Remarks of the Chief Accountant Michael H. Sutton U.S. Securities & Exchange Commission At 1996 AICPA Conference on Current SEC Developments Washington D.C. February 15, 1996 Introduction Good morning. I appreciate the opportunity to be here today and to share with you a few thoughts about financial reporting and the accounting profession. Before I begin, I must remind you that the views you hear during this Conference from me or others on the staff are our own views, and they do not necessarily represent those of the Commission or other staff members. I have been asked frequently what my agenda for the Office is, and the answer to that question has been to do what we can to strengthen financial reporting and to assure that our capital markets continue to receive the relevant, credible, and timely information they need to function effectively and to compete in the world's capital markets. Carrying out that agenda will continue to be my focus. During my first months as Chief Accountant, a significant portion of my time has been devoted to high priority issues, such as derivatives, that were Commission priorities when I arrived. In fact, many of the financial reporting and professional issues that are most relevant to our agenda tend to emerge and define themselves over time. As examples, I think of restructurings, poolings of interests, and derivatives. I believe that an important dimension of our responsibility is to identify those issues and to see to it that they are addressed in a timely and appropriate manner. Other issues on our agenda have a wider reach and involve the relationship of the Commission with the private sector and the Commission's oversight of standards setting and other self-regulatory activities. You will hear from our staff today about a number of current issues that we have concerns about, and you will hear how we are addressing them. I will begin with a few thoughts on financial reporting from my point of view and some observations about the roles of the participants in that process. Financial Reporting The financial reporting system in the United States is often characterized as the best in the world, and I believe that to be the case. Our financial reporting leadership is not a coincidence, however; it is the result of strong commitment, over a long period of time, by all of the stakeholders in the system and, especially, by the private sector participants -- the practicing profession -- preparers, auditors, and standard setters -- to which I would add the regulators. If we are to continue to have the best financial reporting system, that commitment must continue. In that context, let me offer a few thoughts about the relationships among the Commission and the private sector stakeholders and about the future of financial reporting. Our public sector / private sector financial reporting partnership was established early in the history of the Commission, about 60 years ago. Under this arrangement, the Commission, in carrying out its Congressional mandate, has looked to the private sector to assure that our capital markets receive relevant and reliable financial information as a basis for informed decision making by investors. More specifically, the Commission has looked to the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA) to establish credible and useful accounting standards. It has looked to the practicing profession to see that those standards are observed in good faith and to comply with the disclosure rules promulgated by the Commission. And, it has looked to the auditing profession to attest to the reliability of financial information that registrants file with the Commission and, thereby, to help assure that registrants meet their financial reporting responsibilities. Clearly, the end objective is to help assure that financial information reaching the public is credible and decision useful. Implicit in all this is an assumption that private sector standards setters and auditors will act independently and that those who come to market to raise capital will accept the importance of assuring that the process works in the way in which it was designed. Historically, we have relied heavily on the professionalism of registrants, auditors, and standard setters to make the system work. The enforcement powers of the Commission are important, and are used in appropriate circumstances, but the Commission's ability to depend on the professionalism of the private sector participants is critical to maintaining the credibility of our system. Professionalism, however, is under stress. Business competition, domestically and internationally, is intense. Managers express concerns about whether financial reporting and other disclosure requirements will put their companies at a competitive disadvantage. And they sometimes perceive that how a transaction is treated for accounting purposes can result in a competitive advantage or disadvantage. Auditors also are under intense competitive pressures, and exercising professional judgment in the application of accounting standards can be difficult. And, I think it is clear to all of us that standard setters are under more intense pressure than ever to justify their proposals for changes in financial reporting. It is an environment in which initiatives to improve financial reporting for the benefit of all investors have never been more challenging. If this sense of the current environment is about right, what should we -- all of the stakeholders in financial reporting -- do to overcome the barriers to further progress and to assure that the Commission and the private sector continue their successful partnership? That question will require thoughtful reflection and analysis by all of us, and responding will require commitment and leadership. There is no question that the Commission's expectations of the FASB remain high. The pace of progress on the Board's derivatives and hedging