Speech by SEC Staff:
"The Future of Financial Reporting":
Remarks at the Leventhal School of Accounting
SEC and Financial Reporting Institute
Scott A. Taub
Acting Chief Accountant
U.S. Securities and Exchange Commission
Los Angeles, California
June 8, 2006
Good morning. I want to thank Professor Holder and Dean Beatty for again giving me the chance to speak at this conference. It's an honor to lead off a schedule that includes presentations and discussions from so many luminaries in the financial reporting world.
We will no doubt hear during this conference about a number of recommendations on how to make improvements to financial reporting, and about some of the work that is currently being undertaken in an effort to make these improvements. But perhaps as a framework for the discussions I expect will occur later today, I'd like to spend the next few minutes not on specific recommendations for changes in standards or rules, but instead on five suggestions regarding the way we think about and approach financial reporting that can have a pervasive effect on the quality of reports. I believe that if we are able to think about these issues in ways that allow and encourage transparent reporting, we'll drive down errors and the costs of reporting, while making things easier for investors to understand.
Before I get too far into this, however, I need to remind you that my words are my own, and do not necessarily reflect the views of the Commissioners or my colleagues on the SEC staff.
1. Allow Accounting Standards to Focus on Transparency of Information
I'm sure that Chairman Herz would agree that there are a number of areas of accounting in which standards could be improved in order to generate more transparent accounting, and of course, the SEC staff suggested a few of those areas in our June 2005 Off-Balance Sheet Report.1 The FASB is committed to improving standards in the interests of providing better information for investor decision-making. But the FASB's job is often made more difficult when constituents take positions on projects based on considerations other than whether the proposals will produce high-quality financial reporting.
To facilitate the improvements that will make our markets even stronger, we need to support changes in standards that improve transparency - changes that will result in financial reports providing better information, or clearer information, or information that is easier to understand. Now don't get me wrong - I'm not suggesting that the difficulty of implementing a standard shouldn't be considered. Indeed, if a standard is very difficult to implement, it likely won't result in transparent information in financial statements.
Too often though, compromises in standards are caused by concerns over something other than the ability to provide accurate and useful information. For example, I have heard representatives of audit firms push the FASB staff towards detailed rules, because such answers carried less litigation risk in comparison to more principles-based positions that could provide better information. Also, the SEC staff has sometimes pushed for particular guidance in standards in an effort to curb the potential for abuse. These efforts have generally failed, as those intent to abuse seem to find a way to do so despite our best efforts, and in some cases the resulting standards have been weaker for the attempt.
And, of course, many standards include compromises that are intended to allow the reporting of economic events to be deferred or that simply allow certain effects not to be reported at all. We've seen plenty of debates in this area in regards to stock options and leases. And we're beginning to see some of the same as the FASB begins to address defined-benefit pension accounting. About 33 years ago, one of my predecessors in the Chief Accountant role, Sandy Burton, said:
If on the basis of realistic economic data investors would require a greater return on capital, it is not desirable to coax them into an investment on the basis of defective measurements. I have heard … from others, the argument that showing the truth would cause higher costs…or what have you…I don't believe this is adequate justification either morally or economically for falsehood in financial statements.2
His thoughts are still correct today. For reporting to improve, we all need to be committed to accepting standards that choose transparency over predictability, relevance of information over precision of calculation, and investor needs over those of management, regulators, or others.
2. Apply the Standards, Don't Abuse Them
Writing the accounting standards with a focus on promoting transparency is a good start, but in order to achieve the objectives of the standard, it must be applied in the spirit in which it was written. That doesn't mean that one needs to get into the head of the standard-setter in order to properly account for transactions. But it does mean that we need to recognize that the FASB writes standards that are intended to be applied by people who are trying to accurately report the effects of transactions.
You've heard me and others speak about the problems that come with transactions that are intended to result in financial reporting treatment that is inconsistent with the economics of the transaction. I always use FAS 150 as an example in this area, and I'll do so again. The intent of FAS 150 with respect to writing puts on your own stock is pretty clear. If the counterparty of the instrument is in a position where they make money if the company's stock goes down, the counterparty isn't an equityholder, and the company should treat the written put as a derivative liability. Yet I've seen companies seek to replicate the economics of writing a put without liability treatment. Clearly, this violates the intent of the standard.
