AMERICAN ACCOUNTING ASSOCIATION 1996 ANNUAL MEETING August 16, 1996 CURRENT FINANCIAL REPORTING ISSUES: CHALLENGES AND OPPORTUNITIES Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission ____________________________________ 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 Mr. Sutton and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. INTRODUCTION I appreciate the opportunity to be here and to share with you a few thoughts about accounting and financial reporting. Before I begin, I must remind you that these comments are my own and do not necessarily represent the views of the Commission or others on the staff. Recently my colleagues and I were reflecting on the many changes we're all trying to cope with today -- changes in the business and professional environment, the increasing complexity of innovative financial instruments and business transactions generally, and the expansion and diversification of capital markets -- and how difficult it is for our existing accounting framework to digest all these changes. One of them pointed me to the work of Thomas Kuhn and his book, The Structure of Scientific Revolutions. He thought I would find interesting parallels between developments in accounting theory and practice and Kuhn's commentary on the history of scientific development. I was fascinated, beginning with the familiarity of Kuhn's characterization of the typical scientist, which he described as "a somewhat conservative individual who accepted what he was taught and applied his knowledge to solving the problems that came before him." His characterization easily could describe many accountants. As with Kuhn's scientists, we have a tendency to view the route of progress as steady, linear, and cumulative. In Kuhn's model, periods of "normal scientific research" are punctuated by major breakthroughs that are the springboard for important progress. Normal scientific research is work based on an accepted model or paradigm in which researchers look for ways to extend accepted rules to explain analogous, unresolved problems. Kuhn noted that, after a period of time, scientists find that normal scientific research identifies an increasing number of anomalies that don't fit into existing and commonly accepted paradigms. Eventually, a small group of scientists proposes a new model that replaces, in whole or in part, the old framework. But, because of the conservative tendency of most scientists, there is resistance to recognizing that the current framework cannot be refined to explain the anomalies. Kuhn concludes that scientific achievement is not the result of steady progress along a single path, and points out that a linear mind set can obscure our ability to recognize the need for periodic major shifts in approaches to problems. Instead, he claims that progress is achieved through a series of what he calls "developmental episodes in which an older paradigm is replaced in whole or in part by an incompatible new one." But, what relevance does Kuhn's work have to accounting? I think it cautions us not to hold too tightly to old models at all times, and to recognize that there are times -- usually after long periods of experience in which ever-increasing numbers of anomalies are identified -- when it becomes necessary to consider the possibility of replacement models rather than continuing refinements of existing models. Kuhn also cautions us, however, that a conclusion that it is time for major change is a conclusion that must be reached cautiously, after considerable testing of the alternatives, because the cost of being wrong can be very high. Now, let's turn to some of the issues that involve, to differing degrees, struggles to adapt our current models for some persistent anomalies. And the first of these is accounting for derivatives and hedging. DERIVATIVES AND HEDGING Derivatives provide an excellent example of how innovation and change can overwhelm conventional systems. It seems but a short period since derivatives were used in limited circumstances by a few relatively large registrants. As time has passed, the derivatives markets have become deeper and richer; technology has improved; and the sophistication of risk management strategies has increased to a point that the use of these instruments in managing a host of market risks has become relatively common. As a result, the number of constituents that have a stake in the accounting for derivatives has increased significantly, and improving accounting in this complex area has become a challenging, but necessary, task. Further complicating this exercise is the reality that stakeholders have very conflicting interests in the accounting for derivatives, and there are powerful voices calling for preservation of the status quo or modest refinements to the current accounting model. My view is that our current hedge accounting model is broken, and it needs to be fixed. When I say that the model is broken, I refer to the fact that the hedge accounting criteria for futures differs from the criteria for swaps. The criteria for purchased options depends on whether they are foreign currency options or domestic currency options. The criteria for foreign currency options further depends on whether the options are "at or near the money" rather than "out of the money" or "in the money". And, there are differences between the accounting for stand-alone written options and written options embedded in other derivatives, like swaps. I could go on, but I think I have made the point. Applying Kuhn's analysis, this is an area in which standard setters and regulators for years have been wrestling with a laundry list of anomalies in practice, and there have been many frustrating and failed attempts to address those problems. In retrospect, perhaps we've been too focused on trying to resolve those anomalies within the existing paradigm, rather than recognizing that it may be time to adopt a new framework. As a result of that focus, the Financial Accounting Standards Board (FASB) has been, and will be, encouraged