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Remarks before the AICPA National Conference on Banks & Savings Institutions: Advancing High-Quality Financial Reporting in Our Financial and Capital Markets

Wesley R. Bricker, Chief Accountant

Washington D.C.

Sept. 11, 2017

The Securities and Exchange Commission (“SEC” or “Commission”) disclaims responsibility for any private publication or statement of any SEC employee or Commissioner.  This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Introduction

Good morning and thank you Chip Currie for that very generous introduction.  It is an honor to be with each of you attending today’s AICPA National Conference on Banks & Savings Institutions.  As in prior years, this conference continues to serve as a forum for noteworthy discussions on economic, market, and regulatory developments, as well as an opportunity for dialogue among leaders and policy makers in the banking industry. 

Before I begin, let me remind you that the views expressed are my own and not necessarily those of the Commission, the individual Commissioners, or other colleagues on the Commission staff.

Today, our thoughts are with the millions of people affected by the recent hurricane activity.  As with the Commission’s announcement in connection with Hurricane Harvey, the SEC is monitoring market impact of the more recent hurricane storms, and Chairman Clayton has mobilized agency resources to assist affected investors and market participants.[1]

Today is also a day when we honor the victims, responders and others who rose up in service 16 years ago when our country was attacked.  It is fitting that we commit to service on this National Day of Service and Remembrance. 

Let me express a word of gratitude to the Office of the Chief Accountant (OCA) team for its 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 Michael Berrigan, Ying Compton, Emily Fitts, Mark Jacoby, and Godfrey Murangi for their valuable assistance in preparing me to make today’s remarks.

During this year’s conference, from among the SEC staff, you will hear from Kevin Stout and Rachel Mincin from OCA, as well as Stephanie Sullivan and John Nolan from the Division of Corporation Finance. 

This morning my remarks will touch on several current issues the OCA staff has been focused on recently.  In particular, I would like to talk with you about:

  • the role of financial reporting in our financial and capital markets;
  • recent accounting and auditing standard setting; and
  • reminders regarding the importance of broker-dealer compliance as well as regulatory and financial reporting requirements relating to initial coin offerings.

Role of financial reporting in our financial and capital markets

Our work at the SEC contributes to the continued advancement of our capital markets, which are vital to the economy.  We have a three-part mission: (1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation. 

As Chairman Clayton recently said, “[e]ach tenet of that mission is critical.  If we stray from our mission, or emphasize one of the canons without being mindful of the others, investors, companies (large and small), the U.S. capital markets, and ultimately the economy will suffer.”[2]

In keeping with our mission, OCA remains focused on the importance of high quality financial reporting, which is essential to the financial services sector and, more generally, to our financial and capital markets system.  Banks, in particular, are both users and providers of financial reporting information as they intermediate between those who have funds to save or invest and those who need financing.

While banking involves risk-taking, a number of the risks relate directly to the value provided by banks to their customers and the wider economy. Banks are commercial businesses and seek to make a commensurate commercial return through managing these risks.  

Managing and pricing these risks depends, in part, on reliable financial information.  As accountants, we need to continue to challenge ourselves to provide the nature and quality of financial information that investors need.

This requires high quality accounting and auditing standards, which, like internal control and operational standards, are grounded in the fundamental idea of, “what is the best way to do this?”

The New Credit Losses Standard – An Improvement in Financial Reporting for Credit Losses

The FASB’s current expected credit loss standard, for example, marks the continuation of a near century-long history of ongoing developments to the accounting for loan losses and reflects the continued importance to identify users’ needs for credit loss information and the “best way” to meet that need.[3]   

Current standard

Some users have criticized the existing “incurred loss” approach because the thresholds required to recognize credit losses delayed the recognition until the credit losses were probable, even if an entity may have also developed an expectation of a future loss.  Critics argued that delayed recognition results in asymmetry between a company’s financial reporting of the allowance to investors and management’s expectations of credit losses over the contractual life of the financial assets (considering the effect of prepayments).  This same asymmetry can also exist in the market, as investors also seek information about current expected credit losses.  

