Speech by SEC Commissioner:
"Complexity in Financial Reporting and Disclosure Regulation"
Remarks before the 25th Annual USC Leventhal School of Accounting SEC and Financial Reporting Institute Conference
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
June 8, 2006
Thank you, Randy, and good afternoon. It is a pleasure to be here. I also want to thank Don Nicolaisen, our former Chief Accountant at the SEC, for inviting me. And I want to extend regards to the USC contingent from a very special USC alumnus - our Chairman, Chris Cox. Before I begin my remarks, I must make the standard disclaimer that the views I express are my own, and not those of the Commission, my fellow Commissioners or the staff.
My topic this morning is complexity of financial reporting and the underlying accounting standards. Why am I concerned about that? The answer goes to why we have accounting standards and disclosure rules in the first place. What are we trying to accomplish? We want companies to present their business and financial condition based on current knowledge and expectations for the future. We want accurate reports of companies' operating results and cash flows. We also want financial statements to reflect economic and business reality because, ultimately, this helps investors formulate their investment decisions.
If the financial statements distort economic and business reality, capital will be deployed sub-optimally; resources will be misallocated; investors will pay a huge opportunity cost by investing in companies with unrealistic, inflated values; and better investments will get bypassed. Customers and suppliers would make important business and strategic decisions based on a flawed picture of economic reality. Lenders would not be able to price loans consistent with the real risk assumed. Competitors would strive to achieve unrealistic goals. Employees would make career, retirement and investment decisions based on a false picture of their employer's financial prospects. This parade of horribles should sound familiar - these were the very painful consequences of the Enron scandal. Whether financial statements are inaccurate because of fraud or complex financial standards, the result can be the same - an erosion of confidence in the disclosure that fosters investment, and adverse effects on the economy and people's financial wellbeing.
During my tenure at the SEC, the Commission has focused heavily on deterring accounting fraud through enforcement actions and rulemaking. Even before the scandals at Enron and WorldCom, but increasingly so afterwards, the Commission has been relentless in taking enforcement action against companies and company executives that have engaged in financial fraud. The Commission has used all of the weapons in its enforcement arsenal - injunctions, disgorgement, penalties, O&D bars, industry and accounting bars and suspensions - to punish those responsible for fraudulent conduct and to deter others from engaging in similar activity. The scandals raised investor concerns about the veracity of the company disclosures, and they became more apt to question whether companies' operating results and financial condition were accurately reflected in their financial statements.
To restore investor confidence, Congress passed the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), and the Commission promulgated a myriad of new regulations designed to improve corporate governance, enhance auditor independence, and elicit more meaningful and accurate corporate disclosure. While the Commission continued its aggressive enforcement activity after Sarbanes-Oxley, our regulatory focus expanded to include corporate governance and the processes and procedures necessary to further induce public companies to provide reliable financial statements and other disclosures.
Going forward, we should, of course, continue to focus on ensuring compliance with GAAP, its technical standards and the disclosure rules, but we should also examine the actual requirements of the standards and rules themselves. Commentators have suggested that our current prescriptive accounting rules have contributed to a lack of transparency in financial reporting, where boilerplate conceals what is really going on. Thus, it appears that reducing accounting complexity and migrating to a more principles-based accounting system would encourage more accurate and complete financial disclosure. Therefore, standard setters and regulators should consider how accounting standards and disclosure rules can be re-designed to elicit information that is complete, clear and concise, and thus, more useful to investors.
But what makes disclosure useful? The ultimate purpose of disclosure requirements is to elicit full and accurate disclosure of material information. Information is material where there is a substantial likelihood that a reasonable person would consider it important in the total mix of available information to formulating an investment decision. That is what the Supreme Court has said. O.K, that's helpful. But I think we can be a little more specific. Useful disclosure is disclosure that enables investors not only to answer the question, "Should I invest in this security?" but also, "At what price should I invest?" Standard setters and regulators do not always give this latter question ample consideration, but it highlights just how important financial statement disclosure is. The financial statements are the building blocks of valuation. Whether an investor applies a comparable company or transaction analysis, or a discounted cash flow or liquidation analysis, financial statements of the company or other companies are key to valuation and thus, to making an investment decision.
