What is the SEC looking for?

(Published in World Accounting Report, April 2000)

Professor Stephen Zeff, an internationally-known expert in the regulation of financial reporting, analyses the SEC Concept Release and its implications for International Accounting Standards.

In its long-awaited concept release, issued on 16 February 2000, the US Securities and Exchange Commission may have allowed the best to be the enemy of the good.

The SEC, along with many others, realizes that national securities markets, as we now know them, are fading from the scene, with the inexorable emergence of regional and then truly global markets. Profound national differences in the depth and quality of self-regulation by professional accountancy bodies and in the assiduousness with which governments regulate the profession and the securities market will no longer constrain growing enterprises that can pick and choose corporate identities, geographical bases of operation, and capital markets around the world.

This challenge requires a worldwide effort to bring about a significantly higher level of professional self-regulation, to elevate the effectiveness of governmental regulation of the markets, and to support and strengthen the effort recently begun by the Big 5 accounting firms to develop a truly international mindset in their audit engagements around the globe. In all of this, the SEC is prepared to lead the charge.

In its release, the SEC repeats its call of four years ago for a comprehensive set of high quality accounting standards, including the need for comparability and transparency, together with the rigourous interpretation and application of the standards. The SEC's initial focus was mainly on the issue of high quality standards as well as on the desired characteristics of the IASC board that is to set the standards in future.

But in major speeches last November and January, its chief accountant boldly argued for a "global financial reporting framework" that would include key elements to address the SEC's expressed concern over the possible lack of rigourous interpretation and application of IASC standards, including the question of auditor independence. In its concept release, the SEC elaborated on the dimensions of the infrastructure underpinning this framework and on its role in assuring the SEC of the acceptability of the IASC's standards. Elements of this structure include:

Under the heading of profession-wide quality assurance "to ensure quality in the performance of auditing engagements by its members", the SEC stipulated the following elements:

In discussing these elements, the SEC used as its point of departure the US financial reporting model and structure. All of this is an enormously ambitious undertaking, and it portends a considerable impact of the US financial reporting structure on the regulatory and self-regulatory systems in the home countries of companies that enter the US securities market.

For its part, the SEC acknowledges that its staff would need to acquire expertise in IASC standards comparable to what it possesses for US GAAP. The SEC added that, in order to investigate possible securities law violations, its staff "may need to obtain access to a non-U.S. auditor's working papers, as well as testimony". The SEC's message is clear: high quality accounting standards are not enough without the aforementioned infrastructure.

The SEC predicates its actions on "the cornerstone principle underlying our system of regulation--pursuing our mandate of investor protection by promoting informed investment decisions through full and fair disclosure". As the SEC concedes, the financial reporting traditions in some other national cultures have been different, responding to tax authorities and central planners rather than to the needs of equity investors. But conditions even in these countries are changing at a rapid pace, and investor protection, at least in the SEC's view, is coming to the fore everywhere.

The SEC has been courageous in speaking out forcefully in its release, in urging the national professional accountancy bodies (including in the US), the major audit firms, and its regulatory brethren in IOSCO to seize the initiative and not wait until events overtake them.

Yet the SEC's call for a high quality, global financial reporting structure has significantly raised the bar for the acceptance and use of IASC standards in US securities markets. The SEC and IOSCO have always been concerned about the performance of the audit function, but the SEC's elaborate programme of auditing and regulatory reform set out in the concept release is evidently to become a precondition for the acceptability and use of the IASC's standards by foreign registrants in US securities markets without the need to reconcile to US GAAP.

But, of course, the IASC has nothing to do with the setting of auditing standards or with the conduct of the audit function. Nor is it in a position to influence the active regulatory oversight that the SEC believes is also a necessary part of the financial reporting infrastructure. The International Federation of Accountants (IFAC) and IOSCO have major leadership roles to play here.

Because of the global structure envisaged in the concept release, there will be uncertainty among non-US companies and auditors about whether, and when, the provisions of the IASC's core accounting standards that are judged by the SEC to be of high quality may actually be used by foreign registrants in US securities markets before the entire financial reporting infrastructure dictated by the SEC is in place and operating satisfactorily. Moreover, regulators, stock exchanges and standard-setting bodies around the world that are tracking the SEC's steps on the acceptance of IASC standards may not know how, or when, to proceed. Indeed, one might raise the question: how long will it be before the SEC allows foreign registrants to use the acceptable portions of the IASC's core standards in their financial statements, as supplemented by any additional disclosure requirements imposed by the SEC, without the need to reconcile to US GAAP?

The SEC gave no indication in the release of offering a quid pro quo for the IASC board's approval of the proposal last December to restructure itself. In the difficult and pressurised deliberations preceding its final vote, the board conceded almost every point to the SEC so as to become, in the SEC's eyes, more independent, competent, and responsive to the public interest. Therefore, it must be dismaying to the IASC's board, national standard setters, and professional accountancy bodies that the SEC says it will continue to evaluate each new IASC standard on a case-by-case basis. The SEC advises that it does not anticipate "adopting a process-oriented approach (like our approach to the FASB) to IASC standards".

In view of the IASC board's obvious interest in securing the SEC's endorsement of its standards, this posture means that the SEC will be more explicitly involved with the setting of international accounting standards than it has ever been with the setting of US accounting standards. One wonders what the SEC's tack would have been if the IASC's board had opted not to reorganize in conformity with the SEC's wishes--perhaps the SEC would have refused to consider IASC standards for foreign registrants as an option to reconciliation.

Technical differences

While the SEC avers that its staff's previous comments on the IASC standards have focussed on the quality of the standards and not on their differences from US GAAP, the SEC does entertain the possible need for "highlighting what differing information might be provided in financial statements using IASC standards compared with U.S. GAAP financial statements". Therefore, significant differences between IASC standards and US GAAP may still need to be accorded special treatment, whether in the form of a reconciliation or additional footnote disclosure.

This proviso may go some distance toward confirming the suspicions of Europeans and others outside the US that the SEC's hidden agenda all along has been to abide IASC standards for foreign registrants only if they are so much like US GAAP as to be virtually US GAAP. In this regard, the SEC inquires about whether the use of IASC standards by foreign registrants, without the need to reconcile to US GAAP, would place US registrants at a "competitive disadvantage."

The SEC has thus used its concept release to move the dialogue on the acceptability of the IASC's accounting standards for use by foreign registrants in US securities markets to a much larger stage. In doing so, it has ably fulfilled its leadership role in IOSCO. But the SEC will also raise anxiety among leaders of the standard-setting and professional accounting communities outside the US, and among national securities market regulators as well: because, in view of the global financial reporting structure that the SEC says it needs when judging the acceptability of IASC standards for use by foreign registrants in US securities markets, the SEC will be placing its stamp on the character and enforcement of accounting and auditing standards throughout the world.

Stephen Zeff (Rice University, Houston, Texas)