Speech by SEC Staff:
Remarks before the 2003 Thirty-First AICPA National Conference on Current SEC Developments
Donald T. Nicolaisen
Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 11, 2003
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. Thank you very much for the kind introduction and warm welcome.
I am very pleased to take part in this long-running conference. I understand that this is the thirty-first time this conference has been convened, and we at the Commission welcome this as a valuable opportunity each year to meet with our colleagues in both industry and public accounting. During the past two years we have seen radical and necessary changes in the profession changes affecting accounting firms, corporate management, academia, standard setters, and regulators. By embracing change, each of us can play a significant and helpful role in furthering the interests of both the profession and the investing public we serve. Investors, and Congress, have reconfirmed the vital role that financial reporting and auditing plays in our economy. It's now up to us to implement the actions that will dramatically improve the quality and usefulness of financial reporting.
Having been the Commission's Chief Accountant since the end of September, I would like to give you my first impressions from that perspective of the state of our profession, the renewed importance of the relationships between the auditor, the audit committee and management, and the activities that can lead to improved financial reporting.
Before I begin, one of the first things that I have learned at the Commission is the standard disclaimer. So on behalf of myself and all SEC staff who will speak at this conference let me say that as a matter of policy the views expressed by any staff member are that individual's views and do not necessarily reflect those of the Commission or any other member of the Commission staff.
State of the Profession
Prior to joining the Commission less than three months ago, I had been a member of the public accounting profession for thirty-six years and, during most of that time, proud of the CPAs' role in business and society. My father was also an accountant. He wasn't a CPA, but he understood ethics, honesty, objectivity, fairness, and investor protection. He took pride in what he did, just as I know you and so many others in our profession do. During my career, I have been fortunate to wear many different hats, from client service, to various management and governance roles, to heading up a national office accounting and SEC services function. I have devoted my career to this profession and I use the word profession intentionally not trade, not industry, but profession. And as a member of the accounting profession, I, like you, have been extremely disappointed by the events of the last few years events that have damaged the public's perception of corporate America and of the accounting and auditing profession.
We can all recite the scandals that brought us to where we are today Enron, WorldCom, HealthSouth, Tyco, Adelphia, and Xerox among others. We can all point to the tremendous pressure our mixed-attribute accounting model is under with examples such as the notorious complexity of derivative accounting, the public, professional, and political debate over the expensing of stock options, and the focus on an EPS figure that is all-powerful and sometimes too easily managed. And, we know there are too many examples where overly detailed rules have been used to game the system. These and other factors have combined to severely shake investor confidence in the markets and public confidence in the accounting and auditing profession.
The profession has long recognized, through its standards and values, that CPAs are expected to exhibit the traits that are the historical cornerstone of accountancy the demonstration of leadership through example, the exercise of sound professional judgment, and the exhibition of a willingness to learn and adapt to the needs of the public. In short, we need to display the strength of character, objectivity,and integrity that investors expect.
We are at a critical point in the history of our profession. And, I believe our current and near term actions will determine whether we can implement change and be successful in improving financial reporting and restoring credibility to the profession and the capital markets. Let there be no mistake, we simply have to improve. Most of the recent changes affecting the profession were forced upon us, rather than resulting from us taking the initiative. The Sarbanes-Oxley Act and other reforms set a good foundation for our future, but it is up to us, as professionals, to embrace that foundation and build upon it. The goal has to be significant improvement in quality and accountability.
I'm convinced that we can significantly improve the financial reporting model and enhance its relevance. The accounting profession is resilient, with a long and honorable history. The lifeblood of the profession is the ability to use our skill sets to enhance the quality of financial reporting and, in turn, the confidence of investors in reported financial information. But we also know that confidence and trust are fragile commodities. We have seen how easy it is for trust and confidence to be lost, not only by the companies that hire auditors to audit their financial statements, but also by investors who use those statements every day to make the investment decisions that secure their financial dreams of homeownership, college for their kids, and a fulfilling life after retirement. Having lost that confidence, we now are experiencing first-hand how hard it is to regain. One of the keys to restoring confidence is successful implementation of the recent reforms and a commitment to continued improvement in accounting standards, financial reporting, and auditing.
Critical Role of Audit Committees
The lynchpin of the recent reforms and a key element of improved quality of financial reporting is the Sarbanes-Oxley Act of 2002. Among other serious reforms, the Act requires certifications by CEOs and CFOs related to their responsibilities and to the accuracy and completeness of the company's reports. The Act also places the audit committees of public companies front and center. It is certainly a new day for audit committee members and other board members, who, more clearly than ever before, are recognized as shareholders' representatives. One of the most important objectives for audit committees is to strengthen their oversight of both the external auditor and management. The relationship between the audit committee, management, and the external auditor should evolve to one where the expectations of the audit committee are well established and where management and the external auditor are particularly responsive to those expectations.
