NEW YORK UNIVERSITY Leonard M. Stern School of Business New York, NY Seymour Jones Distinguished Lecture Series November 25, 1996 THE ROLE OF FINANCIAL REPORTING IN US CAPITAL MARKETS Remarks by Michael H. Sutton Chief Accountant United States Securities and Exchange Commission Washington, DC ____________________________________ 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 those of Mr. Sutton and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. "The Role of Financial Reporting in US Capital Markets" Introduction Good evening. It is a pleasure to be here to inaugurate the Seymour Jones Distinguished Lecture Series. I will begin with a brief commentary on the Commission's role in financial reporting and our rulemaking and interpretive authority. Then, I will explore our working relationship with the private sector and, in that context, take a look at the future of efforts to harmonize international accounting standards. Overview of the Commission's Role The Securities and Exchange Commission was established in the wake of the greatest financial disaster this country has ever experienced. It was a time when substantial investments had become worthless in a matter of hours and days and when investors and the public had lost confidence in impersonal securities markets. The Securities Act of 1933, the Securities Exchange Act of 1934, and the other laws administered by the SEC1, were enacted to ensure that our markets are fair and honest and to provide the Commission and the courts with the means to accomplish that objective. These laws, and related rules and regulations adopted by the Commission, prescribe the disclosures to be made in registration statements and prospectuses used in securities offerings2 and in annual, quarterly, and other public reports filed with the Commission.3 The goal of the Commission's disclosure system is to encourage and facilitate informed decisions by the investing public. In crafting the securities laws, the Congress recognized that credible financial reporting is critical to an effective disclosure system. Credible accounting, supplemented by meaningful disclosures, provides the transparency that enables investors to make meaningful evaluations of investment opportunities. To provide the mechanism to foster credible financial reporting, the securities laws grant to the Commission the authority to promulgate accounting principles for SEC registrants and to prescribe the form and content of financial statements filed with the Commission.4 The Commission also was given the authority to define accounting terms.5 Relationship with Private-Sector Standard Setting Practically since its inception the Commission has looked to the accounting profession for leadership in establishing and improving accounting principles to be used by public companies.6 The Financial Accounting Standards Board (FASB) is the private sector body recognized by the Commission to perform that role today. Specifically, Commission rules provide that financial statements prepared in accordance with the pronouncements of the FASB will be considered to have "substantial authoritative support," and those that do not follow those standards will be considered to have no such support and to be misleading.7 The Commission's willingness to look to the private sector, however, has been with the understanding that the Commission may exercise its statutory authority and override, supplement, or otherwise amend private sector standards. The Commission has exercised its authority by promulgating rules in Regulation S-X and issuing interpretations in its Financial Reporting Releases, and has overridden private sector standards only on rare occasions. The typical standard-setting activity of the Commission, however, has been oversight of the private sector processes. In addition, the Commission staff plays a significant role in the financial reporting of registrants through its day-to- day monitoring of practice. Our objective is to promote consistent interpretation and application of standards and to see that inappropriate or inconsistent practice is identified and addressed on a timely basis. When practice issues arise that are not addressed by existing authoritative guidance, and time permits, the staff may ask established standard-setting bodies or an interpretive group, such as the FASB's Emerging Issues Task Force, to address those issues. Alternatively, the Commission or its staff may act directly by issuing a rule proposal or a Staff Accounting Bulletin. Involvement in International Standard Setting I hope my remarks thus far have provided a sense of the Commission's perspectives on financial reporting. With that backdrop, I now turn to the international scene. Looking back, the last decade was a time of significant change worldwide -- change that has had tremendous implications for the world's capital markets. Events like the break-up of the Soviet Union and the reunification of Germany, for example, have created major new demands for capital and, therefore, new investment opportunities. Significant privatization efforts, in countries as diverse as Argentina and the UK, have created other demands for capital. Established global companies also have been reaching outside their home country capital markets as they seek to meet their financing needs. At the same time, changes in technology have reduced the constraints of time and distance, with telecommunications and computers linking people and markets all over the world. These and many other forces have created a climate in which capital flows across borders more readily, with fewer logistical or regulatory restrictions, and where investors have broadened their horizons beyond national borders. As capital markets around the world continue to develop, companies seeking capital will look for the best possible terms, and investors providing capital will seek to compare investment opportunities. As these trends continue, the need for a common, high quality financial reporting and disclosure framework can be expected to become more intense. In pursuing a goal of common international accounting standards, however, we must not lose sight of the investor protection mission that has been the foundation of the Commission's public mandate. For the past several years, the International Organization of Securities Commissions (IOSCO), of which the SEC is a member, has been working with the International Accounting Standards Committee (IASC) in an effort to improve the IASC's standards so that they might become the framework for accounting standards to be used in cross-border offerings. Last April, the Commission released a statement of support for the efforts of IOSCO and the IASC and indicated that, if the IASC successfully completes an agreed-upon work plan, the Commission intends to consider allowing foreign issuers to use IASC