Speech by SEC Staff:
"Looking Forward and Back at Financial Reporting"
Remarks Before the SEC Historical Society Annual Meeting
Scott A. Taub
Acting Chief Accountant
U.S. Securities and Exchange Commission
June 6, 2006
Good afternoon everybody. As most of you know, I do a lot of speeches to get the word out about what's happening in the Office of the Chief Accountant. Amongst the speeches and presentations I've given, I have had some very daunting time slots. I've spoken at a 7 am session after a late-night reception. I've done a training session on a Sunday morning. I've been the final speaker at a conference that ended on a Saturday afternoon. And once, I had to follow Paul Volcker- not only was he a better speaker with far more interesting things to discuss than I had, but he's also about 6 foot 9, so when I got to the podium, I had to reach up over my head to get the microphone. And of course, I've been the last speaker before lunch or drinks time and time again. But none of those slots was as challenging as this one - standing between a bunch of SEC staff members and free ice cream. So I promise to keep this brief.
Of course, I need to remind you that I speak only for myself today and not for the Commission or other members of the SEC staff.
You've just heard a distinguished panel discuss many of the key issues facing the financial reporting world. Normally, I would now tell you what the SEC is doing in regards to those issues. But given the audience, many of you already know about those efforts. So instead, I'll spend the next few minutes on several key issues about the framework under which we at the SEC and other participants in the financial reporting process think about the issues. The right mindset in these areas will help ensure that reporting in the future will serve the capital markets as it should, and will allow us to more easily drive down errors and the costs of reporting, while making things more understandable for investors.
1. Allow Accounting Standards to Focus on Transparency of Information
In keeping with the fact that we're at a meeting of the SEC Historical Society, I'm going to start with a quote from one of my predecessors, Mike Sutton, regarding the objective of financial reporting:
…[P]ublic policy objectives…should not supplant or compromise the essential goal of financial reporting to public investors - providing reliable, decision-useful information to shareholders and prospective shareholders. Accounting and disclosure should have no other public policy objectives than to provide the best possible financial reporting to investors that will serve as a sound basis for investment decisions. To accomplish those objectives, financial reporting must portray economic transactions and events, and economic performance, in a neutral way, without slanting the results to favor any one economic interest.1
Unfortunately, many standards include compromises that are intended to allow the reporting of economic events to be deferred or that simply allow certain things to not be reported at all in the interests of encouraging, or at least not discouraging, various transactions. Currently, these discussions generally go to accounting for pensions and leases. In the past, derivatives and stock options. I've sometimes spoken pretty candidly on this subject, and been rebuked for it by policymakers, senior officers of companies, and even my best friend, who happens to be controller of a .com company. So instead of sticking my neck out, I'll reinforce the message by looking to Chief Accountant Sandy Burton, who said in 1973:
If on the basis of realistic economic data investors would require a greater return on capital, it is not desirable to coax them into an investment on the basis of defective measurements. I have heard … from others, the argument that showing the truth would cause higher costs…or what have you…I don't believe this is adequate justification either morally or economically for falsehood in financial statements.2
To ensure vibrant markets, we need to make sure that investors get standards that choose transparency over predictability, relevance of information over precision of calculation, and investor needs over those of management, regulators, or others.
2. Apply the Standards, Don't Abuse Them
To help make my next point, I turn to Chief Accountant Clarence Sampson, who in 1985 contended:
Fair presentation is hard to define, but you know it when you see it….It is…not "fair" to account for a transaction in a manner which presents it in the best light for the company, regardless of the realities of the circumstances. It is not "fair" for a company to structure transactions to report desirable results, thereby artificially disguising its real financial results.3
The FASB writes standards that are intended to be applied by people who are trying to accurately report the effects of transactions. The exact opposite of that is entering into a transaction intended to result in reporting that is inconsistent with the economics of the transaction.
Sometimes when I talk about the evils of structuring, those I speak to raise the concern that it is difficult to identify accounting-motivated structures. But I don't think that's the case at all. Like Clarence said, "you know it when you see it". I believe that a good, knowledgeable accounting professional knows when he or she is "abusing" the literature instead of applying it in the manner in which it was intended - and it is those abusive situations that should be ended.