The Act places new responsibilities on audit committees to engage the independent auditor and to deal directly with the auditor on significant matters related to the company's financial statements. The audit committee should expect that the auditor will approach his or her role with an attitude of professional skepticism, tempered with experience. There should be open lines of active, substantive, and brutally honest communication. The audit committee should be the external auditor's biggest fan and harshest taskmaster.
The audit committee also should take an active role in ensuring the auditor's independence. A loss of independence can have dire consequences for both the auditor and the registrant. From a company's perspective, the audit committee shares in this responsibility. Inherent in this responsibility is the need to understand all aspects of the company's relationship with its auditor. I believe this goes beyond the pre-approval of audit and permitted non-audit services and would include, but certainly not be limited to, any contractual arrangements or similar agreements, special fee provisions, unusual expense reimbursement policies, and plans for audit partner rotations admittedly no small task for multinational companies and companies with decentralized operations. But, if the communication process between the auditor and audit committee is working properly, there should be few surprises.
The relationship between management and the audit committee is equally important. At the broadest level, the ability of the audit committee to assist management in establishing the proper tone at the top is of utmost importance. In addition, audit committees require more information than before to fulfill their mandated and fiduciary responsibilities. For example, audit committee members need a significant amount of information from management to help them understand the company's financial results, focusing on material information that promotes an understanding of financial condition, liquidity and capital resources, the results of operations and cash flows. This would also include key performance indicators, both financial and non-financial, as well as trends, events, commitments and uncertainties that are reasonably likely to have a material effect on the company. This information is supplemented with information from the auditor, including the traditional communications required by the auditing standards and the newer communications required as a result of the Sarbanes-Oxley Act. These additional communication responsibilities include the identification of critical accounting policies, alternative accounting treatments and the auditor's preference among the alternatives, and other material written communications between the auditor and management. In combination, the information will assist the audit committee in understanding the company's business and issues so that it can deliver on its responsibilities to investors.
In addition to working with auditors, audit committees are facing an enormous amount of change in other areas. For this year-end, many companies will be impacted by new consolidation and disclosure guidance issued by the FASB in FASB Interpretation 46. And, the effective date of the Section 404 rules, which set in place new reporting requirements with respect to internal controls over financial reporting, is just around the corner for large companies. These changes address complicated issues that have been debated for many years and are aimed at improving the quality of financial reporting. I would encourage audit committees to have regular meetings with management and their auditors to assess the status of the company's preparation and progress in adopting new accounting principles, governance and disclosure requirements, and internal control processes. Companies that decide to wait until it's too late to prepare for these changes will ultimately regret that decision.
Relationship with the PCAOB and FASB
Any discussion of the changes brought about by the Sarbanes-Oxley Act would be incomplete without discussing the important roles of the Financial Accounting Standards Board (FASB) and the Public Company Accounting Oversight Board (PCAOB).
The FASB and the PCAOB have been charged with working with us to improve the quality of financial reporting and to restore the confidence of investors and the public in our capital markets and our profession. The Commission has an oversight role with regard to both organizations, and I want to spend a few minutes addressing our relationship with them.
Congress established the PCAOB to enhance the audit standard setting process and oversee the work of auditors. The audit profession is now operating in a very different environment. Those who audit public companies are now regulated, and I believe the PCAOB's role is critical to restoring confidence and integrity in our capital markets. As the Chief Accountant, I have the opportunity to work closely with the PCAOB, and I am already impressed with what they have accomplished in a very short time. Beginning as a start-up operation, they are now up and running under the leadership of Bill McDonough, a former banker and Chair of the New York Federal Reserve. U.S. accounting firms that audit public companies have been registered. And, the PCAOB is now considering the public comments it received on its proposed standard on auditors' reports addressing management's assessment of internal control its first effort to draft an audit or attestation standard. And I believe we would all agree that this standard is a very significant undertaking.
As with the creation of any start-up enterprise, and especially a regulatory body with such an awesome scope of responsibility, there will be growing pains. The Commissioners and the PCAOB board members, and the staffs of the two organizations, are firmly committed to successfully executing their respective roles in the regulation of the profession as mandated by Congress. At the same time, you have a critical role in that process. It is imperative to the success of the PCAOB and the audit profession that the PCAOB receive your strong support as well as the benefit of your experiences as they develop and implement effective auditing, ethical, and quality control standards. I encourage you to actively and enthusiastically participate in all of the PCAOB's processes. We all have a vested interest in the success of the PCAOB, and their effectiveness will be enhanced if there is constructive dialogue with the profession. I assure you that I'll do my best to ensure that the PCAOB is a success.
