Speech by SEC Staff:
Financial Reporting and the Global Capital Markets
Commissioner Isaac C. Hunt Jr.
U.S. Securities & Exchange Commission
At the Second European FASB-SEC Financial Reporting Conference
March 23, 2000
Good afternoon and thank you for inviting me to deliver one of the plenary addresses at this important conference on financial reporting. Someone once remarked to me that the world is changing so fast that a person saying something can't be done is likely to be interrupted by a person announcing he is doing it. This sentiment describes the pace of change occurring in today's markets. Who could have predicted ten years ago that on-line trading would account for over 30% of all trades placed by U.S. retail investors? Who would have thought that U.S. investors would have put over $1.2 trillion in non-U.S. equities by the end of 1997? And perhaps most shockingly, who could have foreseen that U.S. markets would actually take steps to eliminate trading in fractions?
The move to decimals, increasing domestic interest in foreign investments, and the proliferation of on-line trading all establish an undeniable inevitability the convergence of regional securities markets into a global financial center. An increasing number of foreign companies routinely raise money in U.S. financial markets, and U.S. investors increasingly seek foreign investments as a form of diversification. Capital seekers around the world are looking beyond their home country's borders for financial resources.
What does this move towards global markets mean for the SEC and its foreign counterparts? Well, it means that securities regulators around the world must adapt to meet the needs of market participants that are becoming more and more diverse, both in terms of levels of sophistication and expectations of market quality. However, while regulators act to adapt to this changing environment, they must exercise due care to safeguard the levels of investor protection and market integrity that are expected of their marketplaces.
As the primary securities regulator in the United States, the SEC is certainly facing the challenges of a globalized market. In November 1998, the Commission took a major step towards meeting that challenge by adopting the International Disclosure Standards developed by the International Organization of Securities Commissions for non-financial information included in disclosure documents. Our decision to adopt the International Disclosure Standards was based on our determination that the standards were of high quality and that their adoption would provide information comparable to the amount and quality of information that U.S. investors receive today.
However, global consistency is needed for financial, as well as non-financial, information disseminated to investors in our markets. Moreover, there is a growing consensus around the world that financial reporting in any marketplace should be of high quality in order to serve the needs of investors. At present, financial reporting requirements vary from country to country, creating inefficiencies in cross border capital flows and hampering efforts to achieve an effective global market. Earlier this year, the SEC moved to address this market inefficiency by issuing a concept release on international accounting standards. Today, I'd like to spend a few minutes talking about that release. Before I continue, let me say what I expect you already know that the views I express here today are my own and do not necessarily reflect the views of the Commission, my fellow Commissioners, or the Commission staff.
Instead of simply proposing a specified course of action on the standards promulgated by the International Accounting Standards Committee ("IASC"), the Commission elected to issue a "concept release" that would initiate a public dialogue on the considerations that should be brought to bear as the U.S. considers acceptance of a set of international accounting standards. The concept release probes some topics that you might expect it to address, but also asks some questions you may not have expected. It raises some concerns that all U.S. market participants are likely to share and, finally, it asks the question of how the Commission should proceed vis a vis international accounting standards. Today, I will mention some of the issues the concept release was expected to address, but I will focus my remarks on the other questions raised in the release.
I. The Expected Question What is the Quality of the IASC Standards?
As you might expect, the Commission's concept release on international accounting standards solicits feedback on the quality of the standards developed by the IASC. As you may recall, in 1996, the Commission issued a press release indicating that once the IASC completed its work on a core set of international accounting standards, the Commission would consider allowing use of the resulting standards in cross border filings by foreign issuers offering securities in the U.S. At that time, the Commission indicated that it would be guided by three considerations in addressing those standards: the Commission would consider the comprehensiveness of the standards, whether the standards would compel comparable, transparent reporting with full disclosure, and whether the standards could be rigorously interpreted and applied.
FASB has been of substantial assistance to those trying to assess the quality of the IASC standards by issuing a comprehensive report on the similarities and differences between the IASC standards and U.S. GAAP. However, more than a comparison is needed before the Commission can conclude that the standards are high quality. To be acceptable, the IASC standards must be able to require the same quality of reporting as U.S. GAAP, but need not mirror U.S. GAAP.
High quality accounting standards are essential to the efficient functioning of a market economy, and the Commission's release solicits comment on whether the IASC standards achieve the necessary level of quality. It is no surprise that the Commission seeks input on the quality of the IASC standards, and I expect that you will hear more from our Chief Accountant, Lynn Turner, about some of the substantive questions the IASC standards raise.