New standard

Recognizing the subjective nature of estimating credit losses, investors supported a change in the timing of credit loss recognition and additional disclosures that would facilitate their assessment of management’s initial credit loss estimate for newly originated loans as well as subsequent changes to those estimates.  The new standard represents an improvement over the measurement objective for a best estimate of incurred losses by providing financial statement users with more decision-useful information about expected credit losses.  The approach more closely aligns an entity’s financial reporting with management’s estimate of expected credit losses which, even today, are informed by and incorporated into the entity’s underwriting, servicing, and collateral management practices. 

Achieving consensus on the financial reporting standard was a substantial undertaking.  The FASB’s extensive outreach activities prior to finalizing the standard included meeting with over 200 users of financial statements and holding more than 85 meetings and workshops with preparers, including field work at 25 company locations to get direct input. [4]  These are just some of the examples from the public round tables, preparer workshops, and other input that informed the FASB’s standard.  The IASB’s efforts for its expected credit loss standard were similarly extensive.[5]    

The FASB concluded that the new standard will provide investors with more decision-useful information about the credit risk inherent in financial assets and the change in expected credit losses occurring during the period.   To achieve this objective, FASB designed the standard to accomplish the following:[6]

  • Result in an earlier measurement of credit losses.
  • Result in greater transparency about the extent of expected credit losses on financial assets held at the reporting date.
  • Improve a user’s ability to understand the realizability of assets held at each reporting period.
  • Improve a user’s ability to understand changes in expected credit losses that have taken place during the period.
  • Improve a user’s ability to understand purchased financial assets with credit deterioration, while also reducing the cost and complexity of accounting for those assets.
  • Provide greater transparency to the user in assessing the credit quality indicators of a financial asset portfolio and changes in composition of the financial asset portfolio over time.

The FASB, like the IASB, considers the impact of its decisions, including considering whether the expected benefits of the new or revised standards justify the expected costs.  The FASB recognized that adopting the new standard will involve transition effort by companies and sought to minimize the cost and complexity by developing an approach that, among other things:[7]

  • Permits an entity to utilize its current internal credit-risk management approaches and systems as a framework for applying the new measurement objective.  
  • Does not generally prescribe specific estimation methods to be used, but rather allows an entity to apply judgment to develop estimation methods that are appropriate, practical, and consistent with the principles of the guidance. 
  • Does not change interest income reporting for originated loans on the basis of feedback received that investors seek (and companies manage) credit risk and interest income separately.

The new standard addresses the timing of recognition of losses, but does not increase, decrease, or change the ultimate amount of credit loss on a loan.   

Implementation of the new standard

As to implementation, companies will need to evaluate the specific impact of the standard and apply judgment in preparing an estimate of the overall current expected credit losses.   

The Commission has long-standing guidance for accounting for loan losses in the Commission’s Financial Reporting Release (“FRR”) No. 28.[8]  The SEC staff also has published guidance in Staff Accounting Bulletin (“SAB”) No. 102 for accounting for loan losses.[9] 

I anticipate that relevant portions of the Commission and SEC staff guidance will continue to apply to the development, documentation, and application of a systematic methodology for determining an estimate of current expected credit losses, which under the new standard, will apply to an entity’s estimate of losses over the entire contractual life.  For example, the systematic methodology and documentation practices in FRR 28 and SAB 102 will continue to apply when determining the allowance and provision for current expected credit losses.  

Companies will have their existing procedural discipline as a useful starting point for identifying and documenting relevant data, assumptions, and methodology when making the transition to the new standard’s measurement objective of current expected credit losses. 

I anticipate that among the judgments to consider in developing management’s estimate of current expected credit losses will be:

Methodology

  • A methodology that is best suited for the characteristics of the institution and the loan portfolio. 

Data

  • The available information relevant to assessing the collectability of cash flows.[10]

Assumptions

  • The period of historical loss and recovery information used by the entity, including the determination of what loans or other assets the historic information relates to, as well as what adjustments are made to the information.
  • The extent to which management expects current conditions and reasonable and supportable forecasts to differ from the considerations that existed over the period of historical information evaluated.
  • If the entity reverts to historical loss information, the loss information selected for periods that are beyond the reasonable and supportable period, and the reversion approach applied by the entity.[11]

Addressing implementation questions

These are just several examples that emphasize the value of identifying – and then addressing – any implementation questions.  The FASB created a Transition Resource Group (TRG) to assist with any questions that arise, and the TRG has met as recently as June of this year.

In addition, the OCA staff is actively monitoring the transition period activities and continues to evaluate any issues identified by various stakeholders post issuance.  

