Remarks before the Institute of Management Accountant’s 2018 Annual Conference and Expo: “Advancing the Purpose and Promise of Those Involved in Financial Reporting”
June 19, 2018
These remarks reflect solely my personal views, and do not necessarily reflect the views of the Securities and Exchange Commission, the individual members of the Commission or its staff. The Securities and Exchange Commission and I reserve the right to use my materials, statements and biographical information in any manner, including at other conferences and legal education programs.
Thank you, Marc [Palker] for the kind introduction and your service in leadership roles over the years at the IMA. Thank you also to Jeff Thomson for the invitation to be with you. I'm grateful for the opportunity to join you today.
At this conference, you are participating in an event described using words like “infinite potential.” Here, you have the opportunity to meet face-to-face with nearly one thousand management accounting and corporate finance professionals, executives, and decision-makers from around the globe who solve business challenges.
Founded in 1919 by farsighted business and accounting leaders, the Institute of Management Accountants (IMA) is now a worldwide association of accountants whose members reflect a wide variety of cultures, nationalities, and ages. As management accountants, your work is vital to the financial reporting process. You safeguard a company’s integrity when you make well-considered and adequately supported judgments and decisions.
As CFOs, controllers, budget analysts, treasurers, and other management accountants, you help drive the information that is ultimately included in many shareholder and creditor communications. These communications, when made with appropriate care and candor, build public trust and help sustain the ability of businesses to raise the capital they need to grow and compete.
Before I continue, let me remind you that the views expressed today are my own and not necessarily those of the Commission, the individual Commissioners, or other colleagues on the Commission staff.
Let me also express a word of gratitude to the entire OCA team for their work in providing advice to the Commission regarding accounting and auditing matters arising in the administration of the federal securities laws. I also want to acknowledge the valuable assistance of Tom Collens in preparing me to make today’s remarks.
Today, my remarks will examine the context for and vital role of management accountants within our financial reporting process and the relationship among management, the audit committee, and the auditor. Finally, I will close by sharing some views on technology.
Business and markets
Business and our capital markets are essential to our economy. In the United States, private-sector companies are the source of 126 million jobs. These businesses contribute to the tax basis of every city and state as well as the federal government. These businesses help our global economy, with approximately $2.3 trillion of American exports in 2017 alone. Among these businesses, public companies are a source of the long-term financial security for a significant number of American households. For example, among all families that held investments in stock as of 2016, which comprised over half of all households, more than 88% owned stock through a tax-deferred retirement account.
Technology and trade have also made our world considerably smaller. Many companies operate in a global market and seek capital globally. In fact, today in the United States, more than ever before American investors are investing directly in the securities of foreign private issuers and companies based outside the United States and registered in non-U.S. jurisdictions. At the end of 2016, U.S. investors had invested $9.9 trillion (of which U.S. mutual funds had invested over $4.3 trillion, and U.S. pension funds had invested over $1.3 trillion) in equity and debt securities listed in non-U.S. jurisdictions. Also, as of the end of 2016, according to one industry ranking of the world’s largest asset managers, U.S.-based asset managers occupied the top four positions and eight out of the top 10 slots.
An effective capital allocation process through the public and private capital markets is critical to a healthy economy that promotes productivity, encourages innovation, and provides an efficient market for the purchase and sale of securities and the obtaining and granting of credit.
Financial reporting information in our markets
Such an allocation process would not be possible without financial disclosures, because adequate and high-quality information helps investors and creditors in the capital markets to judge the opportunities and risks of investment choices accurately. Financial reporting information impacts a company’s cost of capital,which is reflected in the price that investors are willing to pay for the company’s securities.
Whether a long-term Main Street investor or an investment professional, individuals make investment decisions—or rely on others to make decisions for them—based in part on interim financial information and annual audited financial statements. At its heart, public company financial reporting is and always has been about communication. Investors and creditors have the right to expect that the disclosure is complete, accurate, and reliable.
Those involved in financial reporting
We, in OCA, developed three renditionsof an overview of organizations involved in the structure of financial reporting in the U.S. marketsto help visualize and understand our necessarily complicated financial reporting system. The versions, of course, also contribute to an analysis of less obvious aspects of this system. For example, they help identify the multiple points of oversight, review, and advice that both preserve and advance general purpose financial reporting.
