounting data. In November 1978, the FASB released its
first statement as part of its conceptual framework project for financial accounting
and reporting. As a Statement of Financial Accounting Concepts, the board con-
cluded the following on objectives of financial reporting:

Financial reporting should provide information that is useful to present and potential
investors and creditors and other users in making rational investment, credit, and
similar decisions. The information should be comprehensible to those who have a
reasonable understanding of business and economic activities and are willing to
study the information with reasonable diligence.
Financial reporting should provide information to help present and potential in-
vestors and creditors and other users in assessing the amounts, timing, and uncer-
tainty of prospective cash receipts from dividends or interest and the proceeds from
the sale, redemption, or maturity of securities or loans. Since investors™ and creditors™
cash flows are related to enterprise cash flows, financial reporting should provide in-
formation to help investors, creditors, and others assess the amounts, timing, and un-
certainty of prospective net cash inflows to the related enterprise.
Financial reporting should provide information about the economic resources of an
enterprise, the claims to those resources (obligations of the enterprise to transfer re-
sources to other entities and owners™ equity), and the effects of transactions, events,
and circumstances that change its resources and claims to those resources.19

With respect to the first objective of financial reporting, it is apparent that in-
vestors need useful information for investment decisions. However, one must ad-
dress the usefulness of the financial statements to the users. To resolve this
controversy in financial reporting, Kenneth S. Most and Lucia S. Chang found

[t]he accounting contents of the corporate annual report are regarded as its most im-
portant contents, and conversely that the president™s letter to the stockholders and the
pictorial material presented are viewed as relatively unimportant.20 . . . The authors
believe that the results of their research indicate strongly that investors regard finan-
cial statement information as useful for their decisions.21

The second objective of financial reporting means that the investors need fi-
nancial information in order to evaluate their investment objectives. Obviously, in-
vestors wish to safeguard the principal amount of their investment and maximize
the income and capital appreciation. Furthermore, investors must assess their will-
ingness and ability to accept risk. Similarly, management must effectively use the
economic resources of the enterprise in order to generate a monetary return to its

Financial Accounting Standards Board, Statement of Financial Accounting Concepts, No. 1, p. viii.
Kenneth S. Most and Lucia S. Chang, “An Empirical Study of Investor Views Concerning Financial
Statements and Investment Decisions,” Collected Papers of the American Accounting Association™s
Annual Meeting (Sarasota, FL:AAA, August 1978), pp. 245“246.
Ibid., p. 249.
The Investors 105

investors. Thus, “since an enterprise™s ability to generate favorable cash flows af-
fects both its ability to pay dividends and interest and the market prices of its se-
curities, expected cash flows to investors and creditors are related to expected
cash flows to the enterprise.”22
Finally, the third objective of financial reporting relates to the enterprise™s fi-
nancial condition and operating performance. Investors need information on the
current and future financial strength of the corporation to appraise the soundness
of their investment. Such information is critical. Not only does it indicate the abil-
ity of the enterprise to meet its short-term and long-term financial commitments,
but it allows investors to evaluate their risk and return on investment. Furthermore,
investors need information regarding the uses of economic resources in the opera-
tions. Although the enterprise may have an adequate financial position, such a po-
sition may deteriorate because of poor operational performance. In short, investors
want financial information on the use and disposition of the enterprise™s economic
resources in order to assess their investment policy.23 More recent developments re-
garding investors™ need for financial information are discussed later in this chapter.

Role of the Audit Committee
In order to discharge their responsibilities in the area of financial reporting effec-
tively, the audit committee should establish operational objectives.24 The opera-
tional objectives should be based on the investor™s need for financial accounting
information, which is manifested in the board of directors™ stewardship account-
ability. Such operational objectives should be consistent with the FASB™s objec-
tives of financial reporting, because the primary purpose of the committee is to
provide assurance regarding the usefulness of the accounting information in the fi-
nancial statements.
Moreover, in addition to the quantitative representations in the financial state-
ments, the committee should use the following qualitative characteristics to assess
the financial reporting policies and practices of the corporation:

The qualitative characteristics of financial statements, like objectives, should be
based largely upon the needs of users of the statements. Information is useless unless
it is relevant and material to a user™s decision. Information should be as free as pos-
sible from any biases of the preparer. In making decisions, users should not only un-
derstand the information presented, but also should be able to assess its reliability
and compare it with information about alternative opportunities and previous expe-
rience. In all cases, information is more useful if it stresses economic substance
rather than technical form.25

Financial Accounting Standards Board, Statement on Financial Accounting Concepts, No. 1, p. 19.
For further discussion, see SRI International, Investor Informational Needs and the Annual Report
(Morristown, NJ: Financial Executive Research Foundation, 1987).
For further discussion on the director™s role in reviewing financial information and management™s
statements, see Chapters 10, 13, and 14.
American Institute of Certified Public Accountants, Report of the Study Group on the Objectives of
Financial Statements (New York: AICPA, 1973), p. 60. For further discussion, see Financial Account-
ing Standards Board, Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics
of Accounting” ( Stamford, CT: FASB, May 1980).
106 The External Users of Accounting Information


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