Online Extra: Q&A: Words of Warning from the SEC

Securities & Exchange Commission Chairman Harvey L. Pitt, in office since August, has focused on companies' financial reporting as one of his top priorities for overhaul. He spoke to BusinessWeek Senior Correspondent Mike McNamee about the pitfalls investors face with "pro forma" earnings -- and the perils for companies that use shaky numbers to mislead. Here are edited excerpts of their conversation.Q: Companies have created a raft of new ways to present their financial results -- pro forma statements, operating earnings, and the like -- that don't conform to the standards of generally accepted accounting principles (GAAP). Is this a problem?A: Pro formas are an area of enormous concern to me. First, they're not prepared according to GAAP. Second, there is no comparability. Even if all other things were equal -- and they're not -- since different companies apply pro forma disclosures in whatever way moves them, pro formas raise significant problems.

Without appropriate disclosure, no investor -- certainly not any ordinary investor -- can read these in a way that's useful. An investor can't know what's been left out, why it's left out, or how it compares [with other companies' earnings].Q: Are there legitimate reasons for companies and investors to turn to pro formas and other alternate measures of earnings?A: Companies are concerned that they can't communicate effectively what happened, and is happening [using GAAP financial statements]. Shareholders confronting these cumbersome materials are looking for a clearer way to understand what's happening within companies. GAAP, even if it's done perfectly -- perhaps especially if it's done perfectly -- is not going to give the ordinary investor the kind of insight that's desired into company performance. GAAP itself raises, in my view, serious comprehension issues for ordinary investors.Q: So you're not happy with standard financial statements, either.A: The quality of financial reporting leaves a great deal to be desired. Even if there were no issuer problems, the information is not timely -- it's stale when investors get it. Worse, it's impenetrable.

We need to keep the system we have, which is the best in the world, but find ways to communicate that are clear and comprehensible. Improving this is clearly going to require a considered effort, a partnership between investors, companies, and accountants. The commission has a lead role to play. [SEC Chief Accountant] Bob Herdman is starting that work in consultation with investor and accounting groups. We need a system that is understandable, but not so simplistic that it distorts what the real information is.Q: Your predecessor [former SEC Chairman Arthur Levitt Jr.] made policing companies' accounting irregularities a top priority. Where is accounting enforcement in your regime?A: Notwithstanding anything else -- notwithstanding our desire to come up with something better -- the rules of the game as they presently exist still apply. Anyone who uses pro forma disclosure as a vehicle for misleading or obfuscating results will have to answer to us.

In my experience, in any economic downturn, there are always people who try to use [the economy as an excuse] to present a different picture of their actual results. They are tempted -- but those people would make an enormous mistake. We won't think twice. We will be able to move in, and move in quickly, if anyone tries to take advantage of this situation. Our Enforcement Div. is very much on the lookout.Q: But your speeches stress that the SEC wants a more cooperative relationship with accountants and companies. How does that fit?A: Bob Herdman and his staff are willing to be of assistance to companies when they face hard decisions about accounting. We're saying, "Come in before the problem arises." If issuers come in to talk to us beforehand, we, in good faith, will try to assist them. But if they go ahead and do it, they'd better get it right. If you're offered a helping hand, you either have to take it or accept the consequences of not taking it.Q: The SEC issued a report saying that companies that uncover financial irregularities, but cooperate with the SEC's investigations, may get credit, in terms of lighter penalties. Is this an amnesty?A: There's nothing in here about amnesty.

We believe that the most effective enforcement tool is self-policing and self-restraint. But that only works if companies have a sense that, if they have made a mistake, they can come in and discuss it, and not immediately be thrown to the wolves. If you come in and talk to us, and take steps to remedy the mistake, we will give you credit. We haven't said there will be credit in every case, or what credit we'll give.

No one should assume they can act with impunity toward the public, and damage investors, and then make it all better by confessing. Confession is good for the soul, and it is a necessary element, but it's not sufficient. We'll be looking for a real effort to repair any harm, to make sure it doesn't happen again. If senior management is behind the problem, that is a very serious impediment to receiving any credit.

This is not going to be a good program for anyone who has deliberately violated the law. They are not going to find us a kinder and gentler SEC.Q: So enforcement against accounting problems is still a top priority?A: We have not changed any priority, but we have changed the way we proceed. I've talked about "real-time enforcement." If it takes us five or six years to ferret through what happened [in a company's books] and eventually address the potential wrongdoing, in my view, we have helped virtually no one. We want to move with alacrity, warn investors, and put a stop to improper conduct while it's still going on. Our goal is to act in time to actually do somebody some good.

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