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Speech by SEC Staff:
Remarks before the 2004 AICPA National Conference on Current SEC and PCAOB Developments


Scott A. Taub

Deputy Chief Accountant, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 6, 2004

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Good morning. I'd like to thank the AICPA for the opportunity to again address this conference, which I've had the pleasure of doing now for six years in a row as a PAF, a partner with Arthur Andersen and Deputy Chief Accountant. I've been a Deputy Chief Accountant for a little over two years now, which really isn't that long, but it does make me the veteran of this group of senior officers in the office. During my two years, in addition to getting a new Chief Accountant and two new Deputy Chief Accountants, the OCA staff has grown tremendously. Our organization chart currently has 60 people on it, and we have about a half-dozen more slots to fill. Although Julie, Andy, and I all work together on various projects, my responsibilities generally fall in the area of accounting and disclosure, and approximately 20 professionals in OCA are focused in these areas. As some of you may know, as recently as about 3 years ago, 20 professionals were about all there was in OCA.

We've needed all of the new talent to keep up with what's been going on the financial reporting world in the past few years. In addition, we've been able to increase the time and effort we put into oversight of standard setting activities and ensuring consistent high-quality application of those standards. But we're also moving beyond those areas to consider other ways that financial reporting can be improved. Some of the proactive efforts are things we'd have liked to get into some time ago, but it is only now that we really have the time and resources to take them on. I'll mention a few of these items, and the OCA staff in the next section will hit a few more.

A Few Words on Where We Are Today

Before I get ahead of myself, however, and start talking about the things we'll be looking at in the future, I'd like to make a few comments about the recent past and the present. The past several years have been filled with constant changes. That has been true for us at the SEC, just as it has been true for all of you. Even though we have yet to see the bulk of the results of the internal control reporting requirements, I do think we've seen some significant improvements in many areas.

For example, members of senior management now spend more time on financial reporting then they did previously. The talent, thought, and expertise devoted to accounting has increased. And we are seeing signs that audit committee members are recognizing the importance of their enhanced role. The benefits of all of this, while intangible in some respects, should be pervasive on both internal and external reporting.

Auditors, too, are reacting to the changed environment in positive ways, showing more commitment to the public interest. I see audit firms refocusing on auditing and on technical accounting expertise, as opposed to selling work and building relationships. And firms seem to have greatly increased their willingness to say no to their clients when necessary. The work of the PCAOB should help to ensure these changes take hold, as opposed to fading away.

Notably, users of financial information have also increased their participation. The FASB's new User Advisory Committee gives users a direct way to provide input to the standard-setter. Several key users, including the major rating agencies, are evaluating and commenting on the quality of companies' public disclosures. And other users have stepped up their participation in the process through comment letters, by making their information needs known to company management and audit committees, and other activities. I hope that users will continue to organize and make their views known.

Standard-setters have also made changes. Both the FASB and IASB are looking to improve their processes, are taking up projects in areas that have long needed improvement, and are striving to write standards that include few bright lines and exceptions and emphasize objective and principles.

In summary, I have to say that I am encouraged by what I have seen recently. By now, I suspect that everybody in the audience is wondering when the other shoe will drop; when I will say something like "but we have more work to do"; when I'll start talking about what hasn't been going all that well. To those who have those thoughts, the answer is "Now". Because - like Don said -- we do have more work to do, and the status quo, although better then it was a few years ago, still isn't sufficient.

The Compliance Mindset

Over the years, many SEC staff members and commissioners have uttered the phrase "We are the investor's advocate." While that statement may sound trite by now, it does indeed drive our work. Last year, I said in my speech to this audience that I believe the purpose of accounting and financial reporting is to tell the truth, the whole truth, and nothing but the truth -- to explain what happened and why. While the SEC, the FASB and others have passed many rules, standards, and other guidance over the past 70 years, all are focused on communicating with investors and potential investors. In general, these requirements have done their job.

However, an unfortunate effect of the volume of requirements is that many accountants, lawyers, and others view financial reporting as a compliance exercise. That is not surprising in a setting that is rife with standards that lay out requirements, describe appropriate analyses, and prescribe the inclusion of certain information in reports. However, the focus on compliance has resulted in a setting in which the goal in some people's minds is to do what is necessary to comply with the rules, rather than to do what is necessary to communicate to investors. The compliance mindset manifests in many ways that trouble me, and I hope, trouble all of you as well. Until we move away from thinking of reporting as a compliance exercise, we face limits on the amount of improvement we can achieve, and in the amount of trust financial statements will deserve from investors.