I encourage each of you and your organizations involved in the overall structure to consider how you might use the information (or other information) to identify ways on an ongoing basis to prevent financial reporting failures (whether due to errors or fraud) and add value for investors, including by asking what more can we do today to support the financial reporting of tomorrow, such as:
- How can we bolster coordination and collaboration among the organizations involved in financial reporting?
- What can we learn from previous financial reporting failures to evaluate whether and how each participant in the financial reporting process could more effectively contribute to the prevention of financial reporting failures?
- What more could be done to understand and coordinate technological issues (and the programming languages used) within and across each phase of the financial reporting structure?
- What information should be provided in the financial statements to meet the needs of investors, lenders, and other creditors, even as the context of demographics, technology, and market structures change?
- Can more be done to help identify expectations and minimize expectation gaps, both globally and variations within particular markets?
The collective goal of all participants in the financial reporting architecture must be for the information to be complete, accurate, and reliable, the first time it is provided to investors.
There are positive signs in a general, sustained reduction in the number and severity of restatements of financial statements since the implementation of the Sarbanes-Oxley Act, although there are some specific areas that could benefit from a redoubling of efforts. The positive signs are attributable, at least in part, to the vital role of the independent audit committee in overseeing the financial reporting process.
Management’s crucial responsibilities
High-quality financial reporting starts with companies. In companies subject to the reporting requirements of U.S. federal securities laws, management is required to keep and maintain books and records in reasonable detail. From those books and records, management prepares financial statements according to a general purpose financial reporting framework, so that the reporting is comparable, verifiable, timely, and understandable by investors and others.
Accounting helps others understand the past so that users of accounting information can better understand present circumstances and future possibilities. Management accountants are expert historians, in a sense. You provide the critical “eyewitness” account of events and evidence needed to keep and maintain books and records in accordance with the federal securities laws. In accounting and society, we all expect history to be based on evidence and prepared with discipline and diligence so that the historical narrative is reliable.
This is indeed not a new concept. The first written records of history date back a little more than five thousand years ago in Egypt and ancient Sumer. The earliest records look like accounts: lists of property, cattle, and wheat. By the 5th century B.C., the first works of what we might begin to consider modern history began to appear. During this period, the Greek historians Herodotus and Thucydides strengthened the credibility of their works of history by obtaining evidence and eyewitness accounts of the events they chronicled. These efforts, and the fact that once something is written down it is harder to alter, caused people to view written evidence as more authoritative than oral stories.
In a very real way, your work as management accountants has many parallels to the work of historians. And yet your work requires more. In addition to maintaining books and records, management is also required to design and implement internal accounting controls. This requirement applies even if a public company is not subject to the requirements in the Sarbanes-Oxley Act that management assess the effectiveness of the company's internal control over financial reporting or that the auditor attest to, and report on, management's assessment of its internal control over financial reporting.
Your work contributes to public companies being well-run. These companies have effective internal controls not just because internal controls are the first line of defense against preventing or detecting material errors or fraud in financial reporting, but also because strong internal controls contribute to better internal accountability and information flows, among many other attributes of good businesses. In fact, the books and records provisions of the securities laws have long included a requirement that U.S. public companies must devise and maintain a system of internal accounting controls to provide “reasonable assurances” that “transactions are recorded as necessary to permit preparation of financial statements” in conformity with U.S. GAAP. Internal accounting controls include internal controls underlying the financial activities of a business.
As individuals with responsibility for the preparation of financial statements, you are the lynchpin of high-quality, reliable financial reporting. You are the ones who make the often difficult decisions and challenging judgments required to meet the objectives and principles of U.S. GAAP – from the new revenue recognition standard, to leases, to impairments, to fair value determinations, as just examples. The financial reporting system relies on those of you in management accounting, finance, forecasting, and internal audit roles to press and challenge each other on questions you have on transactions, judgments, and risk areas.
I encourage you to foster and share high-quality practices that are cost-effective and responsive to the objectives of securities laws. This can be done through illustrative training and educational materials that translate good practices into demonstrable solutions that are both effective and lead to sustained change. When the best thinking is identified and shared, quality in the preparation of financial statements goes up, and costs generally come down.
Ethics and culture
In addition to supporting your companies with proper controls and each other through the sharing of good practices, you also help each other and our markets through strong ethics and culture. Getting this right—consistently—is essential because even ethical managers sometimes are tested in doing the right thing in a complex business environment. For example, management might face intense pressure to produce consistently improving results. Even though lowering ethical operating standards might appear to provide more favorable outcomes in the short run, history shows that all too often these outcomes fail to be sustainable.