The current questions about the ability of our accounting and reporting framework to communicate meaningful information to investors arise, in part, because the economy continues to evolve at a rapid pace, while reporting standards and mechanisms are in a "catch-up" mode. Globalization and the emergence of new economies and capital markets have increased dramatically. Advances in technology, including the emergence of the Internet, faster and more ubiquitous communication and other technological developments, have changed the way companies do business, as well as changing the types of financial arrangements and instruments that businesses utilize. As the business world has become more complex, so have financial reports and accounting standards.
Several other factors are contributing to problems with financial reporting standards. First, accounting standards and literature flow from a vast array of standard setters, regulators and other sources. The financial reporting landscape is littered with pronouncements from the FASB, the AICPA, the EITF, the APB, the SEC and the PCAOB. We have pronouncements, rules, regulations, guides, bulletins, audit standards, interpretations and practice aids in the form of SOPs, FAQs, SABs, Q&As and FSPs. This has been going on for decades. The result is that today, U.S. GAAP is made up of over 2,000 pronouncements. That's a lot ABCs, even for a CEO or CFO with a CPA.
Second, accounting standards have become overly prescriptive. The standards include many detailed bright-line tests that are vulnerable to financial engineering, whereby companies engage in transactions not for the economic benefit, but to take advantage of accounting treatment that makes the company's financial condition appear to the market to be better than it really is. Numerous constituencies that are involved with financial statement preparation and reporting have asked for, and in many cases obtained, bright-line tests in virtually all areas of financial reporting. In some cases, financial statement preparers have consistently called for standards that include specific examples and associated safe harbors. This permits preparers and parties to a particular transaction to structure the transaction so that it fits within a particular example or set of bright lines to achieve desired accounting treatment, often obscuring the very principles underlying the accounting standard itself.
One example of this is hedge accounting. Hedge accounting is addressed in FAS 133, which is many hundreds of pages long. The principle behind FAS 133 is that companies should report derivatives as assets or liabilities at fair value. Where companies use derivatives to hedge risks in assets and liabilities, they may qualify for accounting treatment that allows them to apply calculation "short cuts." This application is premised on very specific criteria that in some cases have not been applied consistently. It is troubling when these rules are used to manipulate earnings. But it is also troubling that some companies have altered the way they would otherwise hedge their financial risk for the sole purpose of meeting the short-cut criteria of FAS 133. Thus, FAS 133 may have the unintended consequence of impeding optimal risk management. Reporting requirements and accounting standards should not drive business practices. Rather, the business reality of a transaction should determine how it is reported in the financials.
Another example is lease accounting. Particularly in the case of operating leases, companies could potentially take advantage of the bright-line nature of the standards to make a financed purchase look like a rental contract. That's a type of magic, or should I say black magic, that standard-setters should work to discourage. An entire cottage industry has developed over the last several decades in connection with leasing - spurred in part by accounting standards. There are similar problems in areas such as revenue recognition, pensions, and allocation issues and impairment testing related to purchase accounting, just to name a few.
Third, prescriptive accounting rules can create legal problems for preparers and issuers. Bright-line tests and various exceptions to the principles underlying accounting standards may facilitate overly aggressive or even unscrupulous accounting, encouraging companies to take advantage of the complexity to provide misleading disclosure. This could result in securities law violations and be potentially devastating to shareholder value. But this complexity could also cause the well-intentioned people who run the majority of public companies to make honest mistakes, and get tripped up with restatements and possible securities law violations.
Many of us at the Commission and the FASB have been speaking about accounting-standard complexity for some time, and I have some thoughts about how we can begin to address the problem. Part of your afternoon session will be devoted to this issue, so I expect you will have the problem solved entirely by the end of the day.
First, the various accounting pronouncements that make up U.S. GAAP need to be reconciled, organized and rationalized. The FASB has undertaken a major new initiative to codify all of the literature that constitutes U.S. GAAP in one location. Having a single, authoritative codification of all relevant accounting guidance under U.S. GAAP organized by topic should enable preparers and other constituents to perform research more efficiently, promote a more comprehensive awareness of the complete body of literature, and facilitate the identification of inconsistent pronouncements. I support this effort, but think it should be expanded to include all of the other entities that comprise the alphabet soup of standard setters. These entities, including the SEC, should work together to simplify, clarify and rationalize accounting standards.