Let me start with the accounting and disclosures regarding contingencies. As background, remember that FASB Statement No. 5 covers the accounting for contingent liabilities, and requires the recording of an accrual if payment is both probable and estimable.1 Moreover, Statement 5 requires disclosures of the nature of any material contingency, including the amounts that might be paid, if a loss is at least reasonably possible.2 In addition, the SEC's MD&A rules require discussion of items that might affect the company's liquidity or financial position in the future, including contingent liabilities.

Given these requirements, the recording of a material accrual for a contingent liability related to an event that occurred several years before should not be the first disclosure regarding that contingency. Rather, disclosures regarding the nature of the contingency and the amounts at stake should, in most cases, have already been provided. Disclosures should discuss the nature of the contingency and the possible range of losses for any item where the maximum reasonably possible loss is material. Vague or overly broad disclosures that speak merely to litigation, tax, or other risks in general, without providing any information about the specific kinds of loss contingencies being evaluated are not sufficient.

Furthermore, I should point out that Statement 5 and Interpretation 14 require accrual for probable losses of the most likely amount of the loss.3 While the low end of a range of possible losses is the right number if no amount within the range is more likely than any other, I find it somewhat surprising how often "zero" is the recorded loss right up until a large settlement is announced. Those who complain about the detailed nature of some recent accounting pronouncements need only look to the accounting and disclosure of contingencies that fall into the scope Statement 5 to see why standard-setters sometimes move to more detailed guidance.

Financial Instrument Disclosures

Contingencies are one area that the forthcoming SEC staff report on off-balance sheet transactions will likely touch upon. As everybody is aware, that report is one of the remaining tasks still to be completed pursuant to the Sarbanes-Oxley Act. Not surprisingly, the report also will look at the accounting and disclosure requirements related to financial instruments and certain off-balance sheet transactions. We had originally thought the study and report would focus on certain quantitative information that is required to be disclosed under the various FASB standards and SEC rules. However, as we began to gather information, a somewhat different issue came to the forefront. What we found was that even where disclosures seem to meet the minimum requirements, they are often disjointed, explain only pieces of transactions, are spread all over the filing, and do not actually tie out to the financial statements for various reasons. In short, the disclosures are often so hard to follow that it is difficult for readers to understand how they relate to the financial statements at all.

This appears to clearly be an area where the effort has been focused almost solely on complying with the related rules and standards, rather than attempting to communicate useful information to investors. I would encourage issuers and their advisers to think about ways it might be possible to relate the various disclosures to each other, and to the financial statements, so that they present a more complete picture of the risks and arrangements that affect the company, and the way those risks and arrangements have affected the financial statements. And if information that isn't specifically required by any rule or standard is nonetheless needed to complete the picture, disclose that information.

Improving Financial Reports

I do hope that improvements to financial instrument and off-balance sheet disclosures will occur without additional rules or guidance. However, if the quality of financial reports is measured only by compliance with the rules, it follows that financial reporting will wind up with a minimalist approach that does what is required by rules or standards, and rarely more. That results in a tendency to only make improvements when new rules or standards require those improvements. It's not a good idea to fall into that trap. Change that happens only when it is required by law or regulation tends to happen slowly, and in ways that don't necessarily work smoothly for every company. But there is no reason to only make improvements when the rules force them. With a bit of effort, just about any company's financial reporting can be improved.

To start with, everybody involved with preparing or auditing financial statements should think of the ways that those statements could be more communicative. Recent SEC rules provide some help in identifying those ways, because the rules require auditors to make audit committees aware of situations where management has chosen a less preferable method of accounting.4 There are a few things that, based on the accounting literature and what we see in filings, should be on just about every list. For years, US GAAP has stated a preference for the direct method of cash flows.5 Users have often indicated their preference for this method as well. And yet, virtually all companies use the indirect method for reporting cash flows. Similarly, virtually all (perhaps more than virtually all) companies choose to use one or more of the smoothing mechanisms allowed by FAS 87,6 even though many believe such methods allow for distorted reporting. None of those smoothing mechanisms are required by the standard. And these aren't the only examples that can be found by simply looking at the accounting literature.

