The words were direct, hard-hitting and memorable. So memorable, that – 15 years on -- several veteran rulemakers in accounting and accounting academics cited the speech as one of the most important addresses on the craft in which they’ve worked or taught.

“I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting.  Managing may be giving way to manipulation. Integrity may be losing out to illusion.

“Many in corporate America are just as frustrated and concerned about this trend as we, at the SEC, are.  They know how difficult it is to hold the line on good practices when their competitors operate in the gray area between legitimacy and outright fraud.

“A gray area where the accounting is being perverted, where managers are cutting corners, and where earnings reports reflect the desires of management rather than the underlying financial performance of the company.”

The speaker was Arthur Levitt Jr., the longest-serving chairman of the Securities and Exchange Commission. The date was Sept. 28, 1998. The occasion:  an evening in the capital of world capital to mark the creation of NYU’s Center for Law and Business.  The words – aimed at dubious practices in a complicated profession – were not very complicated. In fact, they were bluntly spoken, and probably not too welcome to some in the audience of corporate financial executives and CPAS, for which they were intended.

However, a CPA and future rulemaker was in the room and didn’t seem to mind. “It was a strong, on-point speech at the time,” that veteran of accounting and standard-setting told me in an interview 15 years and two days after Levitt delivered his message on earnings management and “accounting hocus-pocus,” plus an “action plan.” The action plan included work to promote auditor independence and more effective audit committees, as well as guidance-writing tasks for the SEC and the Financial Accounting Standards Board.   

After Levitt’s 1998 speech, some substantial improvements were made in GAAP and regulations over the next few years. Self-regulation for auditors to help guarantee their independence -- tried in the form of the short-lived Independence Standards Board – failed amid SEC dissatisfaction with the results.

And in late 2001, Enron Corp. melted down, followed some eight months later by the spectacular wipeout of WorldCom. Both scandals led to criminal prosecutions, and to passage of the Sarbanes-Oxley reform law. The law featured the creation of the Public Company Accounting Oversight Board, to govern auditing and auditors, and a more independent FASB. For the latter, revenue for its operations no longer would be drawn from contributions from those who applied the rules that the board wrote.

A Tougher, Simpler Message.  

“Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common-sense business practices. Too many corporate managers, auditors and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation.”

In his 2002 memoir, written with Paula Dwyer, Levitt recalled the period after FASB retreated on stocks options expensing in 1995. That “surrender” was spurred directly by the SEC chief’s warning to the board in Dec. 1994 that the agency would not enforce the standard as it had been proposed, to require that stock compensation awards would be reflected in net income. (“In retrospect, I was wrong,” Levitt wrote. “I know the FASB would have stuck to its guns had I not pushed it to surrender. I consider this my biggest mistake as SEC chairman.”)

“Over the next several years, a succession of SEC chief accountants --Walter Schuetze, Mike Sutton, and Lynn Turner -- would warn me that they were seeing a marked increase in corporate numbers games,” the SEC chairman wrote in his book. Turner, who was present at the creation (or at least part of it) of the speech, described the significance of Levitt’s hard-hitting remarks. There was a desire to offer a tough message that would be delivered straight and simply.

“It proved to be very accurate in articulating the serious shortcomings of accountants and auditors, as soon thereafter demonstrated by the corporate scandals and the huge losses suffered by investors,” Turner told me.

The speech led to a number of changes, “including changes in how companies accounted for some of the largest items in their financial statements,” the former SEC chief accountant wrote in an e-mail message. One resulting shift was in how companies “determined a most important item – materiality,” Turner added.

Finally, Turner recalled what he views at the most memorable thing about the speech: a Washington regulator being able to enlist people from a broad range of groups and professions to contribute to “fixing what was wrong.” That has become a rare thing, he suggested.

Five “Accounting Gimmicks.”

 What Levitt listed as “five of the more common accounting gimmicks” seems to be what some veteran standard-setters and academics recall most easily today about the speech. The five are “big bath” restructuring charges, “creative acquisition accounting,” “cookie jar reserves,” “ ‘immaterial’ misapplications of accounting principles,” and the premature recognition of revenue.

The SEC chairman said of the dubious habits of reserving: “A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty losses. In doing so, they stash accruals in cookie jars during the good times and reach into them when needed during bad times.”

Some of the “gimmicks” and accounting issues which Levitt targeted, along with the auditor independence issues, have been cut or resolved in the 15 years since he gave his landmark speech. Business combinations accounting was improved markedly with the issuance of new FASB standards in 2001. New rules on revenue recognition – long in the making [see my previous blog report] – are being prepared for issuance in coming weeks.

 Meanwhile, professors of accounting, both full-time and adjunct, have told me they still guide their students to Levitt’s plain-spoken speech of 1998. “It was and still is probably the most widely distributed speech used in business schools,” according to Turner.

The speech included the following, written a decade before the financial crisis damaged the reputation of U.S. corporate reporting:

“Today, American markets enjoy the confidence of the world. How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?”

• By Steve BurkholderStaff Correspondent, Bloomberg BNA

         [In a forthcoming blog report, other notable speeches on accounting]