Along with the PCAOB, the FASB, in its role as this nation's primary accounting standard setter, plays a critical role in the operation of our capital market system. I am a staunch defender of our financial reporting system. U.S. GAAP is the most comprehensive, well developed, and transparent body of accounting standards in the world today. That is certainly not to say, however, that U.S. GAAP is perfect. There are some standards where detailed rules overwhelm the basic principles of the standard. And sometimes there are bright lines that allow companies to engineer a desired accounting result. U.S. GAAP is a mixed attribute model of historical costs, fair values, and the lower of cost or market. Under current U.S. GAAP, other inconsistencies exist. For example, purchased intangibles are reported as assets, whereas those that are internally-developed by an enterprise generally are not. In short, there are many facets of U.S. GAAP that can be improved.
As required by the Sarbanes-Oxley Act, in April of this year the Commission formally recognized the FASB's standards as being "generally accepted" for the purposes of preparing financial statements under the federal securities laws. The FASB operates in the sunshine and follows a strict process in establishing its agenda and its standards, seeking input from task forces, working groups, advisory councils, auditors, preparers, and users. Currently, they are addressing difficult and often emotionally charged issues, including accounting for stock options and fair value measures. They are looking at perhaps the most basic and yet most complicated area of accounting in revenue recognition. The easy standards have long been written. What we are left with are tough issues.
The Commission's oversight role of the FASB is primarily carried out by my office. In our oversight, we evaluate each standard-setting project to ensure that the FASB process is operating in an open, fair, and impartial manner and that each final standard is within an acceptable range of alternatives that serve the public interest and protect investors. While effective oversight is necessary for the Commission to carry out its responsibilities under the securities laws, the Commission has long supported the FASB's independence in exploring accounting issues. A solid reputation for open, independent, and unbiased discussions of issues at the FASB is critical to the credibility and acceptability of its standards within the investment and business communities.
I could not talk about the FASB this year without commenting on FIN 46, which, as you know, is intended to respond to concerns about the off-balance sheet accounting for special purpose entities and similar vehicles. It's an Enron-inspired standard. I will leave the details for others of my staff to discuss at this conference, but I do want to note that from the outset, we have supported the basic principle contained in the interpretation, which is that the financial results of what FIN 46 describes as a variable interest entity should be consolidated with the financial statements of the company that is the primary beneficiary of that entity. Because the interpretation introduced new concepts and because it requires the exercise of considerable judgment in areas with which the profession has had only limited experience, I supported a temporary deferral of the effective date until December 31. At its meeting yesterday, the FASB discussed proposed modifications to FIN 46 that are intended to address many of the concerns that have been raised. Consolidation of the SPEs-of-old is an important element of reform in the overall restoration of investor confidence, and I am eager to see those consolidations take place. At the Commission, we have been reviewing FIN 46 disclosures made in interim reports and I have to say that while some are excellent, I am disappointed by the seemingly minimal disclosures of many registrants. The adoption of FIN 46, including disclosures, is something we will be looking at closely, not just because of its importance to investors, but also because we will be reporting to Congress next year on off-balance sheet matters, and that report will be influenced by the quality of your filings and disclosures.
Many constituents have been openly critical of the FASB because of the difficulties encountered in implementing FIN 46. Others have been critical in areas relating to the implementation of FAS 150 on the accounting for financial instruments that have characteristics of both debt and equity, and the proposed direction of the FASB's stock option project. In my view, the FASB's efforts over the past year represent movement on accounting issues that have plagued the accounting profession for decades and which need to be resolved to restore credibility to accounting and to our profession. The answers are not easy and the FASB needs your help, constructive input, and support to do its job.
Last summer, the SEC staff released its report encouraging standards that are more objectives-based and less rules-based. I embrace the observations in that study. I favor a reordering of the GAAP hierarchy to put concepts at the top, followed by objectives and principles, supported by detailed guidance or rules. That requires additional and fundamental change to our accounting model. As with most change, it's easy to resist. Resistance to change is part of our DNA. But change we must. And I'm supportive of the efforts of the FASB. Our quest for improved quality in financial reporting depends significantly on the issuance of high-quality, unbiased standards. And, to the extent possible, those standards should avoid unnecessary complexity. That's a tall order and the mark has not always been fully achieved in the past, but we can all learn from our experiences and I intend to work with the FASB in pursuit of improvements.
Scott Taub will provide an update on international matters in a moment, including progress on the FASB's and IASB's pledge to use their efforts to make their existing financial reporting standards fully compatible as soon as is practicable, often referred to as the international convergence initiative.
To facilitate that effort, I am working with Scott and others at the SEC, and elsewhere, to develop a roadmap, if you will, of the steps necessary for statements prepared using International Accounting Standards (IAS) to be accepted by the Commission. I spent part of my career overseas, and I believe there is much we can learn from standard-setters and professionals outside the U.S. and that our investors will benefit from convergence, as we all work to identify the best standards.
