Speech by SEC Staff:
Remarks at Baruch College
U.S. Securities and Exchange Commission
New York, New York
May 3, 2007
Good morning. When Norm Strauss asked me to speak to you for the first time, I was delighted to accept. Norm and I go back a number of years in the easy old days of the accounting profession — pre-Sarbanes Oxley and the 404. He was a big help to me because he was in our National Technical Office when I was with E&Y.
Before I go any further, this is probably a good time to express our usual SEC disclaimer. 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 my own and do not necessarily reflect the views of the Commission or of my colleagues upon the staff of the Commission.
As you may or may not know, this is the second time around for me as a regulator. Actually, I was the first Commissioner for the Department of Financial Institutions for the State of California. That wonderful experience has been of great help in my current role as a securities regulator. Now I have moved from a state regulator to a federal regulator. Before, I was protecting the depositor, the FDIC Insurance Fund, and ultimately you, the tax payer; now, I am protecting the investor. I enjoy doing this.
I reviewed your agenda for today. You will cover some very important topics. I note that my former deputy, Scott Taub, is on the panel for complexity in financial reporting. A topic that I am very interested in and will comment on shortly.
This morning, I will cover the following topics with you:
- AS 5,
- Management Guidance,
- International Convergence and Reconciliation,
- And of course, Complexity.
AS 5 and MANAGEMENT GUIDANCE
Let me begin with the PCAOB's proposed new auditing standard on internal control over financial reporting, which was proposed for public comment on December 19th by the PCAOB. The proposed standard, which is expected to be issued as AS No. 5, is a new standard that will replace the controversial AS No. 2 if it is approved by the Commission. AS 5 should result in significant changes in auditing internal controls, including a more integrated approach to both the internal control and financial statement audits. AS 5 emphasizes a top-down, risk-based approach that is designed to focus auditors on the controls that are most likely to prevent or detect material errors in the financial statements. What should be achieved with AS5 is a better balance of costs and benefits.
We are very interested in the cost versus benefit relationship for smaller companies (4500 public companies with a public float under $75 million — micro-cap). In that regard, the proposed standard includes a separate section on scaling the audit for smaller and/or less complex companies. This separate section will serve as the foundation for additional guidance that we understand the PCAOB, with the assistance of a task force of auditors of smaller companies, is in the process of developing. We are reviewing the feedback that the PCAOB received on this part of the proposal, and are committed to a final auditing standard that can be applied to smaller companies in a way that balances the cost-benefit relationship. This is important because Section 404 implementation and auditing costs can be regressive for smaller companies.
Moving on to our proposal of management guidance for 404 — the Commission exposed the proposed guidance for comment on December 20, 2006. The comment period ended on February 26, coincidentally the same date as the PCAOB's proposal. We anticipate that the guidance the Commission ultimately adopts will be helpful to those companies that will be conducting their first assessments of internal controls in 2007.
The Commission held an open meeting two weeks ago to discuss comments that we and the PCAOB received on the proposed AS 5 and management guidance for 404. At that meeting, the Commissioners endorsed my staff's and my recommendations to eliminate waste and duplication in the Sarbanes-Oxley compliance exercise. The Commissioners urged us to continue to work closely with the PCAOB to make the internal controls provisions of Section 404 of the Sarbanes-Oxley Act of 2002 more efficient and cost effective.
The Commissioners' direction to us will focus the remaining work in four areas
- Aligning AS5 with the SEC's proposed new management guidance under Section 404, particularly with regard to prescriptive requirements, definitions and terms;
- scaling the 404 audit to account for the particular facts and circumstances of companies, particularly smaller companies;
- encouraging auditors to use professional judgment in the 404 process, particularly in using risk-assessment; and
- following a principles-based approach to determining when and to what extent the auditor can use the work of others.
As Chairman Cox has stated, the Commission is slated to consider final adoption of its management guidance proposal on May 23 and the PCAOB's final vote on its revised auditing standards should follow shortly therafter. You can see that we are committed to making the internal control requirements more efficient while maintaining and enhancing effectiveness, by focusing the effort on what truly matters to the integrity of the financial statements.
Moving on to my next topic, our office is devoting significant time and effort on projects related to the international convergence of accounting standards. My predecessor, Don Nicolaisen, laid out what is commonly referred to as the "Roadmap." The Roadmap sets forth the milestones toward eliminating the need for the US GAAP reconciliation requirement for foreign issuers who list in the US capital markets and who prepare financial statements using International Financial Reporting Standards ("IFRS") by 2009 or possibly sooner. I have continued implementing the Roadmap.
This Roadmap is very important because it considers the efficiency of the US capital markets and the effects on investors, and has the potential to lower costs to issuers relative to the current reconciliation requirements. In early March, the SEC staff hosted a roundtable to receive feedback from a variety of constituents on international financial reporting standards and the Roadmap.
As a follow up to the Roundtable, last week, the Commission issued a press release announcing the actions we intend to take relating to the acceptance of IFRS. The Commission anticipates issuing a Proposing Release this summer that will request comments on proposed changes to the Commission's rules which would allow the use of IFRS in financial reports filed by foreign private issuers that are registered with the Commission. In addition, the Commission plans a Concept Release relating to issues surrounding the possibility of treating U.S. and foreign issuers similarly in this respect by also providing U.S. issuers the alternative to use IFRS. As Chairman Cox remarked, "The next steps that the Commission is announcing today will keep us on course with the Roadmap announced in 2005." Pending public comments on the proposal, "we remain on track to eliminate reconciliation by 2009."