II. The Unexpected Question Does an Infrastructure Exist That Would Support IASC Standards?
I find it quite refreshing that the Commission's concept release on international accounting standards reflects an attempt to focus on the forest and not just the trees. Instead of limiting itself to the quality of the IASC standards, the release exposes and explores some of the inherent assumptions people might make in considering whether those standards should be accepted in the U.S.
As our constituents consider the question of adoption of international accounting standards, it is important that they relinquish any preexisting notions of who will be interpreting those standards, who will be auditing those standards, and who will be enforcing those standards. In the U.S. those responsibilities are clearly delineated, but in a global marketplace, the identity of the other participants necessary to a high quality system of financial reporting is less clear. The Commission's concept release explores these various functions and poses questions as to how they should be fulfilled in a global environment.
In essence, the concept release invites a broad discussion on whether there exists in our current marketplace an infrastructure that will support high quality financial reporting. If the Commission were to conclude that the IASC standards were comprehensive, required transparent reporting and could be rigorously interpreted and applied, it would still be uncertain as to the quality of reporting that would result from the use of those standards. Ensuring that high quality financial information is provided to capital markets does not depend solely on the body of accounting standards used. The quality of financial reporting is influenced by more than the standards themselves it is also influenced by the business conditions and regulatory systems of the jurisdictions in which the standards are applied.
The need for a strong financial reporting infrastructure is best demonstrated by a recent study conducted by the former secretary general of the IASC. That study surveyed 125 issuers using currently existing IASC standards and found that a substantial number of those companies failed to comply with the standards. More disturbingly, auditors of some of those issuers failed to identify non-compliance with the IASC requirements in their reports on the issuers' financial statements.
Experiences by the Commission staff in reviewing financial statements purportedly prepared in accordance with the now existing IASC standards echo the findings of the study. The SEC staff has identified a number of situations involving inconsistent application of IASC standards, and even misapplication of the standards. This history raises the possibility that even the most comprehensive, consistent set of accounting standards can still result in poor quality financial reporting. The Commission release explores this possibility in an attempt to ascertain the components of an infrastructure mostly likely to result in the dissemination of reliable, consistent, and understandable financial information. Although we seek comment on these issues, the Commission suggests some elements of such an infrastructure as a starting point for further dialogue.
A. The Interpretive Role of the Standard Setter
To work effectively, a set of accounting standards needs a standard setter who can foster reasonably consistent application of the standards. A standard-setter's responsibility for ensuring consistent application of its standards includes providing an effective mechanism for identifying and addressing interpretive questions in an expeditious manner.
The quality of the standard setter is undeniably relevant to our assessment of the proposed IASC standards, particularly with respect to implementation and interpretation questions. Since many of the IASC standards are relatively new, application issues may arise that require responses from an effective standard setter. Additionally, the quality of the standard setter will affect the development and acceptance of future standards. The Commission has asked commenters whether acceptance of the IASC standards should be conditioned on the ability of the IASC to restructure itself in a manner that will make it an effective implementing and interpretive body.
I note that the IASC has proposed a restructuring plan that would result in an independent Board whose members are selected based on technical expertise, with oversight provided by an independent set of Trustees. This structure is similar to the structure of the FASB, our recognized standard setter in the U.S.
B. The Role of the Auditor
Auditors play a vital role in the quest for high quality financial reporting. Independent auditors must earn the confidence of the investing public by adhering to high quality standards of professional conduct that provide assurances as to the integrity and objectivity of their services. Without competent, independent audit firms to support the application of accounting standards, there is no assurance that those standards will be consistently and correctly applied.
In today's world, we have auditors governed by national rules engaging in international practices. Historically, audit firms have developed internal quality control systems based on their domestic operations. The increasing globalization of businesses and integration of capital markets pose challenges to the goal of providing effective oversight of audit professionals on a worldwide basis through ethical and effective audit and accounting practices. Will the quality controls that were effective in separate national systems be as effective in a global environment?
In the United States, implementation and application of U.S. GAAP are supported through professional quality control practices as well as professional and governmental oversight and enforcement. National technical offices of U.S. accounting firms serve an important function in ensuring vigorous and consistent application of U.S. GAAP and U.S. GAAS. It is less clear how effective those national offices will be in ensuring consistent application of a set of international accounting standards on a global level. The concept release asks whether auditors certifying financial statements prepared using the new IASC standards should be subject to quality control practices such as peer reviews and mandatory rotations of audit partners. It queries whether they should be subject to mandatory training to ensure that all auditors of these financial statements have adequate expertise with the new IASC standards.