While I'm confident that looking at accounting policies will allow many companies to identify ways that they can better communicate, it shouldn't stop there. Disclosures in footnotes and elsewhere in SEC filings provide for innumerable opportunities to give users important information. For example, I hear from user groups all the time that expense information by nature (that is, salaries, material purchases, depreciation, rent, etc.) would be a useful addition to the information by function (that is, cost of sales, selling expenses, etc.) that is generally presented. But very few companies present it. And what about disclosures of depreciable lives? How many are involved with financial statements that report ranges of depreciable lives that say something like "5 to 30 years". Wouldn't it be more helpful to disclose how much of the fixed asset balance is depreciated over 5 years, how much over 10, and how much over 30? And how much of Management's Discussion and Analysis is taken up with sentences that bear a striking similarity to "Sales increased 10.1%, while cost of sales increased only 9.2%, resulting in an improvement in gross margin from 15.1% to 15.3% of sales." Why can't all of that information be provided, if deemed important, in a table? Discussion should focus on the reasons for the changes. It doesn't take an extraordinarily long discussion to actually provide descriptive information that provides real insight. The recent SEC interpretive release on MD&A provides discussion of many ways that MD&A can be improved.

The point is that even without the help of the SEC or the FASB, improvements to financial reporting are possible. And many of them are not all that hard.

The Problem of Structured Transactions

Let me turn now to another significant issue that impairs the quality of financial reporting. One of the major hurdles the FASB faces is that the promulgation of an accounting standard is itself often a catalyst for the development of new transactions. Indeed, in many instances, the issuance (or even expectation) of a new standard triggers an immediate search to determine techniques to structure and/or restructure transactions to avoid reporting the very information sought by the new standard. Standard setters have sometimes responded to structuring efforts by refining and expanding the standards. However, this process leads to a vicious cycle, where restructuring of contracts and the creation of innovative new financial structures lead to revisions in GAAP, which are then followed by the creation of additional financial structures. Under this scenario, the detailed rules themselves come to provide a roadmap for avoiding their intent. This problem was highlighted in the SEC staff report on principles-based accounting standards7 last year, and by Andy Bailey a few minutes ago, as he stressed the importance of complying the spirit, and not just the letter of the standards.

It is no secret that there are many professionals engaged in developing and marketing financial innovations and strategies that assist issuers in avoiding certain accounting results that are considered disadvantageous. This is a phenomenon that I know many of you in the audience are familiar with. We've all seen news stories about some of these transactions, and they have played parts in various financial reporting failures. They also have blunted the impact of many new accounting standards.

Structuring Around New Standards

Perhaps the best example of this relates to leases. When the FASB issued Statement 13,8 many lessees immediately began to restructure their leases to avoid capital lease accounting. Attorneys, insurance providers, investment banks, accountants, and many others have collaborated in such efforts over time. It is often said that an entire industry has grown up around structuring leases to obtain various results under GAAP. For example, I've heard of companies selling residual value insurance on 1% of asset's value - why? So that a lease with payments totaling 89% of the asset's fair value can be accounted for as an operating lease by the lessee but a sales-type lease by the lessor. Poof - the asset winds up on nobody's books, due to an insurance product that exists only because of financial reporting. The standards on lease accounting were developed to provide reasonable information for the types of leases that had been prevalent, but many of the types of leases that have become common since then take advantage of the accounting standard itself. The result is that accounting for leases isn't much more transparent now then before Statement 13 was issued.

Just in case there is a thought that this kind of structuring doesn't go on anymore, I'll point out some recent examples. Recently, the FASB issued Statement 150,9 requiring puts written on a company's own stock to be classified as liabilities. Even before the standard's required adoption date, a structure called a "FAS 150 compliant written put" was being marketed, apparently with little shame. An FASB member lamented at the time that it took investment bankers only about 20 minutes to undo much of the improvement that FAS 150 was meant to bring. And don't forget FIN 46,10 which, while it did result in consolidation of some SPEs, also led many entities to restructure their SPEs to avoid consolidation. That is, many entities sought to change those arrangements simply because the accounting standards had been updated. And you've recently read a lot about what is often called "finite insurance", a product that involves little risk transfer, but, allegedly at least, a large financial reporting benefit. Finite insurance has become Eliot Spitzer's latest focus. And later today, you'll hear other members of the OCA staff talk about CoCos, financing arrangements involving accounts payable, and certain modifications of employee stock options, all of which are have, in large part, an accounting motivation. It won't surprise anybody who knows me to hear me say that I have been gratified to see some of the advisers and facilitators of these kinds of transactions become the focus of recent enforcement efforts.