to incorporate a number of compromises into its approach. While calls for compromise are inherent to the standard setting process, we must be alert to the risk that compromise may weaken the foundations of the framework. Some call the FASB's proposed framework radical -- too major a change from current practice. When I hear the term radical used in this context, I am reminded that one definition of a radical is someone who sees things that others do not see. From my perspective, the FASB's approach is an important shift in our accounting model that should provide a better framework for improving the accounting for derivatives and other financial instruments. I think that it is important to recognize, however, that once the Board decided to include hedge accounting in its model, it effectively committed to a series of rules that would accommodate some, but not all, of the many accounting anomalies that exist in our current mixed attribute accounting model. With that decision it is axiomatic that -- in this limited project -- some anomalies will get resolved while others will not, and some new anomalies will be created. The staff of the Commission is prepared to accept that result, with certain caveats. Because a hedge accounting model permits, in some circumstances, the deferral of realized and unrealized losses, or the acceleration of gains, the staff believes that limitations on the use of hedge accounting are both appropriate and necessary. Specifically, consistent with the Commission's concerns for investor protection, the staff believes that deferral of losses on derivative instruments should be permitted only in very limited circumstances. Broadly speaking, the staff has significant investor protection concerns whenever assets are recorded as a result of incurring losses. Thus, we believe that it is appropriate for the Board's hedge accounting model to include restrictive criteria that can be objectively evaluated and rigorously applied. I look forward to hearing the views of others on this very important matter during the comment process. Now, I will turn for a few minutes to accounting for business combinations, and more specifically, pooling of interests accounting -- a topic which can be characterized as an "old favorite" for an entire generation of accountants. BUSINESS COMBINATIONS When I used to commute into New York City by train, I was introduced to the concept of a "station car." This is the old car that you keep to get you the couple of miles to the train station and back. While it won't do much for your image, you keep it because it's paid for, no one will try to steal it, and your kids never ask to borrow it. Many look at Accounting Principles Board Opinion 16 (APB 16) in the same way -- it isn't elegant, but it's paid for, and it's been running a long time, so why not just keep it in service? The problem is that APB 16 has some major design flaws, especially its pooling of interests provisions, that have created unexplainable anomalies in practice and an endless stream of practice problems. As a result, accountants have been clocking up pretty high repair bills over the years to keep APB 16 on the road. Our experience is that interpreting and applying the pooling criteria of APB 16 has required enormous amounts of time -- by registrants and their auditors, as well as the staff -- that seems to me to be impossible to justify. Since the publication of APB 16 in 1970, continuing consideration of business combination issues has required 39 formal interpretations published by the AICPA; three FASB interpretations, and one FASB Technical Bulletin; more than 50 Emerging Issues Task Force Issues; four Accounting Series Releases published by the Commission and at least eight staff accounting bulletins. In 1973, former Chief Accountant Sandy Burton described the pooling of interests provisions in a memorandum to the Commission, as follows. He said: [They represent] a compromise between those members ... who wished to sharply curtail or eliminate pooling ... and those who merely wished to curb a few of the obvious abuses which had grown up in the sixties. As with any compromise, the result was not an entirely satisfactory one .... What emerged was a list of conditions which had to be met in order ... to qualify for pooling treatment. There is not a great deal of logic in some of these conditions .... Let me give you the flavor of the types of "repair and maintenance" issues we address in applying the pooling of interests criteria of APB 16. Recognizing that a plan to acquire treasury shares issued in the combination would preclude pooling of interests accounting, what impact would a plan to consider acquiring treasury shares have on the accounting? Recognizing that alterations of equity interests in contemplation of the combination would preclude pooling, do alterations in contemplation of a combination but not the combination cause problems? Recognizing that contingently issuable shares would preclude pooling, but putting issued shares in escrow would not, would placing in escrow 80% of the shares issued in the combination be acceptable? Recognizing that paying cash for shares issued would preclude pooling accounting, may a company pay cash bonuses, contingent upon completion of the combination, to employees who also are shareholders? Issues like these, described recently by a journalist as requiring "much unproductive time [devoted] to angels-on-a-pin debates," ignore what is recognized elsewhere in the world as the only logical justification for pooling of interests accounting, and that is a business combination in which an acquirer cannot be identified. While we take pride in the quality of US accounting standards, I think this is one area where we must acknowledge that we are trailing world opinion in permitting an accounting practice that largely is precluded in the rest of the world. Our neighbors in Canada, for example, are concerned that the permissive US accounting practices create an uneven playing field for Canadian companies who