Recent events in the United States have highlighted the importance of high quality auditing standards. We are concerned about whether the training, expertise and resources used in today's audits are adequate. As the concept release indicates, we are also concerned that the audit requirements of some countries may not provide the level of reliability that investors in U.S. markets expect. Audit firms should have a responsibility to adhere to high quality auditing practices on a global basis to ensure they are conducting effective audits of international issuers that participate in markets throughout the world. I note that while the Commission solicits comment on these issues, it does not intend, at this time, to modify its requirement that financial statements filed with it be audited in accordance with U.S. generally accepted auditing standards.
C. Active Regulatory Oversight
Accountability can also be considered a key component of an infrastructure that will support international accounting standards. In every element of an efficient capital market, be it financial reporting, disclosure, standard setting, or self-regulation, effective oversight is needed. It is through such oversight that high quality standards are developed, investor interests are protected, and self-dealing is minimized. I an concerned that certain jurisdictions accepting the new IASC standards may develop conflicting interpretations, or, through lack of expertise, resources, or even authority, may accept applications of IASC standards that would not be acceptable in other jurisdictions. Effective oversight would certainly reduce the development of diverging interpretations of IASC standards.
In a global market, the Commission and its foreign counterparts will have to reevaluate their respective ability to enforce correct and consistent application of IASC standards. At a more fundamental level, U.S. regulators will have to consider their ability to use traditional enforcement tools to reach documents and other evidence of potential fraud that may be located in foreign lands. In this time of mounting multinational activities of U.S. companies, and the rising number of foreign issuers registered in the U.S., audit work papers may be located outside the U.S. Should the Commission adopt rules to enhance its ability to obtain these work papers? Should issuers be required to tell U.S. investors that they might have no access to such information? These questions must be explored before adoption of IASC standards is considered.
III. The Popular Question How Will Acceptance of International Accounting Standards Affect Competition?
The Commission's concept release poses numerous questions aimed at identifying the potential winners and the potential losers in a regulatory scheme that accepts international accounting standards for companies listed in the U.S. Assuming high quality financial reporting, U.S. investors would be winners by having the opportunity to invest in a greater universe of securities. U.S. securities exchanges may also benefit by being able to attract a greater number of foreign listings.
Foreign issuers who had been deterred from listing their securities in the U.S. because of the perceived burdens of U.S. GAAP, or due to an unwillingness to use standards they did not help form, may find U.S. markets more attractive if IASC standards are accepted. But U.S. investors may lose out on the high level of transparency and reliability that accompanies U.S. GAAP. Presumably, adoption of IASC standards would not, alone, be enough to tempt certain foreign issuers to our markets. Issuers concerned about United States disclosure requirements, or judicial standards of liability, might not view acceptance of the new IASC standards in the U.S. as a sufficient motivation to list there. Issuers may also feel pressure to maintain primary listings on the exchanges of their home countries. These possibilities suggest that the competitive effect of acceptance of IASC standards by the U.S. is not totally clear.
Moreover, the Commission must consider whether acceptance of IASC standards will put U.S. issuers, who would still be required to apply U.S. GAAP, at a competitive disadvantage. I expect the Commission will receive numerous comments addressing this question. In any event, the Commission must identify all the possible winners and losers as a result of acceptance of international accounting standards before it can move forward on this issue.
IV. The Final Question Where Do We Go From Here?
At this time, the SEC continues its assessment of the IASC standards and is reviewing comment letters on its concept release as the letters come in. The official comment period on the concept release will close in May of this year.
The Commission's next step in this process could take many forms. For example, the Commission could decide to maintain its current practice of requiring reconciliation to U.S. GAAP for foreign issuers. It could decide to accept certain IASC standards without requiring reconciliation, while continuing to require reconciliation for other IASC standards. The Commission could formulate a process that allows the use of IASC standards for recognition and measurement principles, but require U.S. GAAP and SEC supplemental disclosure requirements for footnote disclosures and to give more detail for the line items in financial statements.
Numerous possibilities exist as to how the Commission can proceed after the IASC standards are fully assessed. Regardless of the result, public comment from the Commission's constituent communities is vital to the process. I personally am concerned that the subject of international accounting standards may be receiving more attention in foreign jurisdictions than it is receiving in the U.S.
The international accounting standards project, in my view, requires substantial input from businesses, securities professionals and investors. I think global convergence of our markets has occurred and it is incumbent on securities regulators around the world to make whatever changes are necessary to accommodate a global marketplace. But I also believe that under no circumstances should investors be short changed by receiving financial information that is of a lesser quality than they currently enjoy. As the Commission continues its work on international accounting standards, it will continue to guard against this possibility.