As I have previously stated, OCA will continue to respect well-reasoned, practical judgments that are grounded in the new standard and are consistent with Commission requirements and SEC staff guidance.  We continue to be available through the consultation process to address questions, which may be particularly relevant as management shifts to implementation of the standard.  Working through entity-specific numbers and processes can be insightful in identifying any questions for resolution.  It could prove useful to institutions in getting a sense for the nature and magnitude of the anticipated effect of the new standard. 

As a related point, I am also encouraged by and supportive of the careful review by U.S. prudential regulators recommended by the U.S. Treasury Department with a view towards harmonizing the application of the standard with regulators’ supervisory efforts.[12]   

International activities

International institutions are also focused on implementing a new credit loss standard.  The IASB issued IFRS 9, which comes into force on January 1, 2018 – two years ahead of the FASB’s standard on credit losses.  The implementation timeline is even shorter for certain companies, such as: 

  • In Canada, six banks have disclosed that they intend to adopt IFRS 9 for their annual period beginning November 1st of this year.[13]  Five of those six banks (collectively representing over $332 billion of market capitalization) have their securities registered with the SEC and are listed in the U.S. capital markets. [14] 
  • Though early adoption is elective, National Australia Bank, one of the four largest banks in Australia with a market capitalization of $62 billion, became one of the first major global banks to adopt IFRS 9.[15]

Some institutions have reporting obligations under both US GAAP and IFRS, such as U.S. banks with large subsidiaries abroad, and foreign banking organizations in the U.S.  I understand that those institutions will maintain parallel processes to satisfy both sets of requirements.  

Internal control over financial reporting

Transition plans for the new standard should include initiatives for identifying and implementing any necessary changes to internal control over financial reporting (ICFR)– a process designed to provide reasonable assurance that the company's financial statements are prepared in accordance with GAAP.[16]  Well-designed ICFR supports the process by which necessary accounting judgments are made. 

Companies that apply the COSO framework for designing their system of ICFR should look to its five components and related principles in developing a structured approach for implementation of new accounting standards generally and of particular importance for the audience today, the current expected credit loss standard.  This includes beginning with an effective identification and assessment of the risks of material misstatement and designing controls to mitigate those risks.   

More generally, there are several areas to highlight as part of the overall design and evaluation of controls that can contribute to both efficient and, importantly, effective ICFR.

  • Control environment.  The judgment involved in estimating current expected credit losses highlights the importance of a company’s control environment – setting the right “tone at the top” and expectations for responsible conduct throughout the organization.  Appropriate tone at the top is the foundation for the consistent application of the sound judgments required by the new standard.  Management should consider whether changes to support the formation of sound judgments are needed in applying the new standard.
  • Technology.  There are more technology options than ever before to help companies prepare their books and records and operate internal accounting control processes.  Technology can provide benefits – from enabling business processes to validating transactional data, among other tools.  With the proliferation of technology there can also be a shift in the nature of risk to be identified and addressed through internal controls.
  • Documentation.  Documentation can facilitate the retention or transfer of knowledge useful in resolving discussions more quickly related to things like the identification and assessment of risks, control design, testing strategy, and evaluation of deficiencies.  For example, sufficiently detailed control descriptions can support the quality and consistency of control operation, particularly where there is judgment in the execution.

Management may take a fresh look at policies, processes, systems, and data used in financial reporting in connection with transition to the new GAAP standards.  For example, in my experience, automated, preventive controls can offer certain benefits versus manual, detective controls.  With that being said, all types of controls can be effective as long as the controls, if designed and operating properly, can adequately prevent or detect on a timely basis misstatements, individually or in the aggregate, that could result in a material misstatement of the financial statements.[17] 

Recent PCAOB Activity 

Just as investors rely on accounting standard-setters to develop and maintain standards with an objective to provide high quality, reliable financial reporting, they also rely on high quality audits and oversight of the auditors who provide such audits to achieve these same goals.  For the past fifteen years, the PCAOB has provided this necessary oversight.

The PCAOB continues to make significant progress on several of its important standard-setting agenda projects.  In June, the Board issued two proposals to strengthen its existing requirements for auditing accounting estimates, including fair value measurements, and using the work of specialists.[18]   

The PCAOB is also making progress on other projects on its standard-setting agenda, including its project on the supervision of audits involving other auditors.  I encourage all of you, as stakeholders in the audit process, to respond to requests for comment from the PCAOB.