Synthetic leases are a common example of a structure that uses the leasing literature in a way that wasn't intended. The lessee guarantees or purchases insurance to cover virtually all of the risk of loss of value of the leased property, and yet operating lease treatment is used.
These examples point out that there are numerous instances of standards being applied to situations they clearly weren't written for, in ways that clearly weren't intended. Yet managers and auditors continue to sign off on the accounting for these transactions, even without disclosures regarding what was done. The mindset seems to be that it's the FASB's fault for not writing foolproof standards; or that until and unless the SEC catches it and stops it, it's OK. Again, that's not the framework in which the standards are written.
Sometimes when I talk about accounting-motivated transactions, those I speak to raise the concern that it is difficult to identify the accounting-motivated structures. But I don't think that's the case at all. I believe that a knowledgeable accounting professional knows when he or she is "abusing" the literature instead of applying it in the manner it was intended - and it is those abusive situations that should be ended.
3. Professional Judgment is Necessary to High-Quality Reporting
Judgment is a necessary part of preparing financial statements, auditing them, and, for regulators like the SEC, reviewing them. We have seen already what happens if we try to provide step-by-step guidance for every transaction - we get hundreds of pages of literature that make it difficult for practitioners to be comfortable that they are considering all of the appropriate pronouncements, and we fuel the need for even more interpretations of interpretations. Instead, the standards and regulations should provide objectives and principles, as well as guidance to help understand and apply the principles in context. The SEC staff has, of course, written at length about this in our 2003 report on objectives-oriented accounting standards.3
I've spoken recently about the importance of applying judgment, and some of the responses have surprised, and even shocked, me. Some have responded by telling me, on little question cards like the ones you have in front of you, that they refuse to apply judgment because doing so will put them at risk of being second-guessed. Others have stated that in the environment we are in now, expecting people to apply judgment is a fantasy. And others have suggested that the way the SEC staff enforces accounting standards, including those that include bright lines, indicates that we aren't serious about wanting people to apply judgment. Well, now is as good a time as any for me to respond, so if you're about to send up a card with a similar refrain, wait a minute or two and see if you still need to send it up.
First of all, I will admit that the SEC staff does believe that bright-lines in the standards ought to respected - not necessarily because we like them, but because it seems appropriate to apply the standards that exist, as opposed to the ones we might wish existed. The process around setting standards and regulations exists to ensure appropriate opportunity for input and deliberation - ignoring the output of that process on a case-by-case basis with no public input or deliberation seems at best inappropriate. So we will ask you to capitalize the lease even if you just barely went over the 90% threshold. And we won't accept application of short-cut accounting when you've met all but one of the criteria necessary to be scoped into that method. On the other hand, we won't ask you to capitalize a lease because it has minimum lease payments equal 89% of the fair value of the leased asset, even if we do think that would be better accounting, and we won't object to the application of the short-cut method if you do meet all the criteria, even if it's clear that some ineffectiveness is ignored. But to suggest that this means the SEC doesn't really respect judgments is taking it too far. Ignoring the guidance in the standard isn't a "use of judgment", it's violating GAAP. If the guidance is bad, let's use the process and change it, rather than selectively deciding when to apply it and when not to.
However, while bright lines exist in many areas, there are plenty of places where the accounting literature calls for the application of judgment. Curiously, in those instances we find sometimes that there are those who want to create bright lines that FASB did not. Last year a big flap occurred over an EITF consensus related to evaluating whether impairments of financial assets were other than temporary. The consensus had no bright lines in it and called for the application of judgment and evaluation of the available information. Nonetheless, after the consensus was issued, discussion centered on a "tainting" notion in which a company that sold a security at a loss without previously recording an impairment would be deemed incapable of forming an intent to hold other impaired securities until recovery. The consensus didn't say anything like this; the SEC staff indicated that such a tainting notion was inappropriate. But it remained at the top of everybody's minds, and the consensus was eventually withdrawn because it was obvious that a bright line was going to be applied even though the standard didn't have one.