Before I go any further, I need to make sure my words aren't taken for more than I mean them. I am not, by anything I say today, meaning to suggest that all companies who have structured transactions to meet accounting goals have restatements coming. It is in fact true that the accounting for some of these transactions is clear under the literature, and that the structuring therefore works. However, I am suggesting that whether these arrangements achieve their accounting goals or not, employing them is not in the best interests of investors, does not promote transparency, and is evidence of the fact that the focus on compliance undermines quality financial reporting.

Disclosures of Structuring Activities

I recently had the opportunity to hear a speech from the person who writes "The Ethicist" column for the New York Times. He talked about various ethical models. One of them, which he called a good start to an ethical framework, but in and of itself insufficient, was a model he called "transparency" - interestingly, a term we also use in financial reporting. The "transparency" ethical model can be summed up as "If you wouldn't want people to know you've done something, it may not be ethical." I believe that thought process ought to be applied to disclosures about accounting-motivated transactions. If a company leases equipment under a lease with payments whose present value is 89% of the fair value of the leased assets, investors should know that the lease is structured that way to avoid recognizing the asset and related obligation on the books. And if a company does not include performance criteria in its employee stock options because doing so risks income statement volatility under Opinion 25, that too should be disclosed. In other words, if you really believe that it's a good idea to structure things around the accounting or disclosure guidance, you shouldn't be embarrassed to tell readers of your reports that that's what you've done.

But what troubles me the most about all of this transaction structuring is that it is so well-entrenched into the financial reporting framework that it has come to be considered normal. A short example. In a couple of recent situations, the staff in OCA concluded that a company that had attempted to structure around the accounting literature had, in fact, not met the requirements to achieve its intended accounting. What surprised me at the time, but probably shouldn't have, is that the registrants in these situations expressed their belief that they shouldn't be forced to restate because they hadn't purposely done anything wrong. The companies believed that because they thought they were following GAAP, they shouldn't be subject to what they perceived as harsh penalties just because it turned out they were mistaken. In my view, however, the companies had been trying to do something wrong - they had been trying to exploit the literature, and design transactions whose financial reporting didn't match their economics. I believe that our different ways of thinking about these activities stem in part from the fact that it is has become thought of as part of a financial executive's job to skirt the limits of the literature. As I said before, these types of arrangements work sometimes, and other than requiring proper disclosure, there isn't much I can do to dissuade them. But I don't have much sympathy for a company that attempts to design a transaction around the literature and fails.

Working with Registrants

Before I turn over the podium to the other speakers from OCA, I'd like to spend a minute or two explaining how we intend to work with registrants on accounting issues. I've already alluded to the fact that where registrants seek to structure transactions for financial reporting purposes, we will expect disclosures even if the accounting goal is achieved, and we can be expected to seek restatement where we don't believe the literature has been fully complied with. However, I would contrast that with a situation in which a company has entered into a complex transaction that did not have an accounting motivation, has attempted to account for the transaction in a transparent manner and has made appropriate and robust disclosures. In those situations, it is far easier to accept differing views as to the appropriate accounting. We do understand that even with the same set of facts and the best of intentions, reasonable people can reach different conclusions, and we don't feel the need to substitute our judgments for yours in these situations. I should also reiterate a point Don made. We continue to encourage registrants to contact us about difficult questions ahead of time and directly. It is, as always, easier to address issues that come to us in that manner, rather than through a review by the Division of Corporation Finance or Enforcement. We are also quite interested in discussing issues that particular industries face with groups representing those industries. It's obviously more efficient to resolve an issue for a group of companies rather than one at a time.

I've just spent most of my time up here explaining as best I could the problems created by a mindset that looks at financial reporting as a compliance activity, rather than one focused on communication. However, recognizing that I am not always a clear or eloquent speaker, I will borrow words that Chairman Donaldson used just last week in addressing a similar issue. "Some managers will pursue questionable activity right up to technical conformity with the letter of the law, and some will step over the red line either directly or with crafty schemes and modern financial technology that facilitates deception. What's really needed is a change in mindset - one that fosters not only a culture of compliance but also a company-wide environment that fosters ethical behavior and decision-making."11

Thank you for your attention. I look forward to taking questions at the end of the day.



Modified: 12/06/2004