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Speech by SEC Staff:
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| The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Ms. Lago and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff. |
Thank you very much for the opportunity to be here today. It’s a truly unexpected pleasure, so I should start with an explanation and a few disclaimers. First, I am not Mary Tokar, who is the SEC’s leading accountant dealing with international issues. Mary was supposed to be with you today, but during her international travels she’s been struck by a weird virus that is defying Western medicine. Second, I’m not an economist, an academic or even an accountant. My most important disclaimer is one that will be familiar to those of you who have heard SEC presentations: the views that I express today are my own, and don’t necessarily represent the views of the commission or other SEC staff members.
With that out of the way, let me turn to more substantive issues. Dr. Kothari’s paper is based on a premise near and dear to the hearts of securities regulators: that the quality of information provided to capital markets affects the allocation and pricing of capital. Dr. Kothari explores factors that impact the effectiveness of disclosure, including:
When I first started reading Dr. Kothari’s paper, I became quite concerned – not by the idea that high quality financial reporting is important to efficient capital markets, or by the idea that high quality financial reporting is a multi-dimensional issue, and not just solely one of technical accounting standards. Rather, I was concerned that this would be an exceedingly dull session, with all of us nodding our heads in total agreement.
In international fora such as IOSCO (or, as the FT calls it, the club of the world’s securities regulators) or the Financial Stability Forum (FSF), participants are very comfortable discussing, debating and analyzing standards – including accounting standards. But, in these international meetings, some participants want to end their discussion of financial reporting issues at the level of standards. That approach is fundamentally flawed because the issue should be looking at the product – the financial reporting that results from the application of standards – rather than looking only at the words of the standards. Achieving this real-world analysis requires looking beyond the nominal adoption of the standards, and focusing on the implementation and enforcement of the standards. Dr. Kothari’s paper focuses our attention on this messier truth: the quality and effectiveness of financial reporting is a multi-dimensional issue, not a single-dimensional one.
As Dr. Mueller noted, this same issue – the multi-faceted nature of financial reporting systems – is recognized and addressed by the U.S. Securities and Exchange Commission in its concept release on international accounting, which was issued this past February. This concept release identifies a number of issues being considered by the SEC and poses about 25 questions, seeking public input to help shape further SEC actions.
When the SEC staff started working on the concept release, our initial focus was narrower: should a foreign company’s financial statements, if prepared in accordance with standards issued by the International Accounting Standards Committee (IASC), be accepted by the SEC without requiring a reconciliation to US GAAP? In other words, are the IASC standards of sufficiently high quality? But we quickly realized that looking just at the text of the IASC’s accounting standards was not enough. From our experience with US capital markets, we know that effective financial reporting is not solely the product of the high quality standards issued by the FASB. It also relies on company management preparing financial statements that faithfully apply those accounting standards; on effective audits of financial statements; and on regulatory oversight and enforcement of the activities of market participants. Therefore, the concept release that the SEC ultimately issued addresses not only the words of the IASC standards, but also raises questions about infrastructure issues:
And, looking at the quality of audits necessarily raises the question of how standards are enforced in jurisdictions outside of the United States.
The SEC raises these broader issues because it wants to make decisions about whether to accept IASC standards based on the way the standards are applied in the real world, and around the world, and not just on how the standards look on paper.
As I noted earlier, I originally was concerned that this session would be dull because the panelists would be in total agreement – but when I got to Dr. Kothari’s conclusion, I realized that we’d all be saved from this fate! Dr. Kothari recommends removing requirements for disclosure and letting companies choose the quality and amount of disclosure that they want to make. In his view, this would permit companies to make firm-specific determinations of cost-benefit, weighing information-gathering and disclosure costs against the effect on their price of capital.
I must disagree with this recommendation. Why? Because it fails to recognize the importance of investor confidence in the market as a whole, and therefore would undermine the liquidity, stability, fairness and success of US capital markets. Dr. Kothari’s suggestion would return the US to the market conditions of the 1920’s, when investors struggled time and again to determine whether the information they were receiving about public companies was indeed full or fair disclosure. And today, the situation is even trickier than in the 1920’s, because investors now are participants in a global, rather than just a national, capital market.
In securities markets it’s critical that investors have confidence in the integrity of markets as a whole. And, to have that confidence, investors need to know the benchmarks – the minimum standards – to which market participants are held accountable. Dr. Kothari’s approach instead asks investors to evaluate, on a company-by-company basis, whether the disclosure is complete and of high quality. Such an approach would, in my view, reduce investor confidence in the integrity of US capital markets. This, in turn, would cause investors to increase the general risk premium that they apply to all market participants, including even those companies that had elected to make complete and high quality disclosures.