standards in securities offerings in the US. Importantly, the statement identified three key elements that, in the Commission's view, are necessary for the IASC's standards to gain that acceptance. A Core Set of Standards The first key element identified by the Commission is a requirement that the standards include a core set of accounting pronouncements that constitute a comprehensive, generally accepted basis of accounting. In 1994, IOSCO reviewed the existing IASC standards and identified 14 completed standards that, with certain reservations, would be considered acceptable core standards. IOSCO also identified those standards that had "essential issues" still open -- issues deemed critical by some countries that need to be addressed before acceptance of IASC standards can be recommended. In July 1995, IOSCO and the IASC agreed on the work plan referred to in the Commission's April 1996 statement, and in April 1996, IASC announced an intention to accelerate that plan with the objective of completing the core standards by March 1998. Comparability and Transparency The second condition established by the Commission is that the standards must be of "high quality" -- they must result in comparability and transparency, and they must provide for full disclosure. When I speak of comparability, I have two meanings in mind: * First, I mean that each company should prepare its financial statements on a consistent basis, so that investors can meaningfully analyze performance across time periods. * Second, I mean that reporting by different companies should be comparable, so that investors can make meaningful comparisons among investment alternatives. High quality accounting and disclosure that provides comparability and transparency is an absolutely essential ingredient for well-informed capital allocation decisions and market integrity. In the US, a critical factor in measuring quality and, therefore, success will be the acceptability of IASC standards to US investors and investment analysts. I believe that acceptability to that audience inevitably will depend on how well IASC standards measure up when compared to US GAAP. Rigorous Interpretation and Application The third key element for success is the need for rigorous interpretation and application of the accounting standards. The IASC recently discussed this issue and agreed at its last meeting to establish an interpretive body -- the Standing Interpretations Committee. That is an encouraging step, and while agreeing on how international accounting standards are to be interpreted and applied will be difficult and, at times, contentious, I believe that an effective interpretive process is critical to achieving meaningful international harmonization. IOSCO had encouraged the IASC to take this step, in part, because already we have seen diverging interpretations of existing IASC standards. Let me give you an example. International Accounting Standard (IAS) 22 addresses the accounting for business combinations. Like other non-US accounting standards for business combinations, it limits the application of "uniting of interests" accounting, which in the US we call "pooling of interests" accounting, to the "rare situation" in which an acquirer cannot be identified. The guidance of IAS 22 lists several means of identifying an acquirer, starting with the combining shareholder group that receives the majority ownership interest in the combined entity. The staff of the Commission believes IAS 22 is clear -- uniting of interests accounting would be appropriate only when there is virtually a 50:50 split between the ownership interests of the shareholder groups of the combining companies. Yet, we have heard arguments for uniting of interests accounting in circumstances in which the shareholder group receiving the majority ownership interest in the combination is clear. In one case, the consideration received by the respective shareholder groups was split on a 70:30 basis. We have been told that IAS 22 has been interpreted in other countries to permit uniting of interests accounting in such circumstances when other qualitative factors were considered. Such an interpretation, in my view, fails the third benchmark for rigorous interpretation and application. If accounting standards are to satisfy the objective of having similar transactions and events accounted for in similar ways, whenever and wherever they are encountered, auditors and regulators around the world must insist on a consistent application and interpretation of those standards. Otherwise, the comparability and transparency that is the objective of common accounting standards will be eroded. Other Proposals Some in the US are suggesting that the Commission should consider other approaches to increasing access to our markets by foreign issuers. For example, some have urged the Commission to relax its reporting requirements for selected "world class" foreign companies and allow those companies to list in the US without supplementing their home- country accounting and disclosures. Proponents of this approach argue that, by segregating those companies on a separate list, investors would be adequately warned of the additional risks that could arise from incomplete disclosures. Another argument made to support this approach is that it will bring US investors, currently trading outside the safety of US markets, back "on-shore." I have serious concerns about that approach. It suggests a return to the "caveat emptor" market that prevailed 65 years ago. Underlying the Commission's participation in the IOSCO and IASC initiatives to improve international accounting standards is a strong belief that the success of US capital markets is due in large measure to the high quality of accounting and disclosure standards used by US public companies. Those standards give investors confidence in the credibility of financial reporting in the US -- an essential ingredient that we cannot afford to compromise. The US accounting and disclosure system supports -- indeed, makes possible -- the deep and far-reaching tradition of participation by individual investors in our capital markets, because it enables all investors to have access to robust financial information about public companies. The willingness of individual households to invest in stocks and bonds creates a much larger pool of investor funds in the US than anywhere else in the world. Recent articles about efforts in Germany to encourage individuals to subscribe for Deutsche Telekom stock, for example, have observed the lack of experience with individual ownership of equity investments in that country.8 In some countries, including some industrialized nations, stock markets remain embryonic, and industry relies instead on banks and insurance companies for capital.9 I fear that loosening reporting requirements for selected foreign