Disclosing Corporate Finances to Reduce Risks to Investors
Created as a response to crisis, the United States’ system of corporate financial disclosure was cobbled together in 1933 and 1934 as a pragmatic compromise. Millions of Americans were left holding worthless securities when the stock market crashed in October 1929. By 1932, the value of stocks listed on the New York Stock Exchange had fallen by 83 percent.
Congressional hearings revealed patterns of inflated earnings, insider trading, and secret deals by J. P.Morgan, National City, and other banks, hidden practices that contributed to the precipitous decline of public confidence in securities markets. Echoing Louis D. Brandeis’s declaration that “sunlight is...the best disinfectant,” Franklin D. Roosevelt, the nation’s newly elected president, championed legislation to expose financial practices to public scrutiny.
The Securities and Exchange Acts of 1933 and 1934 required that publicly traded companies disclose information about their finances in standardized form in quarterly and annual reports. Congress also authorized the newly created Securities and Exchange Commission (SEC) to issue uniform accounting standards for company financial disclosures. To gain support for a workable compromise, the disclosure requirements excluded banks, railroads, and many companies. Felix Frankfurter, Roosevelt’s senior adviser on the legislation, called the Securities Act a “modest first installment” in protecting the public from hidden risks.
Later crises strengthened disclosure requirements. In the 1960s, the scope of disclosure was broadened when an unprecedented wave of conglomerate mergers followed by a sudden collapse of their stock prices created pressures for better information. Congress responded in 1968 with the Williams Act, which required disclosure of cash tender offers that would change ownership of more than 10 percent of company stock; Congress strengthened the law two years later by lowering the threshold for reporting to 5 percent and adding disclosure of product-line data.
In 1969 and 1970, the Accounting Principles Board, an outdated instrument of accounting industry self-government, was replaced with the Financial Accounting Standards Board (FASB) as one way to improve investors’ confidence in the disclosure system. The new private-sector board had authority to set accounting standards and featured broader representation and funding, a larger professional staff, and a better system of accountability. Over time, the board substantially tightened accounting standards.
In the late 1970s, congressional investigations raised new questions about FASB’s domination by big business. In response the board opened meetings, allowed public comment on proposals, provided weekly publication of schedules and decisions on technical issues, framed industry-specific accounting standards, analyzed economic consequences of proposed actions, and eliminated a requirement that a majority of its members be chosen from the accounting profession.
Over the years, other crises broadened the scope of disclosure and improved the accuracy and use of information. In 1970, for example, after 160 brokerages failed, Congress required new disclosures from broker-dealers concerning their management and financial stability. In 1977, Congress broadened transparency in response to publicity about bribes and illegal campaign contributions by corporate executives, requiring companies to maintain new accounting controls that assure transactions were management-authorized to discourage illegal transfers. Lapses in management in some of the nation’s largest corporations led the SEC to issue rules in 1978 and 1979 that required new disclosures concerning the independence of board members, board committee oversight of company operations, and failure of directors to attend meetings. In the 1990s, increases in individual investing and the rise of online investing led the SEC to adopt “plain English” disclosure rules, which required prospectuses filed with the agency to be written in short, clear sentences using nontechnical vocabulary and featuring graphic aids.
The sudden collapse of Enron Inc. in December 2001 once again created a crisis/response scenario that generated pressures to improve corporate financial reporting. Shareholders lost their savings and employees lost retirement funds when the nation’s largest energy trader filed for bankruptcy.
Enron’s collapse pointed to systemic problems with the United States’ most trusted public disclosure system. The SEC charged executives of Waste Management, WorldCom, Adelphia Communications, Tyco International, Dynergy, Safety-Kleen Corp. and other large companies with a variety of offenses related to withholding information from the public. Executives of Enron, WorldCom, and other large companies were indicted for fraud and other offenses. Ten large investment firms settled with the SEC, the New York State attorney general, and other regulators for permitting improper influence of their research analysts by their investment banking interests. Arthur Anderson, Enron’s auditor, was charged with obstruction of justice for destroying auditing documents, a blow to the firm’s reputation that drove it out of business. Evidence of collaboration by accounting firms that also earned huge consulting fees, stock boosting by analysts, and inadequate oversight by company boards, as well as a declining stock market, once again called into question the integrity of the corporate financial disclosure system.