When the literature says to use a best estimate, or to consider all available information, or to assess the likelihood of something occurring, those are all cues to use judgment, and preparers and auditors need to be comfortable doing just that if we're to get useful reporting. And perhaps most importantly, when a transaction arises for which the literature is unclear, which is bound to happen time and time again, the application of good professional judgment is needed to determine an appropriate accounting model. Don't twist the facts to allow an analogy to the accounting that is seen as preferable, and don't look for the answer that seems the "safest". Being a professional means seeking the treatment that provides the most transparent accounting for the transaction.
Many have blamed the SEC in large part for the current state of affairs, suggesting that our actions raise the fear of being second-guessed to the point where people just don't want to leave open that possibility. I continue to try to do something about that. We obviously shouldn't be objecting to well-founded, reasonable judgments that are made within the context of the existing accounting literature. But we often see biased and unprincipled accounting improperly described as "the application of judgment." And of course, we should object to that when we see it. Another of my predecessors as Chief Accountant, Andrew Barr, explained this quite well, back in 1963:
The acceptability of "judgment" and "estimate" in accounting does not extend to willful or wishful expedience …The estimates and judgments must have a rational basis under the circumstances, that is, justification stronger than self-seeking arbitrary choice and stronger than a desire to have accounting figures show what one wishes them to show.4
Preparers and auditors need to be professionals and make the necessary judgments to ensure high-quality reporting. And so long as those judgments result in transparent reporting, they are unlikely to raise concerns that would cause us to object.
4. Go Beyond the Minimum Disclosure Requirements if it Helps Users
I have a slide that I use when I do presentations that says "Financial Reporting is a Communication Exercise, Not a Compliance Exercise." And a recommendation along those lines is included in the SEC staff report on Off-Balance Sheet Arrangements that I mentioned earlier. Too often though, the attitude seems to be that if a disclosure isn't explicitly required, then there's no reason to make it. I have actually heard of an executive of a company suggesting that there wasn't a disclosure violation in regards to backdating of stock options, because the executive compensation rules don't specifically require disclosures about backdating. And I constantly hear people cite the fact that key performance indicators aren't in SEC reports as evidence of a deficiency in the standards or rules. This is even though there is nothing to stop companies from disclosing those key performance indicators voluntarily - not many of them do it. So why is it that so many seem to be content to limit the things they disclose to those things that are explicitly required? It shouldn't be that way. Management knows best what the key measures are of the health or performance of the business - why not give that information to investors?
Let's face it -- there is no way the SEC and FASB can write standards and rules that comprehensively list all of the disclosures that might be important to investors. Indeed, attempts to do that are likely to contribute to confusion, complexity, and disclosure overload. We will be much better off if, instead of only disclosing what is specifically required, companies disclose the key information, whether a specific requirement to disclose that piece of information exists or not. If this happens, quality of disclosure will improve without any new regulatory burden.
5. Accept Diversity in Practice and Deal With It Transparently
The first time I was ever quoted in the mainstream media was about six years ago, and the quote was "The line is very fuzzy." Literally, that was my first quote. My parents were proud - I was embarrassed. I'm sure I said many more intelligent things to the reporter that day, but somehow it was the comment about a fuzzy line that made the story.
The second time I was quoted, though, was much better - it was something like "Having two companies account for the same transaction in different ways is not good for investors". I was proud of that quote, as it seems quite logical. If you do the same thing as your competitor, your accounting for it should be the same. But the longer I stay at the SEC, the more I see that striving for complete consistency is not always in the best interests of the market. It is in part the desire for consistency that has led to the rules that pervade our accounting model. If you want consistency, hard and fast bright lines are awfully attractive.
If we're going to be comfortable in a structure with less rules, reliance on principles and objectives and the application of professional judgment, it follows that we must also be comfortable with two companies with the same facts making different judgments on the best accounting. It's clear that diversity in practice can develop without any ill intentions by anybody involved.
