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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Improving Standard Setting To Advance the Interests of Investors


Robert K. Herdman

Chief Accountant,
U.S. Securities & Exchange Commission

Before the 22nd Annual Ray Garrett Jr. Corporate & Securities Law Institute
Northwestern University, Chicago, Illinois
April 11, 2002

Thank you for the introduction and for the invitation to be part of the Ray Garrett Jr. Corporate and Securities Law Institute program. It's great to be here in Chicago-my hometown; to be at Northwestern University, where David Ruder has made such a difference, just as he did as Chairman of the SEC; and to be at an Institute that honors the memory of Ray Garrett who, like David, was a strong SEC Chairman at a time that demanded it. I was here in Chicago when Ray Garrett was appointed to SEC Chairman, and I remember the derived pride that someone from the "Second City" had been appointed to a position of such importance to accountants and lawyers whose practices were concentrated on the capital markets and the securities laws.

Let me add one more note about David Ruder. As an accountant, I want to acknowledge and thank him for his services as a trustee of the foundation related to both the Financial Accounting Standards Board ("FASB") and the International Accounting Standards Board ("IASB"). As Chief Accountant of the SEC, I want to thank him for his willingness to be "of counsel," so to speak. David is involved in, and most thoughtful about, the activities of both these organizations, and I learn something every time I speak with him.

It is the role of those boards, and how to improve the effectiveness of accounting standard setting to advance the interests of investors, that I will speak about today. And while I realize that for the most part you are private legal practitioners and corporate counsel, I think you will agree that accounting has become quite topical in recent months, and hope you will bear with me.

Before I begin I must remind you that the views I express here today are my own and do not necessarily reflect those of the Commission, other Commissioners, or the Commission's staff. And to further establish my Chicago bona fides, let me gloat a little and point out that in this very new baseball season, the White Sox – my team – are well on the way to another .500 season, while the Cubs – well, you know.

Our financial reporting system has long been considered the best in the world and is one of the underpinnings of our capital markets, which are the deepest and most liquid in the world. However, certain aspects of the system can and should be improved so changes to accounting standards can be implemented more quickly, be more responsive to market changes, and provide more transparent information to investors. Our current system's weaknesses are more visible as a result of Enron's failure.1 . However, these weaknesses did not arise overnight, rather they evolved over many years. Investors expect our system to be the finest in the world. We intend to see that it remains the finest, and today I will discuss what I believe should be done.

Overview of U.S. Standard-Setting Process

The SEC relies on an independent, private sector standards-setting process that is thorough, open, and deliberate. While the Commission has the statutory authority to set accounting principles,2 for over 60 years it has looked to the private sector for leadership in establishing and improving accounting standards.3 The quality of our accounting standards and our capital markets can be attributed in large part to the private sector standards-setting process, as overseen by the SEC.

The primary private sector standards-setter is the FASB, which was established in 1972. An oversight body appoints the members of the FASB. This oversight body, the Financial Accounting Foundation ("FAF"), is comprised of investors, business people, accountants, and David Ruder and others who represent the public interest. The FASB's standards are designated as the primary level of generally accepted accounting principles ("GAAP"), which is the framework for accounting. The FASB's standards set forth recognition, measurement, and disclosure requirements to be used in preparing financial statements.

The secondary standard setter is the Accounting Standards Executive Committee (AcSEC), which provides guidance in the form of Statements of Position (SOPs), subject to the affirmative concurrence of the FASB. The principal purpose of AcSEC, which is a committee of the American Institute of Certified Public Accountants (AICPA), is to develop standards for specialized industries.

The interpretative body of the FASB is the Emerging Issues Task Force (EITF). It meets every other month to provide interpretative guidance, or develop new guidance, on narrow, new or emerging issues that arise under existing GAAP and when GAAP does not exist.

Criticisms of U.S. Accounting Standards and Standard Setting

We are working with the FASB to address concerns about timeliness, transparency, and complexity. Specifically, the FASB is addressing criticisms that:

  • The current standard-setting process is too cumbersome and slow.
  • Much of the recent FASB guidance is rule based and focuses on a "check-the-box" mentality that inhibits transparency.
  • Much of the recent FASB guidance is too complex.

Recently, some people have suggested that the FASB should be federalized instead of remaining in the private sector or otherwise be brought under government control. Those who suggest this apparently have lost confidence in the FASB's process. There is no assurance that simply placing the structure within the federal government would result in better accounting standards. For example, many question whether the FASB's proposal to expense stock compensation, before the Congress intervened, would have been better for investors. And more clear lessons are available from the government's intervention in accounting for the oil and gas and savings and loan industries in the 1970s and 1980s, respectively.

When done properly, standard setting in the private sector is the best alternative for our capital markets as it provides a number of advantages over federalized standard setting. Private sector standard setting has greater flexibility to complete rules more quickly than accounting standards set by the government. The FASB is comprised almost entirely of accounting experts and has a greater ability to attract and retain qualified personnel. Similarly, AcSEC and the EITF are composed of members with accounting expertise.