project, for example, has been a source of concern, and we have made our concerns and expectations known for some time. I don't question for a moment the importance of constituent input and thoughtful consideration by the Board of constituent views, but as I have observed the Board's processes over the years, it seems to me that the extent of those processes may have passed the point at which the delay involved outweighs the benefit received. I am pleased with recent reports that the Board has reached consensus on an approach to accounting for derivatives that they believe will be an improvement. I also consider it a positive sign that the Board is planning an exposure draft in a few months and a final standard late this year or early next year. I have been briefed on the Board's progress, and I can say at this point that I agree that the approach that they are developing would be an improvement. In particular, I believe that the Board's essential conclusion that derivatives should be marked to market results in more transparent, and therefore better, accounting. We must recognize that each of the approaches that the Board has considered has its advantages and disadvantages and implementation issues. There are inherent conflicts involved in reconciling the anomalies of our current mixed attribute accounting model for financial instruments -- a model in which some financial instruments are accounted for on a historical cost basis and others are marked to market currently or adjusted to market when certain events or conditions exist. But, we cannot wait until the accounting for all financial instruments has been addressed to take this important step of improving the accounting for derivatives. With respect to the broader question of the effectiveness of the standards setting process, I am aware that the Board is reviewing its organization and activities in connection with a substantial strategic planning project, and I applaud that effort. Over the last week or so we have read press reports that the business community is seeking to increase its influence on the FASB. Those reports arose, in part, from correspondence to the Financial Accounting Foundation (FAF) in which the Financial Executives Institute (FEI) made a number of recommendations for changes in the FASB's structure and processes. To the extent that those suggestions would undercut the Board's effectiveness and independence -- for example, a part time board or an outside body responsible for the Board's agenda -- I must say that we are greatly concerned. If the FASB is to be successful, it must be able to add important, and usually controversial, issues to its agenda and to resolve those issues with credible, conceptually sound, accounting standards. And, doing that requires intense effort and independence. The Commission's Chairman has made it clear that he would oppose any initiative, by any group, that would compromise the FASB's effectiveness or the fact or perception of its independence. I fully support the Chairman's position. While I appreciate the important need for the Board to interact with and receive input from its constituents, any changes in its size, structure, or operating procedures should not result in a standards setting process that is more political, less credible, or more subject to special interest pressure. In the final analysis, before any proposals receive serious consideration, a convincing case will need to be made to demonstrate how the proposed change would make the FASB more effective and also maintain its independence. I suspect that the tensions around standards setting will always be with us. Standards setting is, after all, an important element of the self regulation of financial reporting. And, I believe that periodic evaluation of the effectiveness of the process can be beneficial and can help assure that the results continue to be relevant and responsive to the needs of investors and the public. Under the present structure, that responsibility rests with the FASB and the FAF, and we are looking to those organizations to review their performance, both as standards setters and as governors of private sector standards setting, and to consider any need for change. We will oversee those efforts and contribute our thoughts at the appropriate times. For all participants, there needs to be realistic thinking and candid dialogue about the need for the FASB to effectively address the most important financial reporting issues of the day, along with a renewed commitment to strengthening a standards setting process that has produced the best financial reporting system in the world. In meetings with the leadership of the auditing profession and the business community, we have urged, and will continue to urge, that those leaders and other concerned constituents address and speak out on the important issue of maintaining strong private sector standards setting and on ways that process can be improved. It is an important time in the history of private sector standards setting, and it is a time for all who have an important stake in the success of the process to be counted. Let me now turn to some of the topics that you will hear more about from the staff later in the Conference. International Harmonization I don't think that many seriously doubt that the capital markets will continue to become more and more global and that, as globalization occurs, there will be an increasing need for a more common financial reporting framework to facilitate cross-border financings. And, it is difficult to argue in principle with the objective of a common body of uniformly accepted accounting standards. There is no question that achieving that goal is an ambitious task, however, and that it will require an unparalleled degree of cooperation among standards setters and regulators around the world. It involves a process of reconciling the interests of different