I should also note that convergence is a two-way street and in some cases will require change on our part. For example, the IASB approach to voluntary accounting changes is to require retrospective application, with the objective of improved comparability between periods. The FASB has had a different approach and has tentatively decided to expose for comment a change to U.S. GAAP in that area to make it consistent with IAS. If the change is finalized, we at the Commission will endeavor to ensure that investors understand that retrospective application of a preferable method differs from restatements that occur due to other reasons.
At the same time that we are thinking of large, world-wide impacts of accounting and auditing standards, we cannot forget that small businesses, which play a vital role in our economy, are expected to adhere to those same standards to the extent that they have like transactions. Small business has long been a growth engine for our economy and continues to be a source of innovation, employment, and production capacity. Many small businesses have entered into our public markets to raise the capital needed to finance their operations and planned expansions. During the comment periods for Sarbanes-Oxley Act rulemaking, the SEC received many comments focusing on the increased burden that the proposed rules would place on smaller-sized public companies. Some additional costs are inevitable. However, the burden to smaller companies can be disproportionate and needs to be appropriately weighed against the protection of investors. This balancing act is something that the SEC staff will continue to monitor as the ramifications of the Sarbanes-Oxley rules become evident, and we will recommend adjustments to our rules if unintended consequences arise. It is also an important consideration for the FASB and the PCAOB. We all need to strike the right balance.
Other Disclosure and Reporting Considerations
At the Commission we are considering the issuance of new interpretive guidance with respect to MD&A. The objectives are straightforward to improve the usefulness for investors by using plain English, less boilerplate, fewer words, more tabular presentations, less discussion, but more analysis, emphasis on the important, identification of risks, and use of estimates. And where useful, an introductory or executive summary to set the context for the MD&A. You'll hear more from other members of the Commission's staff during this conference regarding our experiences and why we believe this important investor tool is not always used as it was intended.
Preparers may want to consider another financial reporting changes in the near term. I've heard many investors express a strong preference for use of the direct method of preparing the statement of cash flows. It's widely understood and believed by many to be a more informative presentation. We are not requiring a change, but it is an action you could consider to promote transparency given the importance to investors of cash flow information.
Interaction with the Office of the Chief Accountant
Times of change can be stressful, but they also are times of great opportunity. I know a lot has happened in the past year and there are days when you feel as if it is all coming too quickly. Unfortunately, everything we do is live, and we can't just take a timeout. We must keep up the pace, but the result significant improvement in the quality of financial reporting and improved corporate governance is worth the effort, and I look forward to working with you to meet the challenges before us. In particular, I am looking for suggestions for improvements to the current accounting model. It is strained and I am willing to consider how we might use additional performance measures, technology solutions, broader disclosures, additional statements, or investor education to improve financial reporting and disclosure. Changes to the financial reporting model have been talked about for decades, but changes require concrete, workable solutions.
I've been blessed in that the SEC staff is comprised of talented people, fully dedicated to quality financial reporting and investor protection. In that regard, I extend an open invitation to preparers and auditors alike to seek out our staff through the pre-filing consultation process when dealing with complex or emerging accounting and auditing matters. We will have more to say on that this morning. I can promise you that we will listen carefully to your views, give your issue thoughtful consideration, and handle your issue in a professional and timely manner.
During my many years of practice, I have seen the best this profession has to offer and I've also seen times when it has drifted away from its ideals. The events of the past few years and the resulting Sarbanes-Oxley Act are a call to action for us all. Our actions today will have a long-lasting impact on the future of our profession. This is likely the profession's last chance to prove itself and as I said before, we must improve. What a great time to be part of, or just entering, the profession. I challenge everyone here to do his or her part by:
- Ensuring compliance with both the letter and the spirit of Sarbanes-Oxley, helping all those with a role in governance and financial reporting, especially the audit committee, to faithfully and fully exercise their responsibilities;
- Participating in the standard-setting processes by providing honest and constructive feedback to the FASB and the PCAOB as they set standards;
- Executing the daily tasks of basic accounting and auditing, including challenging transactions that appear to lack commercial substance that are being used only to circumvent accounting standards; and
- Enhancing communications to investors through improved disclosures that go above and beyond the bare minimum.
I believe the overwhelming majority of accountants are honest and committed professionals. But those in the profession who fail to recognize that our profession is changing, and that each individual and firm must embrace a culture that champions the interests of investors, should not be surprised if they become the focus of disciplinary action. I care too much for investors and for the integrity of the accounting profession to let those who cannot or will not adhere to the spirit, as well as the letter, of the Sarbanes-Oxley Act to inflict further harm to either our capital markets or our profession. We have an obligation to the next generation of CPAs to leave behind a legacy of integrity, quality, professionalism, and an ever-improving financial reporting model.
Thank you very much for the opportunity to speak to you today. I believe they have scheduled a little time for some Q&A and I'd be glad to answer some questions at that time.