Federalization of the FASB not only would require increases to the federal budget, but also might disenfranchise those who are best qualified to address the highly complex business and accounting issues that must be resolved. I believe that with the Commission's leadership and cooperation by the FASB, the FASB can be effective, and confidence in the process can be restored. Private-sector standard setting can work in our current business environment, even as financial transactions become more complex. In spite of recent events, we still have the best financial reporting system in the world, and the Commission is intent on making it even better.

Evolution of Standard Setting

As we contemplate reform, we need to consider how we got here. In the early to mid-1980s, the FASB undertook a series of projects to drastically change how financial information is reported to investors and other financial users. These projects, which include consolidation of subsidiaries and accounting for financial instruments, represent major conceptual changes in financial reporting. As you might expect, such sweeping change has been very controversial and sapped the resources of the FASB.

As a result, issues such as revenue recognition (which is a factor in approximately one-half of all restatements and financial reporting enforcement cases) and consolidation of SPEs have not been adequately addressed by the FASB. The EITF and the SEC staff have attempted to address some of the issues, but without an underlying principle the result has been disappointing.

In other cases, the FASB has delegated broad issues such as accounting for partnerships; property, plant and equipment; and the accounting for environmental liabilities to AcSEC. AcSEC is comprised of part-time volunteers from the preparer, auditor, and user communities and is subject to affirmative review by the FASB each step of the way. As a result, AcSEC is ill equipped to deal with broad issues in a timely manner. While AcSEC's guidance has been of high quality, it often takes years to issue because of its infrastructure constraints.

Another criticism that has arisen over time is the trend to complex, rule-based accounting standards. This trend can be attributed to a number of factors including (1) changes in how companies do business; (2) granting alternatives in the face of new controversial proposed standards; (3) internal conflicts in the accounting literature as the conceptual underpinnings change; (4) demands for a single answer to every question, and frankly (5) a cynical attitude that companies and auditors are incapable of applying an different approach. FASB Statement No. 133 on accounting for derivatives and hedging and Statement No. 140 on transfers of financial assets and extinguishments of financial liabilities are two prominent standards that have been subject to such criticism.

In response, the FASB has announced that it is working on these issues as part of its project on simplification. While it is too early to tell whether it will be successful, I am enthusiastic that the Board has taken the first step by adding such a project to its agenda. Success is going to be largely dependent on all of us – preparers, auditors, users, and regulators. I encourage you to challenge yourself, as we at the SEC plan to, the next time you feel the need to ask the FASB for an answer on a specific fact pattern or an exception, as you consider a new FASB proposal.

Improving Timeliness

Several other actions should be taken to continue to ensure that our financial reporting system remains the premier system in the world. For example, the FASB must change the manner in which it carries out its activities and the scope of many of its technical projects.

The FASB uses a building-block approach when developing standards. That is, the Board addresses a handful of issues at any given meeting instead of all of the issues that comprise a single proposal. This approach tends to expand the time it takes to resolve reporting issues and can compromise standards because Board members do not see the entire picture during the debate. In contrast, the SEC staff generally presents an entire proposal to the Commission for consideration. I believe that the FASB should reconsider its approach.

In addition, the Board's major projects tend to be very broad. For example, the FASB currently has on its agenda a liabilities and equity project that raises six or seven issues. I believe the scope of this project is too broad. It attempts to weave too many issues into a conceptual framework everyone can agree on. As it turns out, most people agree that more guidance is needed on equity derivatives and redeemable preferred stock. Why not separate out these issues and provide timely guidance on them? The remaining issues, such as minority interest and requiring separate accounting for elements of certain debt instruments where many believe no additional guidance is necessary, can be addressed at later dates if necessary. Narrowing the scope to its critical elements allows the process to move forward in a timely manner.

As another example, the FASB currently is trying to decide how to address the issue of revenue recognition. It is considering expanding the scope of the project to include liabilities as well. We have encouraged the Board to limit the project to revenue recognition. If, however, at the end of the revenue recognition project it is evident that the liability recognition guidance needs improvement, then we think that would be the appropriate time to revisit those issues.

Some are calling for a limitation on the time a project can be on the FASB's agenda. I share their concerns about timeliness. It is clear that the FASB must work more quickly in order to be more responsive to market needs. For example, how it deals with the issue of when to consolidate SPEs is important. This project must be finished so it can be both effective for, and implemented by, the end of this year, although there undoubtedly will be some transition issues for past transactions. If the FASB is not able to make progress on such important issues as they arise, the SEC has the responsibility to take action. Because of our oversight responsibilities, we are obligated to ensure that the FASB works on the appropriate projects and completes them in a timely manner.

After a review of recent events, the Trustees of the FAF agreed that there is a need for the FASB to be more flexible in responding to change and to increase the efficiency of its standard-setting process. The Trustees are committed to accelerating the standard-setting process by improving the FASB's efficiency without compromising the quality of its open due process. To meet that objective, the Trustees proposed the following:

  • A reduction in the size of the FASB from seven to five members.
  • A simple majority-voting requirement of 3-2 for the five-member board. The current board has a 5-2 supermajority voting requirement.
  • A recommendation to the FASB that it expose proposed standards for shorter comment periods.