The systemic problem was that the disclosure system had failed to keep pace with changing markets. After the fact, in a 2002 report titled "Protecting the Public's Interest," the General Accounting Office (GAO) concluded that "changes in the business environment, such as the growth in information technology, new types of relationships between companies, and the increasing use of complex business transactions and financial instruments, constantly threaten the relevance of financial statements and pose a formidable challenge to standard setters....Enron’s failure...raised...issues...such as the need for additional transparency, clarity, more timely information, and risk-oriented financial reporting."
By 2002, another round of disclosure reform was under way. Public companies, accounting firms, stock exchanges, analysts, and other participants in securities markets all made voluntary changes. On July 30, 2002, President George W. Bush signed into law the most far-reaching reforms of financial disclosure since the 1930s. The Sarbanes-Oxley Act, sponsored by Senator Paul Sarbanes (D-Md.), senior Democrat on the Senate Banking Committee, and Representative Mike Oxley (R-Ohio), chair of the House Financial Services Panel, created a new agency charged with watching over the accounting watchdogs.
The private, nonprofit Public Company Accounting Oversight Board, consisting of five members appointed by the president and a staff of five hundred, was authorized to establish auditing standards, monitor accounting firms’ practices, and fine them for improprieties.
The law also limited consulting services that auditors could offer to corporate clients and required rotation of partners assigned to corporations every five years. It established new criminal penalties, including twenty-five-year jail terms for securities fraud and twenty-year terms for destroying records. It required chief executives and financial officers to certify financial reports and required that material changes in financial condition be disclosed immediately in plain English. It also established a restitution fund for wronged shareholders. In what would become the law’s most controversial provision—because of its high cost, as its requirements were translated into new demands on companies by outside auditors—section 404 held managers responsible for maintaining adequate internal controls over financial reporting.
In other disclosure reforms, the SEC required public companies to file annual and quarterly reports more quickly (generally annual reports within sixty rather than ninety days after the end of the year and quarterly reports within thirty-five rather than forty five days after the end of the quarter). New disclosure rules also required expensing of stock options, fuller financial disclosure by mutual funds, and more information about executive pay.
The accounting scandals of 2001 and 2002 also led to new ideas about making financial reporting more useful to investors. A GAO forum on Governance and Accountability, convened in December 2002, noted that the model of financial reporting had not changed since the 1970s and was “driven by the supply side...accountants, regulators, and corporate management and boards of directors.” The GAO suggested layering reporting to give users the information they needed and encouraging “demand-side,” user-centered disclosure reforms. In an interesting complementary effort to improve the capacity of information users to understand financial information, Congress also approved the Financial Literacy and Education Improvement Act, which created a commission to develop a national strategy to promote financial literacy. The new law responded to research that suggested that many Americans lacked the knowledge needed to make informed financial judgments.
Another challenge to the nation’s most mature disclosure system arose as investors increasingly sought information about public companies’ environmental, social, and governance practices (often referred to as ESG practices). Asset managers responded to those interests by creating portfolios that emphasized those practices. By 2020, more than three-quarters of Fortune 500 companies issued voluntary reports on environmental or social aspects of their businesses. European regulators also added diverse requirements, including, significantly, a 2022 European Union corporate sustainability reporting directive, applicable to most companies doing business in the EU.
By 2022, robust efforts were underway in the United States and internationally to standardize reporting so that investors could compare company ESG practices. That turned out to be a tall order due to the complexity of investors’ varied concerns and companies’ varied operations. In general, disclosure systems work best when directed toward a single factor that can be easily quantified. However, a variety of voluntary reporting regimes emerged, and private and public organizations rallied to improve metrics. Those organizations included the International Sustainable Standards Board, the International Organization for Standardization, the Business Roundtable, and many others.
In 2022, the SEC joined the effort to standardize reporting by proposing a new 490-page disclosure rule for greenhouse gases, including emissions from operations, energy purchases, and, when material, supply chain elements. That was a significant departure from past approaches. Traditionally, the SEC relied mainly on company judgments of what non-financial factors represented material risks and had to be reported. A number of interest groups protested that the proposed greenhouse-gas reporting exceeded the agency’s authority and promised court challenges.
Updated October 2022
This case study is drawn from Full Disclosure, Fung, Graham and Weil, 2007.
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