In your roles as board members, managers, or employees, each of you can play a vital role in supporting management to run the companies you serve in a manner that will promote long-term shareholder value without compromising the integrity of the company’s reputation for high-quality financial reporting. This gives management the courage to make right decisions.
Many companies acknowledge the value of an ethical culture. They see a clear linkage between long-term performance and a company’s behaviors. A company with clearly stated ethical values that are understood, promoted, and upheld can help attract or retain top talent. Just the opposite also can arise. Unethical behavior can damage reputations, in addition to bottom lines, as companies and employees see their reputations tarnished. All these negative effects undermine value.
Chairman Clayton just yesterday spoke about the importance of effecting positive culture in the financial profession. Similarly, in previous remarks, I also have discussed how corporate structure and culture, when paired in positive ways, can nurture appropriate behaviors and have provided a spectrum for assessing the maturity of a culture. I want to mention a few illustrative attributes of an ethical corporate culture, which is foundational to an effective control environment. For example:
- The board and corporate leaders must consistently demonstrate ethical behavior in words and actions. Employees must be able to trust the board’s and management’s commitment to systems that both prevent and detect bad behavior, including in the financial reporting and preparation processes.
- As companies become more geographically diverse, the more important it can be for senior management to be heard across geographies and at all levels regarding expectations about compliance with the company’s code of conduct.
The importance of ongoing training and literacy
Change is constant, even in financial reporting. And so, cultivating ethics and culture among the other elements of an effective control environment on an ongoing basis will require management accountants to contribute to the literacy of members at every phase of the financial reporting process. As management accountants, you play a crucial role in not only being literate in these items, but also providing essential briefings to the boards, senior leaders, investors, lenders, and others, so they understand the information and its usefulness.
Responsibility of auditors
Preparers, of course, are not solely responsible for high-quality financial reporting. It also depends on thorough and objective audits performed by independent, knowledgeable, and skeptical public accountants. Indeed, while preparers are the lynchpin of high-quality financial reports, auditors are the critical gatekeepers for those reports, protecting shareholders by promptly identifying and addressing issues.
Whether or not engaged to report on internal control over financial reporting separately, external auditors are still responsible for considering internal controls in the performance of their audits. In an audit of the financial statements, the audit process includes deciding whether and how much to plan to rely on the company’s internal control over financial reporting. By obtaining an understanding of internal control over financial reporting, auditors can better plan their audits and provide management and the audit committee with observations about a company’s internal controls. These procedures provide meaningful feedback to the auditor in performing other audit procedures.
Significant credit for the increase in audit quality should be given to the PCAOB. The PCAOB has had a positive impact on the firms’ system of quality controls. I continue to support the continuity of the PCAOB's core activities that further its statutory mission to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports. Notably, the Board has decided to reach both within and beyond its own four walls for input into what strategic direction to take to improve audit quality through surveys, interviews, and other outreach. The Board is demonstrating a belief, which I also hold, that consistent and meaningful engagement with key constituencies is critical to effectively shaping the PCAOB’s future direction.
Responsibility of audit committees
Boards of public companies in the U.S. have a financial reporting oversight responsibility, which they usually assign to their audit committees. The entire board has to approve the release of public company financial reports. As a result, management and directors have a vital interest in whether the quality of the company’s books and records and related internal accounting controls enable them to address their responsibilities adequately.
Companies and directors should carefully choose who serves on their audit committee, selecting those who have the time, commitment, and experience to do the job well. Just meeting the technical requirements of financial literacy may not be enough to understand the financial reporting requirements fully or to challenge senior management on major, complex decisions.
Audit committees of every company must be committed to their oversight of financial reporting. They must, for example, be able to adequately review how management is designing and implementing internal controls. As I mentioned earlier, the responsibility to maintain internal controls is incumbent upon management, with oversight of the audit committee, regardless of the size of the company.
As part of their oversight of the external audit, audit committees can make a positive impact on financial reporting by asking probing questions of external auditors about the auditor’s risk assessment and strategy undertaken for the audit. For example,
- In an audit of the financial statements, was the external auditor able to rely on a company’s internal control over financial reporting?
- If not, which of the business processes included the internal controls on which the auditor did not (or could not) place reliance? What were the factors that prevented reliance?