Until April 17 the Trustees are accepting public comments on the proposal and will carefully consider responses before deciding on a course of action. I encourage each of you to weigh in, or encourage your clients to do so.

In addition, the FASB has recently realigned its staff and is contemplating more changes with the hope of improving efficiency. We are encouraged by the fact that these efforts of the FAF and the FASB are directed towards gaining increased efficiency, which is our principal goal as we reform our oversight of the Board's activities. When Ed Jenkins, the Chairman of the FASB, announced last Fall his intention to retire on June 30 of this year, he expressed regret that the Board had not achieved greater speed in completing projects. He certainly has "set the table" for his soon to be chosen successor to be able to work on this aspect of the Board's performance.

Principle-Based Accounting Standards

As I mentioned in my introduction, over the last few years many of the FASB standards have been rule based, as opposed to principles based. Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting. As I mentioned before, an example of rule-based accounting guidance is the accounting for derivatives and hedging. Another is the 25-year old rules concerning leasing. And, of course, questions keep coming. Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard.

Furthermore, a byproduct of rule-based accounting standards has been an increase in the number of "SAS 50" letters issued to investment banks providing opinions as to whether hypothetical transactions follow accounting standards. SAS 50 letters may be used as the basis to structure complex transactions that technically comply with accounting standards, but do not accurately reflect the objectives of the standards. I believe it is in the public interest that the Auditing Standards Board ban those types of letters, and in February I sent a letter to the Auditing Standards Board urging that it do so. I understand that the ASB is considering this issue next week and I encourage the Board to act on it expeditiously.

An ideal accounting standard is one that is principles-based and requires financial reporting to reflect the economic substance, not the form, of the transaction. FASB Statement Nos. 141, Business Combinations, and 142, Goodwill and Other Intangible Assets, which were issued in 2001, appear to be steps in the right direction. These standards set forth principles and clear objectives, and will serve as a test of the level of specificity needed to strike a balance between rules and principles. Principles-based standards will yield a less complex financial reporting paradigm that is more responsive to emerging issues.

A move to principles-based standards requires greater discipline by the corporate community, the accounting profession, private sector standard-setting bodies, and, indeed, the SEC staff. A move away from a check-the-box approach to financial reporting means that all constituencies must make concerted efforts to report transactions consistent with the objectives of the standards. While this may mean that not all transactions are recorded in exactly the same manner, it is my belief that similar transactions in this system of principle-based standards will not be reported in materially different ways, thus preserving adequate comparability.

While the FASB addresses issues of timeliness, transparency and complexity it must remain nimble to deal with changes in the market. Looking ahead, it must accelerate its efforts to achieve short-term convergence with the International Accounting Standards Board and coordinate with the SEC's financial reporting and disclosure reform initiatives so our capital markets can continue to be the deepest and most liquid in the world.

The IASB has determined that it will take a principles-based approach to its standards. This was not a surprise, because I knew from many of my former non-US associates that they would loathe accepting the style of Anglo-American standards. But the leaders of that Board also have pointed out that that approach should allow it to move with greater speed, an idea we obviously like very much, and an imperative for IASB standards to be ready for the European Union's dictate that IAS be used by all listed companies starting, for the most part, in 2005.

SEC Oversight

As I stated at the outset, the FASB is subject to the oversight of the SEC. We, too, have a role to play in improving the efficiency and effectiveness of it processes.

Allow me to describe how I believe that oversight should work. In light of its enforcement and filing review activities, the SEC is in a unique position to provide input into the FASB's agenda. We have a responsibility to do that, and the FASB has a responsibility to address the issues we refer to them in the time frame that we request, even if it is as short as 180 days. I believe that we can and should stay out of their way once we ask them to take on a project, and only intercede if we believe the contemplated solution is not in the interest of investors, which I believe will rarely be the case. However, we will meet with the FASB frequently to monitor the status of their projects. If projects are languishing, we must understand why, and when appropriate give the Board our views about what should be done.


In summary, let me reiterate that we have the deepest and most liquid capital markets in the world largely because of the high quality of our financial reporting system. While it is imperative that the issues of standard-setting timeliness, transparency, and simplification of accounting standards be addressed, we should not abandon the system that has allowed us to achieve such past success. Instead we should take the opportunity to improve our current standard setting system to ensure our continued leadership in the world's financial markets.

1 In a Form 8-K dated November 8, 2001, Enron Corporation stated that it would restate its financial statements for the years ended December 31, 1997 through 2000 and quarters ended March 31 and June 30 2001 because it did not follow GAAP. On December 2, 2001 Enron filed for bankruptcy.
2 See, e.g., section 19(a) of the Securities Act of 1933, 15USC 77s(a), and section 13(b)(1) of the Securities Exchange Act of 1934, 15 USC 78m(b)(1).
3 Accounting Series Release (ASR) No. 4 (April 1938) and ASR No. 150 (December 1972).




Modified: 04/22/2002