Earlier this year, the PCAOB completed a nearly seven year process of outreach and public comment by adopting a new auditor reporting standard.[19]  The auditor’s reporting model release would revise the standard audit report under PCAOB standards to retain a pass/fail opinion, while adding communication of critical audit matters, disclosure of audit firm tenure, and other revisions.[20]   

The Commission’s public comment period closed on August 18.  The Staff is currently evaluating the comments received and after consideration of these comments, the Commission will determine whether to approve the standard.  Statutorily, the Commission must take action by October 26.

The PCAOB’s continued focus on audit quality extends beyond its standard-setting activities, such as the PCAOB inspection and enforcement programs. For example, the PCAOB remains active in its oversight of broker-dealer audits and attestation engagements.  This includes annual inspections of a broad cross-section of broker-dealer audits under its interim inspection program[21] and enforcement efforts such as a disciplinary action the PCAOB recently settled with a large accounting firm for, among other things, the alleged firm failure to adequately test a broker-dealer’s internal controls over compliance with the “no lien” requirement of the SEC’s Customer Protection Rule.[22]       

I encourage all parties, including management of broker-dealers, auditors, and audit committees, to take a broad view of the results of PCAOB inspections and enforcement actions related to audits of broker-dealers to address any deficiencies in broker-dealer compliance activities.

Financial reporting implications of certain initial coin offerings

Finally, let me turn to the topic of initial coin offerings, also called ICOs or token sales. 

In July, the Commission issued a report on its investigation of an offering of digital tokens by the “The DAO,” an unincorporated virtual organization.[23]   The report makes clear that the federal securities laws apply to those who offer and sell securities in the U.S., regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, whether those securities are purchased using U.S. dollars or virtual currencies, or whether they are distributed in certificated form or through distributed ledger technology.

All offers and sales of securities in the United States, unless otherwise qualifying for an exemption, must be registered with the Commission.  In addition, any entity or person engaging in the activities of an exchange must register as well, unless it operates pursuant to an exemption from such registration.  

The SEC’s registration requirements, including for securities offerings, include various requirements for filing of audited financial statements. 

An organization should consider applicable accounting and reporting guidance, for example in U.S. GAAP, when preparing financial statements.

The guidance addresses relevant considerations, including, for example, those regarding presentation and disclosure of financial statements, consolidation, translation, assets, liabilities, revenue, expenses, and ownership.  In this regard, issuers and holders should consider, for example, the application of the guidance in addressing questions such as:

Issuers

  • What are the necessary financial statement filing requirements?
  • Are there liabilities requiring recognition or disclosure?
  • Are there previously recognized assets that require de-recognition?
  • Are there revenues or expenses requiring recognition or deferral?
  • Is there a transaction with owners, resulting in debt or equity classification and possibly compensation expense?
  • Are there implications for the provision for income taxes?

Holders

  • Does specialized accounting guidance (such as for investment companies) apply to the holder’s financial statement presentation?
  • What are the characteristics of the coin or token in considering whether, how, and at what value the transaction should affect the holder’s financial statements?
  • What is the nature of the holder’s involvement in considering whether the issuer’s activities should be consolidated or accounted for under the equity method?

Again, these are intended only to be illustrative questions.  An entity involved in initial coin or token offering activities will need to consider the necessary accounting, disclosure and reporting guidance based on the nature of its involvement.

Closing

As with each of the matters discussed today, our general practice is to encourage companies and their auditors to consult with OCA on accounting, financial reporting, and auditing concerns or questions, especially those involving unusual, complex, or innovative transactions, as well as on issues regarding auditor independence.  Guidance for companies and auditors is available on the Commission’s website.[24]

I want to thank you again for the opportunity to be with you today.  Investors are counting on each of us to fulfill our respective responsibilities for high quality financial reporting. 

Thank you for your attention. 

 

[1] See SEC Press Release, SEC Monitoring Market Impact of Hurricane Harvey (August 30, 2017), available at https://www.sec.gov/news/press-release/2017-150.

[2] Jay Clayton, Chairman, U.S. Securities and Exchange Commission, Remarks at the Economic Club of New York (Jul. 12, 2017), available at https://www.sec.gov/news/speech/remarks-economic-club-new-york.