- Were any significant deficiencies or material weaknesses identified (and communicated in writing)?
- How did management consider that feedback in preparing the financial statements, including in its period end closing processes?
Audit committees can take insights from the conversation with auditors about whether, where, and why they were unable to rely on internal controls. The audit committee’s expectations for clear and candid communications from the auditor and management in this area should not be taken lightly, particularly when it is time to evaluate the relationship with the auditor. Just the same, the auditor should expect appropriate support and tone from audit committees when internal control or other matters arise.
Relationship with the external auditor
A board and audit committee should also understand the external auditor’s compliance with the auditor independence rules and the impact on the board and company of noncompliance.
Trust in financial reporting is maintained by protecting the independence of the outside auditor from its audit client. Audit committees of listed companies play an especially important role in this regard by safeguarding auditor objectivity, in part, through direct oversight of the audit relationship. The audit committee must own the selection of the audit firm, make the final decision when it comes time to negotiate the audit fee and oversee the auditor’s independence.
In a recent survey conducted of members of the CFA Institute, 86% of respondents said that standards for auditor independence should be a “high priority” for audit standard-setters and regulators. On May 2nd the Commission proposed for public comment rulemaking to address certain substantial practical challenges to compliance related to one part of our auditor independence rules, known as the “Loan Provision.” I encourage you to read the proposal and provide us with your input as part of this rulemaking.
Innovations and emerging issues in technology and commerce
Turning now to innovations and emerging issues, perhaps a useful way for each of us to think about the effects of innovations in technology and commerce on an issuer’s financial reporting to investors is to organize our thinking along the following lines:
- It is a role of the SEC staff and of the accounting profession to consider the possible effects of innovations in technology and commerce on the financial reporting obligations of issuers of securities to those who invest in the public capital markets.
- In order for an issuer to appropriately report the financial statement effects of its innovation efforts to investors, the company’s management and its auditor, respectively, must understand the nature of the innovations.
- The very innovations in technology and commerce that the public capital markets help to bring about can, not surprisingly, prompt questions regarding how management should prepare and how auditors should audit a company’s financial statements in accordance with the respective accounting and auditing standards.
It may be helpful to use an example to illustrate this approach to organizing one’s thinking about innovations in technology and commerce.
Considering the Possible Effects of Innovations
A useful way to illustrate the first point, above, may be to consider distributed ledger—sometimes referred to as “blockchain”—technology, an innovation in technology and commerce that is of current interest in the business world and whose possible uses are becoming more prevalent. These potential uses may involve an issuer’s books and records, its internal control over financial reporting, its application of accounting standards and, correspondingly, the audit of its financial statements.
Another related area is in the cryptocurrency and initial coin offering space. In a speech given just last week, my colleague Bill Hinman, Director of the Division of Corporation Finance discussed the application of aspects of the securities laws to digital assets. I encourage you to read a copy of his remarks. It is critical that we keep ourselves informed about these emerging technologies so that the accounting profession can continue to perform the essential gatekeeper function for issuer compliance with both the financial reporting and auditor independence frameworks.
As we do so, it is essential to keep in mind that innovations in technology can be the ally of a company’s financial reporting activities, not their opponent. Accordingly, changes in technology need not work against the model for financial reporting to investors in the public capital markets. For example, even with the advent of innovations in technology, and in particular distributed ledger technology, management accountants should maintain appropriate books and records—regardless of whether distributed ledger technology, smart contracts, and other technology-driven applications are used or not. Likewise, the auditor of an issuer should determine the nature and extent of the audit procedures to perform based on the circumstances of the company and the auditing standards applied.
In addition to seeing the innovations in distributed ledger technology and digital assets, each of us needs to take what is learned and then act appropriately within the parameters of the existing internal control and financial reporting requirements of the federal securities laws. Distributed ledger technology and digital assets, despite their exciting possibilities for financial recordkeeping, do not alter this fundamental responsibility.
I want to thank you again for the opportunity to be with you today.
We all have a shared and weighty responsibility to advance the role of high-quality information in our capital markets, which leads to better decisions and outcomes for investors and all Americans.
Your and your colleague’s responsibilities create a collective culture around safeguarding that internal controls are effective, robust, and sufficiently elastic to respond to the varied and substantial changes shaping today’s companies. Investors are counting on each of you to fulfill your responsibilities towards the production of high-quality financial reporting.