3. Use Professional Judgment
Again looking to the past to help me envision the future of financial reporting, I'll plagiarize comments of Chief Accountant Andrew Barr, who said in 1963 "…accounting is not an exact science …[P]recise rules or mathematical formulas cannot be devised as guiding principles …[A]ccounting decisions are largely a matter of judgments."4
Unfortunately, we have gotten to a place today where there is something of an aversion to applying judgment. Often, the answer people seek is whichever one is perceived to be safest, but those answers are not always the most transparent for investors. And we constantly get calls for every potential interpretive matter to be documented and the answer officially blessed. This, of course, leads us further into complexity and rules-based accounting, places that most of us say we don't want to go. The SEC staff has, of course, written at length about this in our 2003 report on objectives-oriented accounting standards.5
As that report noted, successfully implementing principles-based standards will necessitate an ever greater reliance on professional judgment. This will be difficult if practitioners continue to be reluctant, afraid, or unable to make well-reasoned professional judgments. Some of the factors that have gotten us to this point are clear - fears of litigation to rise, and scrutiny of accounting and auditing is as high as its ever been. It's not surprising that in this environment, people feel like they are exposed if they rely on their own judgment to make important reporting decisions.
Many have blamed the SEC in large part for this state of affairs, suggesting that our actions raise the fear of being second-guessed to the point where people don't want to leave open that possibility. I continue to try to do something about that. We obviously shouldn't be objecting to well-founded, reasonable judgments that are made within the context of the existing accounting literature. Keeping to the pattern of this speech, I tried to find words from a former Chief Accountant to help me here, and found a comment on the subject of judgment from Walter Schuetze in 1993:
…some people say that financial statement preparation ought to be left, in large part, to the judgment of those who prepare and audit financial statements. That we should have broad, general financial accounting and reporting standards emanating from the FASB, with their implementation being left to the issuer of the financial statements and its auditor. That approach will not work…broad general rules left to the judgment of issuers and their auditors have not worked and will not work.6
Ok…so maybe Chief Accountants over the years have not always sent completely consistent messages on this topic. I believe, though, that what Walter was really complaining about was biased and unprincipled accounting improperly described as "the application of judgment." And of course, we should object to that when we see it. In the same 1963 speech I referred to before, Andrew Barr, reading from an earlier publication, explained this quite well:
The acceptability of "judgment" and "estimate" in accounting does not extend to willful or wishful expedience …The estimates and judgments must have a rational basis under the circumstances, that is, justification stronger than self-seeking arbitrary choice and stronger than a desire to have accounting figures show what one wishes them to show.7
In the end, while bright lines need to be respected when they exist in GAAP, there are plenty of places where the accounting literature calls for the application of judgment. Preparers and auditors need to be professionals and make the necessary judgments to ensure high-quality reporting. And so long as those judgments result in transparent reporting, they are unlikely to raise concerns that would cause us to object.
4. Sometimes it is Important to go Beyond Minimum Disclosure Requirements
I'll quote Clarence Sampson once more to make my final point. He noted that "management knows more about the company than investors or creditors, and can often increase the usefulness of financial statements by identifying certain events and circumstances and explaining their financial effect on the company."8
I have a slide that I use when I do presentations that urges companies to go beyond the minimum requirements if needed to better communicate with investors. And a recommendation along those lines is included in the SEC staff report on Off-Balance Sheet Arrangements.9 Too often though, the attitude seems to be that if a disclosure isn't explicitly required, then there's no reason to make it. I actually heard an executive of a company suggest that there wasn't a disclosure violation in regards to backdating of stock options, because the executive compensation rules don't specifically require disclosures about backdating. And I constantly hear people cite the fact that their key performance indicators aren't in SEC reports as evidence of a deficiency in the standards or rules. This is even though there is nothing to stop companies from disclosing those key performance indicators voluntarily - not many of them do it.
Let's face it -- there is no way the SEC and FASB can write standards and rules that comprehensively list all of the disclosures that might be important to investors. Indeed, attempts to do that are likely to contribute to confusion, complexity, and disclosure overload. We will be much better off if, instead of only disclosing what is specifically required, companies disclose the key information, whether a specific requirement to disclose that piece of information exists or not. If this happens, quality of disclosure will improve without any new regulatory burden.
In conclusion, let me say that I hope you've enjoyed spending these few minutes exploring the financial reporting issues of today with me, and with the others whose words I used so liberally in making these remarks. There is a lot to do as we move forward, but the Historical Society reminds us, and the preparation of these remarks has reminded me, that we can often learn a lot about the issues of today by looking to the past. Thank you for your attention.