filers, though "world class" they may be, could discriminate against individual investors and risk loss of investors' confidence in US capital markets. There is some evidence that, as foreign registrants gain experience with the US system of reporting, managers are finding that the costs are not as high as they feared, and the benefits are greater than they expected. Professor Louis Lowenstein, in a recent article in the Columbia Law Review, noted that senior officers of two US-listed foreign registrants "reported a long list of managerial gains from improved financial disclosures... [including findings that] they have found it easier to manage the company intelligently.... Not surprisingly, they also reported greater access to world capital markets and better stock prices reflecting greater confidence on the part of investors."10 Commission Objectives Let me complete my remarks about international harmonization by commenting on what I believe are some misconceptions about the Commission's participation in the IOSCO and IASC initiatives. First, we are not attempting to coerce other capital markets around the world to accept US GAAP. Adoption of US accounting standards is not the only method of achieving high quality financial reporting. We are seeking to encourage credible capital markets grounded in transparent financial reporting standards of comparable quality to US GAAP. Conversely, this is not about replacing US GAAP with international accounting standards. US GAAP is, and we want it to remain, an integral component of the success of the US capital markets. Third, it is important to remember that the Commission has not already agreed to accept IASC standards in filings in the US. That question will be decided after the IASC's core standards project is completed, based on the substance of those standards. The key elements to Commission acceptance of IASC standards that I described earlier will be critical to that decision. Finally, we view the development of accounting and disclosure standards for use in cross-border filings as a long-term process. The IASC's efforts to complete a core set of accounting standards is the next important milestone, not the end of the road. There is no question that the success of this initiative will require an unparalleled degree of cooperation among standard setters and regulators around the world. Reaching agreement on internationally accepted accounting standards involves a process of reconciling the interests of different business, professional, and regulatory cultures and systems, and we must acknowledge that the prospects for success are uncertain. The process, however, also can be a rich source of new analysis and approaches to problems. We need to be willing to evaluate the proposals objectively, measuring them not by whether they are identical to US GAAP, but rather by how well they would resolve accounting and disclosure problems. As the process continues, we remain firmly committed to the proposition that, to be accepted in US capital markets, international standards must result in credibility and rigor comparable to that produced by US standards. Role of the FASB I want to emphasize that our involvement in initiatives to improve financial reporting in cross border filings does not conflict in any way with our commitment to the continuing improvement of accounting standards and financial reporting in the US. Indeed, the FASB has had, and will continue to have, a leadership role -- not only by establishing credible, conceptually sound accounting standards for US issuers, but also by participating in, and influencing the outcome of, international standard setting efforts. Another important role for the FASB is to seek opportunities to harmonize standards developed in the US with those developed internationally, without sacrificing the quality of financial reporting that US investors enjoy today and will expect in the future. The US can make a tremendous contribution to the development of international accounting standards. We have, on the whole, the most successful private sector standard setting process in the world. Through the FASB, as well as the efforts of the Commission, we have the opportunity to help shape the development of accounting standards internationally and to help assure that investors around the world receive the credible financial information they need for making decisions. Conclusion I will conclude with these thoughts. The US Congress created the SEC to restore and maintain investor confidence after the 1929 stock market crash. The Commission achieved that goal by assuring investors that, in our markets, their interests would come first. This policy is often summarized as a commitment to investor protection. Much of the success of this policy can be attributed to a regulatory system that incorporates the basic principle of full disclosure, supported by strong market oversight and vigorous enforcement. Because of that commitment, investors have confidence in US capital markets. And, because investors have confidence in the integrity of US capital markets, they are willing, to an extent unmatched in any other country, to invest their savings in our capital markets. If we want US capital markets to be as successful in the future as they are today, then we must continue to build on our strengths -- market integrity and investor confidence. Thank you again for inviting me and for your attention this evening. I would be pleased to respond to your questions. _______________________________ 1 See, e.g., the Public Utility Holding Company Act of 1935; the Trust Indenture Act of 1939; the Investment Company Act of 1940; and the Investment Advisers Act of 1940. 2 Sections 7, 10, and Schedule A, to the Securities Act of 1933 (the "1933 Act"). 3 Section 12 of the Securities Exchange Act of 1934 (the "Exchange Act"). 4 Sections 7, 19(a) and items (25), (26), and (27) of Schedule A of the Securities Act of 1933 ("1933 Act"), sections 12, 13(b)(1) and 17(e)(2) of the Securities Exchange Act of 1934 (the "Exchange Act"), sections 5(b), 14, and 20 of the Public Utility Holding Company Act of 1935 ("PUHCA"), and sections 8, 30(e), 31, and 38(a) of the Investment Company Act of 1940 ("ICA"). 5 Section 19(a) of the 1933 Act, section 3(b) of the Exchange Act, section 20(a) of PUHCA, and section 38(a) of the ICA. 6 Accounting Series Release ("ASR") No. 4 (April 4, 1938). 7 ASR No. 150 (December 20, 1973). See also, Rule 4- 01(a)(1) of Regulation S-X. 8 See Andrews, Edmund L., "Making Stock Buyers of Wary Germans", New York Times, October 17, 1996, page D1 and Cochran, Thomas N., "Germany's Biggest Deal", Barron's, November 4, 1996, page 20. 9 See Lowenstein, Louis, "Financial Transparency and Corporate Governance: You Manage What You Measure", Columbia Law Review, Volume 96, No. 5 (June 1996), page 1354. 10 Ibid, p. 1357.