It is not an easy job, and we will continue to do what we can to share our perspectives with the participants in the financial reporting process – whether through rulemaking; or by providing staff views on the implementation of new or existing standards to help prevent failures in financial reporting.
We are witnessing a whole succession of technological innovations, but none of them will do away with the need for integrity in the individual or the ability to think.
Thank you, and I look forward to taking your questions.
 See“U.S. Trade in Goods and Services - Balance of Payments (BOP) Basis,” U.S. Census Bureau, Economic Indicator Division (June 6, 2018),available at https://www.census.gov/foreign-trade/statistics/historical/gands.pdf.
 See “Changes in U.S. Family Finances From 2013 to 2016: Evidence From the Survey of Consumer Finances,” Federal Reserve Bulletin Vol. 103, No. 3 (Sept. 2017), at pages 20-21, available at https://www.federalreserve.gov/publications/files/scf17.pdf.
 See “U.S. Portfolio Holdings of Foreign Securities, as of December 31, 2016,” U.S. Department of the Treasury, Federal Reserve Bank of New York, and Board of Governors of the Federal Reserve System (Oct. 2017), at page B-8, available at http://ticdata.treasury.gov/Publish/shc2016_report.pdf.
 See “The World’s 500 Largest Asset Managers,” Pension & Investments and Willis Towers Watson (Oct. 2017), at page 29, available at http://www.ioandc.com/wp-content/uploads/2017/11/7-WYW-Top-500-report.pdf.
 See Cassell, C., Myers, L., and Zhou, J.,The Effect of Voluntary Internal Control Audits on the Cost of Capital, (2013)available at,http://ssrn.com/abstract=1734300(finding that, among non-accelerated filers from 2004 to 2010, six percent voluntary complied with Section 404(b)).
 See “Remarks at the Economic Club of New York,” Chairman Jay Clayton, U.S. Securities and Exchange Commission (“SEC”) (July 12, 2017), available at https://www.sec.gov/news/speech/remarks-economic-club-new-york.
 The three renditions on the financial reporting structure include: (1) Blue Print – an illustration of the players involved; (2) Flow Chart – a simplified representation of the blue print; and (3) Segment Chart – variations in financial reporting requirements in three different market segments: domestic issuers, foreign private issuers, and private companies.
 See “U.S. Financial Reporting Structure for Public Issuers,”available at https://www.sec.gov/oca/us-financial-reporting-structure-public-issuers.
 See “2017 Financial Restatements Review,” Audit Analytics (June 7, 2018), available at http://www.auditanalytics.com/blog/2017-financial-restatements-review/.
 See Section 13(b)(2)(A) of the Securities Exchange Act of 1934 (“Exchange Act”).
 See Section 13(b)(2)(B) of the Exchange Act.
 See id.
 See id.
 See Section 13(b)(2)(B)(ii) of the Exchange Act.
 See Remarks at the NY Fed “The Importance of Effecting Positive Culture in the Financial Profession,” Jay Clayton, Chairman, SEC (June 18, 2018).
 See Remarks before the 2018 Baruch College Financial Reporting Conference: “Working Together to Advance Financial Reporting,” Wesley Bricker, Chief Accountant, SEC (May 3, 2018), available at https://www.sec.gov/news/speech/speech-bricker-040318.
 See Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard (“AS”) 2110, Identifying and Assessing Risks of Material Misstatement, paragraphs .18 through .38.
 See Section 101(a) of the Sarbanes-Oxley Act of 2002.
 See “PCAOB Transitions for the Future,” William D. Duhnke, Chairman, PCAOB (May 17, 2018), available at https://pcaobus.org/News/Speech/Pages/PCAOB-Transition.aspx?utm_source=PCAOB+Email+Subscriptions&utm_campaign=5737c06839-EMAIL_CAMPAIGN_2018_05_08&utm_medium=email&utm_term=0_c97e2ba223-5737c06839-125364285.
 See Rule 10A-3(b) of the Exchange Act.
 See “CFA Institute Member Survey Report: Audit Value, Quality, and Priorities,” CFA Institute (2018), at page 13, available at https://www.cfainstitute.org/en/research/survey-reports/audit-value-quality-priorities-survey-report.
 See Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018), available at https://www.sec.gov/rules/proposed/2018/33-10491.pdf.
 See “Digital Asset Transactions: When Howey Met Gary (Plastic),” William Hinman, Director – Division of Corporation Finance, SEC) (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418.