[3] Wesley R. Bricker, Interim Chief Accountant, U.S. Securities and Exchange Commission, Remarks Before the AICPA National Conference on Banks and Savings Institutions (Sept. 21, 2016), available at https://www.sec.gov/news/speech/bricker-remarks-aicpa-national-conf-banks-savings-institutions.html.

[4] See FASB News Release, FASB Issues New Guidance on Accounting for Credit Losses (June 16, 2016), available at http://www.fasb.org/cs/ContentServer?pagename=FASB%2FFASBContent_C%2FNewsPage&cid=1176168232900.

[6] Accounting Standards Update (“ASU”) 2016-13, Financial Instruments – Credit Losses (Topic 326), Basis for Conclusions at BC7 (June 2016) (identifying additional benefits of the standard), available at http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168232528&acceptedDisclaimer=true.   

[7] Id. at BC8. 

[8] Accounting For Loan Losses By Registrants Engaged In Lending Activities, FRR 28 (Dec. 1, 1986).  This guidance is in addition to the requirement for public companies to comply with the books and records provisions of the Securities Exchange Act of 1934 (the “Exchange Act”), which under Sections 13(b)(2) - (7) of the Exchange Act, registrants must make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the registrant.  Registrants also must devise and maintain internal accounting controls that are sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit the preparation of financial statements in conformity with GAAP.

[9] SAB 102, Selected Loan Loss Allowance Methodology and Documentation Issues, Section 2A, Question 1.

[10] Accounting Standards Codification (“ASC”) 326-20-30-7.

[11] ASC 326-20-30-9.

[12] See U.S. Department of Treasury, A Financial System that Creates Economic Opportunities – Banking and Credit Unions (June 2017), available at https://www.treasury.gov/press-center/press-releases/Documents/A%20Financial%20System.pdf.

[13] See Canadian Office of the Superintendent of Financial Institutions’ (“OSFI”), Advisory – Early Adoption of IFRS 9 Financial Instruments for Domestically Systematically Important Banks (Jan. 2, 2015), available at http://www.osfi-bsif.gc.ca/Eng/Docs/freifrs9.pdf.

[14] These five banks are Royal Bank of Canada, Canadian Imperial Bank of Commerce, Toronto Dominion Bank, Bank of Montreal, and Bank of Nova Scotia.  Based on information from these five banks’ reports to shareholders for the 2nd quarter of 2017 (all ending on April 30, 2017), the total of their market cap is $453 billion in Canadian dollars, which is about $332 billion in U.S. dollars.

[15] National Australia Bank adopted IFRS 9 for its financial report for the year ended September 30, 2015.

[16] See Rules 13a-15(f) and 15d-15(f) of the Exchange Act, and Item 308 of Regulation S-K.

[17] See Commission Guidance Regarding Management’s Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, Release No. 33-8810 (June 20, 2007). 

[18] See Proposed Auditing Standard on Auditing Accounting Estimates, Including Fair Value Measurements and Proposed Amendments to PCAOB Auditing Standards, PCAOB Release No. 2017-002 (June 1, 2017), available at https://pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx.  See also Proposed Amendments to Auditing Standards for Auditor’s Use of the Work of Specialists, PCAOB Release No. 2017-003  (June 1, 2017), available at https://pcaobus.org/Rulemaking/Pages/docket-044-auditors-use-work-specialists.aspx.

[19] See The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, PCAOB Release No. 2017-001  (June 1, 2017), available at https://pcaobus.org/Rulemaking/Pages/Docket034.aspx.

[20] Id.

[21] Annual Report on the Interim Inspection Program Related to Audits of Brokers and Dealers, PCAOB Release No. 2017-004 (Aug. 18, 2017), available at https://pcaobus.org/Inspections/Documents/BDA-Interim-Inspection-Program-2017.pdf.

[22] See In the Matter of PricewaterhouseCoopers, LLP, PCAOB release No. 105-2017-032 (Aug. 2, 2017), available at https://pcaobus.org/Enforcement/Decisions/Documents/105-2017-032-PwC-Merrill.pdf.  The Customer Protection Rule, Rule 15c3-3 of the Exchange Act, requires broker-dealers to safeguard both the cash and securities of their customers so that, among other reasons, customer assets can be quickly returned if the broker-dealer firm fails. 

[23] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf

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