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Need for a New Financial Reporting Rating System

In the continuing discussion over corporate accounting abuses, poor board governance and low investor confidence, very little attention has been paid to the quality, transparency and completeness of financial reporting in corporate 10-Ks, 10-Qs and proxies – the mainstay of US financial corporate reporting. While the Securities and Exchange Act of 1934 spells out the reporting requirements and what should be covered, in reality, there is a wide discrepancy in actual practice because of gaps in the manner and extent of the actual reporting which is left to each company’s interpretation. RateFinancials’ philosophy is to let the companies’ public reports speak for themselves. Our analysts do not speak with the companies’ management. We rate the actual reporting.

One of the main problems is that neither the SEC nor the research analysts critically review company reporting. As we have learned, post-Enron, only a small handful of companies’ financial reporting is reviewed by the SEC staff, e.g. less than 20% of the 10-Ks are reviewed annually. Many research analysts have told us that with the heavy workload of having to cover too many companies, they often will not read all of the 10-K’s, 10-Qs, proxies, etc. issued by the companies they cover.

There is a pressing market need and demand for rating and ranking corporate reporting because, over the past ten years, we have witnessed a continuing series of corporate abuses, conflicts of interest, fraudulent and aggressive accounting practices, and inflated financial statements that have caused a market loss of several trillion dollars. These practices were supplemented by numerous examples of senior corporate officers engaged in unlawful behavior and corrupted by conflicts of interest, self-dealing and corporate malfeasance. In addition, this behavior was aided by the unprofessional practices at the major accounting firms and by the lax and under-funded supervision by the Government’s regulatory agencies. Market credibility was further damaged by the unlawful practices and numerous conflicts of interest created by the leading investment banking firms and their analysts, who continued to recommend purchase of stocks that were known to have major problems at the time they were recommended.

The underlying issues that have caused these problems stem mainly from:

1. Aggressive and Fraudulent Accounting Practices

- Revenue recognition issues – inflating/deferring
- Reducing, shifting or capitalizing expenses
- Adoption of aggressive accounting policies –
  impacting revenue and earnings – which
  involved revenue, expenses, reserves,
  inventories, stock options, pension plans,
  tax deferrals, investment gains, etc.
- Poor reporting disclosure practices pertaining
  to footnotes and accounting policies
- Non-expensing of stock options
- Misuse of pro forma accounting
- Using pension plan gains to inflate earnings

2. Poor Board Governance
- Poor board governance affecting the
  independence and performance of the Boards
  of Directors, Audit, Compensation and
  Nominating committees
- Inability of Audit Committees to properly
  monitor, control and evaluate their companies’
  financial reporting, aggressive accounting,
  degree of risk, performance and results of
  the audit
- Examples of senior corporate officers, who have
  resigned under pressure, and were allowed to
  receive outrageous compensation while their
  companies’ stocks declined significantly
- Inability of directors to detect and/or evaluate
  any related-party transactions to insure that
  companies are avoiding conflicts of interest

3. Reduced Role and Funding for the SEC

4. Problems with Using and Understanding the Limitations of GAAP

5. Inability of the FASB to Tighten its Standards

As a collective result of these practices, investors’ confidence has been lost both in the financial reporting of public companies and in the accounting firms that audit them. RateFinancials’ system of rating and ranking financial reporting should establish new standards for corporate public reporting, accounting practices and governance. For institutional and retail investors, this will offer substantial benefits and restore confidence in the reporting.

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