seek to compete in the US capital market. In 1973, Sandy concluded his comments to the Commission on APB 16 by saying, "[I]t seems apparent, therefore, that the area of business combinations is one which must be looked at by the new Financial Accounting Standards Board." I believe that the time is now ripe for reconsidering APB 16 and the circumstances, if any, in which pooling of interests accounting should be permitted. Whenever the prospect of restricting pooling of interests accounting is discussed, the very next issue raised is accounting for intangible assets and goodwill. Some will suggest that any new standards for business combination accounting not require amortization of goodwill and other intangible assets that are perceived to have indefinite useful lives, but rather require a periodic impairment test. That proposal has been raised in the project on intangible assets of the International Accounting Standards Committee (IASC), and the UK's Accounting Standards Board is considering such an approach in its project to reconsider accounting for intangible assets. I have serious reservations about that approach. It seems to me that, under our historical cost accounting model, the cost of long-lived intangible assets, as with all other long-lived assets, should be allocated (amortized) over the estimated useful lives of those assets. That accounting, I believe, is fundamental to the decision to recognize intangibles as long-lived assets. The "indefinite useful life with an impairment test" approach was the accounting model that preceded APB 16, and it didn't work very well. The forty-year maximum amortization period required by APB 16 was established to assure that the cost of intangible assets would not be allocated over extremely long periods, but the forty-year limit also has resulted in a number of practice issues that has led the staff to insist on shorter lives in a number of circumstances. One alternative -- not recognizing goodwill as an asset -- has been considered and rejected by standards setters in the past. I suppose that one possibility would be to reconsider that question, and I would be open to that debate. Having raised the subject of international trends in accounting, I'll turn to my last topic, international accounting standards. INTERNATIONAL ACCOUNTING STANDARDS There is no question that standard setting in the US has been enormously successful, and that the role of the FASB has been, and will continue to be, critical to our capital markets. The US capital markets have achieved a level of integrity that has made them the deepest and most liquid in the world, attracting ever-increasing numbers of investors and foreign registrants. At the end of March, more than 750 foreign reporting companies, representing over 45 countries, were registered with the Commission. The preeminent position of US capital markets has been achieved in large measure because of the high quality of the US accounting and disclosure system. As capital markets around the world continue to develop, companies seeking capital will look for the best markets, and investors providing capital will need to make comparisons of investment opportunities so that they can make informed investment decisions. We are facing a future in which capital flows across borders can be expected to continue to grow, and the need for a common, high quality financial reporting and disclosure framework to facilitate cross-border financings will become more intense. The Commission and its fellow regulators around the world are seeking to accomplish this goal, and have been working with the IASC to achieve it. There are some key points about this process that I'd like to emphasize. As the trend towards global capital markets accelerates, it is difficult to argue in principle with the objective of uniformly accepted accounting standards that meet the needs of investors in all markets. However, this project is not an attempt to coerce other capital markets around the world to accept US GAAP. What we're trying to build is, instead, transparent markets grounded in credible financial reporting of comparable quality to US GAAP. Similarly, this is not about replacing US GAAP with international accounting standards. US GAAP is, and we want it to remain, an integral component of the success of the US capital markets. SEC acceptance of IASC standards has not already been agreed to. The decision will be made after the core standards are completed, based on the substance of those standards. There are important criteria I will discuss shortly, including development of a means to ensure rigorous and consistent interpretation, that must be satisfied. Our participation in the development of international accounting and disclosure standards is a long-term process. The IASC's efforts to complete a core set of standards is the next important milestone, not the end of the road. To begin, I'll review where we are, and what progress we've made to date, as background for where we are trying to go. In 1993, the International Organization of Securities Commissions (IOSCO) wrote to the IASC detailing the necessary components of a core set of standards that would comprise a comprehensive body of accounting principles for enterprises undertaking cross-border offerings. The list included certain elements that were not covered by existing or planned IASC standards. That group of standards is referred to as the "core standards." In 1994, the IASC completed a comparability and improvements project. Prior to this project, a number of IASC standards served to codify existing practice in many jurisdictions, permitting several alternative treatments for a single transaction. As a result of this project, many alternatives were eliminated; in a few areas, the IASC standard designated both a "benchmark" treatment and an allowed alternative. Also in 1994, IOSCO reviewed the IASC standards, as amended, and identified fourteen completed standards that, with certain reservations, would be considered acceptable core standards. IOSCO