Markets can and should compete on the basis of quality, and high quality minimum disclosure standards are an emblem of US capital markets. These high minimum requirements, combined with effective enforcement of the requirements, give investors a level of confidence that allows them to reduce the overall (i.e., non-entity or industry specific) risk premium built into the cost of capital. The success of the US capital markets in attracting foreign listings – well over 1,000 – demonstrates that our markets are competitive. Foreign companies aren’t required to list in the US and subject themselves to the exacting US disclosure regime and SEC oversight. Instead, it’s something they’ve elected to do in order to capture the advantages offered by US capital markets. What are those advantages? Incredibly large, stable pools of capital, which are unavailable anywhere else in the world.
Let’s look at Dr. Kothari’s example of the German Neur Markt, with its requirement for companies to use either US Generally Accepted Accounting Principles (GAAP) or IASC standards for financial reporting. Dr. Kothari views the Neur Markt as an example of companies voluntarily moving to high quality disclosure, and of the peaceful co-existence of high and low public disclosure firms in one economy. I view the situation quite differently. To me, the Neur Markt is an example of a nascent market seeking to validate itself, and establish immediate legitimacy, by requiring use of the world’s two most demanding and complete set of accounting standards. The Neur Markt, and the companies listing on that market, are seeking to establish credibility for their market as a whole on the basis of their high quality reporting requirements.
US disclosure requirements, including those for financial reporting, are a cornerstone of investor confidence, because they spell out a very real minimum of information that each investor has the right to expect from every company competing for her investment dollar. To remove this minimum, and instead just warn investors that each company is free to provide the level of disclosure that the company believes maximizes its cost-benefit computation, abandons the basic tenet of 65 years of US market regulation: full and fair disclosure.
Having spent some time embracing and repackaging Dr. Kothari’s argument to arrive at a different conclusion, I’d like to end by reverting to an area where we are in complete agreement: The belief that enforcement is a key determinant of the quality of financial reporting and, ultimately, of securities markets.
The activities grouped by Dr. Kothari under the label "enforcement" occur at the SEC in several layers, each of which leverages and reinforces the other. First is the requirement that public companies file financial statements that have been audited by an independent auditor. This is the single most critical enforcement mechanism for ensuring complete and faithful application of US disclosure requirements, and in particular, US accounting standards.
The SEC recognizes the crucial role of auditors in the application of accounting standards. An auditor is the only outside professional a company is required to hire before offering securities to the public. Because the role of auditors, and audits, is so critical, the SEC explores several different facets of effective audits in its concept release on international accounting, including:
Questions in the release about these topics go to the issue of how accounting standards are implemented, in practice, in different national environments.
Meanwhile, the SEC continues to look critically at audits in a domestic and international context. There are initiatives underway in several areas to raise the quality and effectiveness of audits that might be of interest to this group. First, two weeks ago a group called the Panel on Audit Effectiveness1 (also known as the O’Malley Panel) published a report aimed at strengthening the effectiveness of independent audits. The Panel was established by the independent oversight body for the accounting profession, the Public Oversight Board, or POB, at the request of SEC Chairman Arthur Levitt in 1998. The report includes recommendations for restructuring the POB and for strengthening the US peer review process. And shortly, the SEC is due to consider a proposal to modify current auditor independence requirements.
The second layer of "enforcement" is the SEC’s Division of Corporation Finance, or "Corp Fin" as we call it. Corp Fin processes and reviews the filings of all SEC registrants. These reviews involve a team of staff lawyers and accountants who review the financial and non-financial disclosures made by a company. The review team will write to the company with any questions about information that appears incomplete or inconsistent with our disclosure requirements, including the requirements of accounting standards. It’s not at all unusual for this process to result in revisions to a company’s filings -- and enhanced disclosure for investors.
Corp Fin’s review is important, both as a deterrent and as a problem identification process. It’s a deterrent just as the threat of an IRS audit is a deterrent to cheating on a tax return – and the chances of a filing being reviewed by the SEC are much higher than the chances of being audited by the IRS. For example, in 1998 Corp Fin reviewed the filings of approximately 21% of US registrants. I think that the SEC’s international reputation as a "strong enforcement agency" stems in part from the fact that the SEC is one of the few securities regulators that actively reviews the disclosure documents that are filed with it. In most other countries, a much less exhaustive review is carried out – and by the stock exchanges, rather than the securities regulator.
The third, and by no means least, element of the SEC’s enforcement activities is the traditional, after the fact, investigation and prosecution that is carried out by the SEC’s Division of Enforcement – i.e., the SEC’s law enforcement function. About half of the SEC staff is involved in enforcement. Their work resulted in the initiation of over 475 cases in 1998. And the SEC’s work is augmented by criminal investigations and prosecutions by the Department of Justice.
Taken together - audits, review and comment, investigation and prosecution - all add up to a powerful toolkit for promoting rigorous enforcement of US standards. They work to back up the disclosure commitment made by companies to investors.
I hope that my remarks show how the important issues raised by Dr. Kothari can be regarded as challenges to be addressed in delivering effective financial reporting, rather than as an excuse to return to a caveat emptor, free-for-all world.
1 This report is available at www.pobauditpanel.org
http://www.sec.gov/news/speech/spch389.htm
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