I know that there is often a concern that SEC staff will not accept diversity. That isn't true. We don't object to a company's interpretation and application of generally accepted accounting principles simply because it is different than another company's interpretation. Anecdotally, I can tell you that on a number of occasions recently, my office has been taken to task by issuers and auditors because we accepted an interpretation that these constituents believed we should not have accepted. That's fine -- we should have to answer for the decisions we make, and I am far more comfortable accepting two reasonable interpretations of the literature than choosing amongst them with little time for discussion or analysis.
That being said, we do expect companies to explain to investors the practices they have chosen and why they chose those practices. And we will not hesitate to ask an issuer to disclose when its policies are different from those used by comparable companies for similar transactions, and how the decision regarding the policy affected the financial statements. Disclosures like this are needed to allow diversity in practice to exist while still ensuring investors can understand the information presented to them. Differing treatments that are explained can provide investors with good information and insight.
In the event that the diversity in practice becomes troublesome even with appropriate disclosures, new guidance from the standard-setter might be needed, and the FASB has shown a willingness to provide guidance in those situations.
Making it Happen
So that's it - five changes in the way we think about financial reporting that will help propel improvements. They'll allow us to make financial reports more transparent and informative, easier to prepare and easier to audit. But, as you know, this kind of change is a lot harder than changing an accounting standard or a disclosure rule. Let me share with you, however, some of the suggestions that we've heard and some of thoughts that I have in this regard.
First, I want to acknowledge some recommendations that were made by the SEC's Advisory Committee on Smaller Public Companies. The Committee recommended a sort of safe harbor that would "protect well-intentioned preparers from regulatory or legal action when a prescribed process is appropriately followed and results in an accounting conclusion that has a reasonable basis." The Committee also recommended that the SEC "consider additional guidance…with respect to materiality related to previously issued financial statements." And, of pertinence to many of the issues I've discussed, the Committee recommended that the SEC "Formally encourage the FASB to continue to pursue objectives-based accounting standards."
Speaking only for myself, I believe that each of these recommendations is worthy of consideration, and that they are, in fact, generally consistent with the way we practice and operate at the SEC. As I stated earlier, I have no desire to take regulatory actions against those who have made reasonable conclusions, which is part of the request the Committee makes in the safe-harbor recommendation. And regarding materiality, we have been talking to various parties, including representatives of industry and large auditing firms, regarding what kind of additional guidance might be helpful. While some have suggested things I believe are inappropriate, such as setting a specific quantitative threshold that would determine materiality, others have asked for guidance in areas like the ones in the Committee's recommendation, and I believe further discussions may prove fruitful on those issues. And finally, with respect to objectives-based standards, I know that Chairman Cox and others at the SEC have expressed support for moving in this direction. The fact that the Committee felt the need to make these recommendations despite the fact that we're already moving in the directions they suggest tells me that perhaps making our actions more official, as it were, might serve to ease minds, and move things in the right direction.
We've also been asked to be more open to companies contacting the SEC and asking advice or help in determining the accounting for particular transactions. I would tell you that we are extremely open to such inquiries. The process for submitting an issue to my office for consideration is clearly explained on the SEC's internet site. And we have a member of the Office of the Chief Accountant on call every day to field telephone inquiries - sometimes the on call accountant can answer a question right away, and other times we need more information. Either way, we'll take your submission, your views, your time, and your explanations seriously. So if you are in a position where you are considering the accounting for an important transaction, and you feel you have made a reasonable judgment to get to transparent accounting, but have some concern about the second-guessing issue, come talk to us.
No doubt there are other actions that we could take that might be thought to make participants in the financial reporting process more comfortable in their work, in making the judgments that need to be made, and in providing transparent information to investors. Do you believe we should talk more in public about the kinds of questions we're getting? Or is it better that we talk less? Should the SEC staff make our views on FASB projects known publicly, or should we refrain from doing so to preserve the FASB's independent process? Are there things about the way auditors conduct their work that we should seek to change? Are there parts of our disclosure rules that discourage, rather than encourage, full and fair disclosures?
We're thinking about all of these questions and many more as we try to find the right way to improve financial reporting, and I hope I can count on some of you to be part of that process. I appreciate your attention, and look forward to your questions, and your suggestions. Thank you.