also identified those standards where there were "essential issues" remaining that were deemed critical by some countries to recommending acceptance of IASC standards. This review concluded by noting that final endorsement of the standards for use in cross-border offerings is dependent on IOSCO's assessment of the total package of core standards, when complete. In July 1995, IOSCO and the IASC reached a major milestone when the two groups agreed that the IASC's proposed work program would, if successfully completed, comprise a comprehensive core set of standards. IOSCO agreed that, if the resulting core standards are acceptable to the Technical Committee of IOSCO, that group would recommend endorsement of IASC standards for cross-border capital raising and listing purposes. In April 1996, the IASC announced a plan to accelerate its work program with the objective of completing the core standards by March 1998. The Commission shortly thereafter released a statement of support for the IASC's efforts, but with the express condition that successful completion of the program involves three key elements: The standards must include a core set of accounting pronouncements that constitutes a comprehensive, generally accepted basis of accounting; The standards must be of high quality -- they must result in comparability and transparency, and they must provide for full disclosure; and The standards must be rigorously interpreted and applied. The Commission's statement noted that, upon completion of the IASC's work plan, it is the Commission's intention to consider allowing foreign issuers to use the resulting standards in offering securities in the US. We are encouraged to see that the supporters of the IASC's program have expressed their determination that the international standard setters not seek the lowest common denominator, but rather the highest degree of credibility. In the final analysis, the success of the plan will be dependent on the quality of the standards promulgated and their acceptability to the IOSCO members. In the US, a critical factor in measuring success will be the acceptability of the standards to US investors. And, I believe that acceptability to US investors inevitably will depend on how well those IASC standards measure up in terms of transparency and credibility when compared to US standards. This process will be challenging, but it also can be a rich source of new analysis and approaches to problems. We need to be willing to evaluate the proposals objectively, measuring them not by whether they are identical to US GAAP, but rather by how well they would resolve problems that we have experienced. In other words, we need to consider whether they appropriately address known anomalies, rather than measure their quality only by comparison to our current US standards. We remain firmly committed, however, to the proposition that, to be accepted in US markets, international standards should result in the same credibility and integrity that are produced by US standards. As the IASC goes through its standard-setting process, the staff will continue to express reservations about provisions that we feel are not appropriate, or when we feel that the coverage is not adequate. There is no question that the success of this initiative will require an unparalleled degree of cooperation among standard setters and regulators around the world. Reaching agreement on internationally accepted accounting standards involves a process of reconciling the interests of different business, professional, and regulatory cultures and systems, and we must acknowledge that the prospects for success are uncertain. I will wrap up this section by emphasizing that our support for initiatives to improve financial reporting in cross border filings does not conflict in any way with our commitment to continuing improvement in accounting standards and financial reporting in the US. Indeed, the FASB has had and will continue to have a leading role -- not only by establishing credible, conceptually sound accounting standards for US issuers, but also by participating in and influencing the outcome of international standard setting efforts, and by seeking opportunities to harmonize standards developed in the US with those developed internationally without sacrificing the quality of financial reporting that US investors enjoy today and will expect in the future. And, a critical continuing role for the FASB, and an important part of its international leadership, will be to continue to identify and address in the US the difficult issues of the day to ensure that US financial reporting standards continue to lead the world in meeting the needs of investors. CONCLUSION In conclusion, these are just a few of the challenges we're dealing with today. The issues I've talked about vary in type and in the scope of the needed response. The FASB's proposal for accounting for derivatives offers a significant step forward in our accounting model. Accounting for business combinations needs a fundamental reexamination to replace a model that elevates form over substance and lacks cohesive underlying principles. And, the development of a new international accounting framework, responsive to the needs and expectations of investors around the world, will require extraordinary determination and cooperation. We all will have to stretch ourselves to deal with these and many other changes. We have to recognize anomalies when they exist, rather than trying to explain them away. We need to develop solutions that are not weighed down by linear thinking and recognize when breakthroughs, rather than extensions of the existing paradigm are needed. Certainly, some or all of these projects will impact the contents of the curriculum you teach. They also open new avenues for research, and I encourage you to use your research skills to help develop breakthroughs in dealing with some of our persistent accounting dilemmas. That concludes my prepared remarks. I would be happy to respond to your questions. # # # # # # #