Receiving feedback from such a diverse group of constituents at the Roundtable on these important issues was extremely valuable to me. Each of the panelists had clearly thought deeply about international convergence and the ramifications of dropping the reconciliation requirement. Panelists observed that, while progress is being made by the FASB and IASB on the convergence of US GAAP and IFRS, removal of the reconciliation requirement in the near term may well mean that IFRS and US GAAP co-exist in the US capital markets for some period of time. Many of the panelists expressed a willingness to accept co-existence. However, it was also clear to me that many of the panelists see the ultimate endgame as one set of global standards that allow investors to compare companies around the world on an apples-to-apples basis.
In order to accomplish this objective, I encourage the FASB and IASB to continue expending their collective efforts to converge the two sets of standards. Difficult choices will need to be made, and at times it may be necessary for the two Boards to compromise on a reasonable converged solution rather than delaying in the hope that perfection can be achieved. Because the benefits to investors are expected to be enormous, all of this hard work toward convergence is well worth the effort.
Reducing unnecessary complexity in financial reporting is one of my top priorities for this year. This is an issue of great concern in the global business community. In November 2006, I participated in the "Global Public Policy Symposium" held in Paris. At the symposium, the CEOs of the six largest accounting firms issued a paper entitled "Global Capital Markets and the Global Economy." The paper included the following thoughts on complexity:
- Today's rules can produce financial statements that virtually no one understands.
- Complex rules must be resisted and withdrawn.
If left unchecked, I am concerned that unnecessary complexity in our financial reporting system has the potential to undermine the competitiveness of our capital markets. First and foremost, complexity can impose significant costs on investors by making it difficult for the average investor to understand the amounts and disclosures in a company's financial statements.
Unnecessary complexity can also impose significant costs on companies and auditors, who find it increasingly difficult to ensure that they have identified and properly analyzed all of the pronouncements and interpretive guidance that may speak to the accounting for a particular transaction. This could result in excessive compliance costs, and an increased risk of errors in financial reporting, even for the most well-intentioned companies. This trend may be reflected in the ever-rising number of restatements each year.
In 2001, only 6 years ago, a predecessor of mine, Lynn Turner, observed in a speech that revenue recognition was the largest single issue involved in restatements of financial statements. A number of those restatements related to intentional manipulations in reported financial results, alerting investors to potentially serious problems.
Moving forward to the current environment, a recent study by Audit Analytics found that there were 1,876 restatements in 2006, four times the level in 2001. Of these, many relate to highly technical areas of the accounting literature such as embedded derivatives. Restatements in these areas can result from unintentional misapplication of complex rules. I was surprised to learn that revenue-recognition was not even among the top 4 causes of restatements in 2006. Some have recently suggested that the alarmingly high number of restatements dilutes public confidence in financial reporting, and makes it difficult for investors to determine which restatements are indicative of more serious underlying problems at the affected companies.
One important step we must take to reduce unnecessary complexity is to get back to the "P" in GAAP, instead of using rules for our standards. There is no "R" in GAAP, and never has been.
The challenges are many, and will require a joint effort by the SEC, FASB, PCAOB, and all constituencies in the financial reporting community. About two months ago, I initiated a complexity project with the support of FASB and PCAOB. One alternative is for an advisory committee headed by a prominent person to begin this project. This committee would conduct a study that focuses on what created the need, if any, for our complex financial reporting systems and on solutions to the underlying issues that create those complexities. Stay tuned.
We are committed to doing our part. But, if we are truly going to be successful in decreasing unnecessary complexity, this effort must be a two way street. We will need the buy-in of all participants in the financial reporting process, so I need your help. If you are serious about reducing complexity, I must ask you to do your part and refrain from entering into accounting-motivated transactions. Attempts to structure transactions to achieve a financial reporting result that is not reflective of the underlying economic substance of the transaction work contrary to the goal of reducing complexity and moving toward principles-based standards. Such attempts only breed additional rules and regulations.
My deputy, Jim Kroeker, will speak about one such accounting-motivated transaction that has recently come to our attention in connection with the adoption of FASB Statement 159. These types of activities are disappointing, and you can be certain that the SEC staff will be vigilant in stamping out abusive practices. I firmly believe that substantially all companies have the objective of clearly and transparently portraying their financial results to investors, and I expect that companies will approach the adoption of principles-based standards with exactly that mindset.
In closing, I want to leave you with a couple thoughts. While I have addressed several topics that can improve financial reporting, we should not lose sight of the enormous accomplishments from the past few years. In addition to the implementation of Section 404 by accelerated filers, one significant accomplishment that is often overlooked is the acceleration of filing deadlines for many public companies. More timely information provides enormous value to investors. Large accelerated filers are now filing their annual financial statements within 60 days of year end, a 30 day acceleration. By in large, companies have responded by meeting these new deadlines while at the same time improving the quality of the reporting process through the adoption of the internal control requirements of Section 404. All participants in the financial reporting process should be proud of these accomplishments.
We have accomplished much in the past few years, and the future looks even brighter. The initiatives I have discussed today have the potential to build on our recent improvements to financial reporting, solidifying the position of the US capital markets as the most transparent and reliable in the world.
Thank you for your attention and time. It has been a pleasure to be here.