business, professional, and regulatory cultures and systems. It will be a challenging task, but one that is worth the effort. I support the objective of international harmonization, and I support the June 1995 work plan of the International Accounting Standards Committee (IASC). The Technical Committee of the International Organization of Securities Commissioners (IOSCO), of which the SEC is a member, has agreed that the IASC work plan will result, on successful completion, in a comprehensive core set of standards that would be recommended for acceptance in cross-border filings. IASC is looking at ways to accelerate completion of their work plan, and I support those efforts as well. The success of the plan, however, is dependent on the quality of the standards promulgated and their acceptability to the IOSCO members. And, as the IASC goes through its standards setting process, the SEC staff will insist that the standards proposed for the comprehensive core be of high quality. We will continue to express reservations about provisions that we feel are not appropriate or when we feel that the coverage is not adequate. The staff also will insist that the core standards, when accepted in filings with the SEC, be applied rigorously. By that we mean that the standards, though they may be different than US standards, should be applied with the same degree of rigor and with the same degree of adherence to the spirit and intent of the standard that we now expect of US registrants applying US standards. Let me give you an example of what I mean. Since we began accepting International Accounting Standard (IAS) 22 criteria for determining whether a business combination should be accounted for as an acquisition or as a uniting of interests, we have considered several proposals by registrants that uniting of interests accounting be permitted in circumstances in which the standard seemed to call for acquisition accounting. Those were situations in which, first, the transactions did not clearly result in a substantially equal exchange of voting common shares, and, second, one of the combining parties could be reasonably identified as the controlling party. We rejected those proposals as being inconsistent with the explicit requirements as well as the spirit of IAS 22. When the staff agreed to accept the IAS 22 business combination criteria in filings with the SEC, it was with the understanding that the circumstances that would call for uniting of interests accounting would be unusual and rare, and that continues to be our expectation. Disclosures About Derivatives Later in the program, you will hear about the Commission's derivatives disclosure proposal released for public comment on December 28th. The Commission's objective for the proposal is to provide disclosures that will help investors better assess the market risks of registrants and better understand how those risks are managed. The proposals were developed after extensive review by the staff of disclosures made by registrants and consideration of the findings of studies published by various public and private sector organizations, such as the Association for Investment Management and Research (AIMR), the AICPA Special Committee on Financial Reporting (Jenkins Committee), the Group of 10 Central Bankers, the Basle Committee, the Group of Thirty, and a task force of the FEI. We believe that the proposal is responsive to the concerns of investors and will make disclosures about derivatives and other related instruments more useful. In an effort to learn whether we have accomplished our objective, we have asked for comment on more than 60 questions about various aspects of the proposals. The comment period ends in early May, and we look forward to receiving your comments. Auditor Independence Auditor independence issues continue to receive a lot of attention, particularly issues relating to perceptions about auditor independence as the result of providing certain non-audit services to audit clients, and the impacts on auditor independence of certain business relationships, financial arrangements, organizational structures, and so on. Internal audit outsourcing, for example, has been a challenging issue that has generated a lot of dialogue. I understand that the AICPA Professional Ethics Executive Committee will soon expose for public comment new ethics guidance that would clarify how extended auditing services impact auditor independence. We have had discussions with Committee members and staff about our concerns and expectations around this issue, and you will hear more about that later in the program. With respect to the broader issues relating to non-audit services, we have considered, and are considering, a number of situations that have focused on two questions -- "What service lines and professional disciplines are compatible with the public interest role of the independent auditor?", and "How do organizational structure and financial arrangements among the professional personnel impact the fact and perception of auditor independence?" Those issues are of special concern to the Commission because of the importance we attach to the role of the auditing profession as one of the primary gatekeepers in the Commission's capital markets program. I am aware that the Public Oversight Board recently has asked the AICPA to consider whether the Code of Professional Conduct provides an adequate framework and guidance for addressing the implications on auditor independence of new service lines and organizational structures. And, I understand that the AICPA's SEC Practice Section is initiating a project to consider those issues. I think that the POB's recommendation is timely, and we will follow the AICPA's project with interest and contribute our thoughts at the appropriate times. Conclusion That concludes my prepared remarks. Again, I appreciate the opportunity to be here today and to share my thoughts with you.