Second, standard setters should work to ensure that accounting standards are principles-based and objectives-oriented. Complicated and prescriptive accounting standards contribute to the illusion of precision in financial statements. To use an analogy from the art world, financial statements are more akin to the impressionism of Degas than the precision of Vermeer. As you well know, the various columns and rows of numbers that appear so definitive in financial statements are based in large part on estimates, assumptions and sampling. For example, pension liabilities can be premised on projected multi-billion dollar payments based on assumed discount rates applied over future periods that can extend for decades. That is an estimate loaded with assumptions, and the range of outcomes can vary widely and have dramatic effects on the balance sheet and income statement, and therefore on valuation and investment decisions. Similarly, estimates and assumptions are important, for example, in stock option expensing, depreciation and amortization, and establishing reserves.
In keeping with my art analogy, the challenge, of course, for standards setters is not to promulgate pronouncements that result in financial statements resembling distorted Picassos. Accounting standards should be concise statements built around specific objectives with sufficient detail and structure to be applied consistently, while minimizing exceptions and avoiding excessive details. To ensure that accounting standards keep pace with business developments, we must continually reassess the answer to the ultimate question, "What do investors really need to know?" Obviously, investors need accurate and relevant historical information, but it would also be helpful to know the key drivers of the business and the risks the company faces. Standards should encourage management to disclose key performance indicators and other relevant information, and concentrate on the best way to manage the company, not manage the numbers.
Prescriptive, hyper-technical rule language is not the sole province of GAAP and accounting standards. We face the same problem in securities regulation generally. The SEC is responsible for administering and promulgating its own set of statutes, rules and regulations, to which there is no clear guide for the uninitiated. In addition to the '33, '34 acts, there is the Trust Indenture Act of 1939. In 1940, we got two acts - one regulating investment companies and another regulating investment advisers. Over the last 70 years or so, the Commission has developed a very thick rule book. The list starts off benignly with Regulations A, B, C, D and E, but it is downhill from there. Regulations include S-X, S-K, S-B, M-A, S-T, M, AB, AC, FD, G and S, just to name a few. There are rules, releases, no action letters, FAQs, SABs, SLBs… Well, I think you get the idea. We have our own arcane, secret language and jargon, and it's complicated. As the SEC's Task Force on Disclosure Simplification summarized the problem in 1996,
"Like all agencies . . . the SEC has suffered from
the bureaucratic tendency to create ever thicker rule books. Each complication breeds another level of complexity and, over time, the original regulatory goal becomes obscured amid thousands of words of detailed dictates. Some SEC rules, intended to guide market participants in daily decisions, have become a kind of Latin liturgy, comprehensible only to those of us who have devoted our professional lives to abstract regulatory nuances."
As many of you know or have probably figured out by now, I am an economist, not a securities lawyer or an accountant. When I joined the Commission in 2002, I asked for an organized list of, or clear guide to, the various SEC regulations. I quickly learned that such a list or guide does not exist. I think it should.
Going forward, I believe the Commission needs to work to simplify its rules and streamline its regulatory scheme. The Commission should identify and eliminate obsolete and duplicative regulations, rationalize definitions, update regulatory thresholds, and consolidate forms. In particular, the Commission's disclosure regime needs to "catch-up" with the times, and take advantage of advances in Internet and communication technology. Today, we are beginning to make use of interactive data that enables filers to use special definitions to "tag" various items in their financial reports. I analogize tagged interactive data to Lego building blocks. Investors can use the data to construct for themselves financial, operating ratio or other meaningful information about companies just as Lego blocks can be used to build a variety of different structures. Users can retrieve the tagged data through computer searches and analyze it quickly and easily using software tools. This saves time and money and ensures better accuracy, ultimately resulting in more robust and efficient analyses. I am confident that this powerful technology could make the information that registrants file with us more useful to investors and other global market constituents. In the meantime, I want to let you know that we are working on other projects to make EDGAR filings more easily searchable. As of this week, you can now do electronic searches through the full text of the last two years of EDGAR filings on the SEC website.
As you know, my tenure as an SEC commissioner is coming to an end. As I leave for new challenges, you too will be facing challenges, including those I mentioned today. My parting advice is to take a step back and try to see the forest, and not just the trees, as you tackle these challenges. As public accountants, you are the entrusted gatekeepers of the financial statements, which are the building blocks of valuation and investment decisions. Especially, in light of the accounting scandals, you need to continue to work to renew that trust. Please, remember - and take seriously - that important responsibility.
I thank you all for your time today. I wish you luck, and I wish you well.