INSTITUT DER WIRTSCHAFTSPRUFER Hanover, Germany October 1, 1997 CAPITAL MARKET STANDARDS FOR FINANCIAL REPORTING Perspectives from the Securities and Exchange Commission Remarks by Mary B. Tokar Senior Associate Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission Washington, DC USA __________________________________ 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 Ms. Tokar and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. CAPITAL MARKET STANDARDS FOR FINANCIAL REPORTING: Perspectives from the Securities and Exchange Commission Thank you very much for welcoming me here today. Before I joined the Commission I worked in public accounting for 12 years and had several friends from the German practice. I know from them that membership in this distinguished organization is earned only after rigorous training and examinations, and it is an honor to be able to speak to you today. But, before I begin my remarks, I must remind you that the views I express today are my own, and do not necessarily represent the views of the Commission or other staff members. INTRODUCTION Looking back over the last decade, we have seen significant political and economic change worldwide -- change that has created major new demands for capital and, therefore, new investment opportunities. At the same time, investors have broadened their horizons beyond national borders. As these trends continue, the call for more harmony in capital market financial reporting and disclosure can be expected to continue. But as we attempt to answer that call, it is important to focus, first and foremost, on the needs of capital markets, and capital market participants. We often hear that accounting is an art, not a science. Indeed, different accounting traditions have developed around the world in response to the different needs of the users for whom the information is prepared. In former Soviet bloc countries, financial reporting was designed for central planners; in other nations, the objectives of tax authorities or private creditors may be the dominant force influencing the development of accounting conventions. Reporting practices that are shaped by different forces are successful if they serve the needs of their users -- but the needs of all users are not the same. What I’d like to discuss today is the importance of having any set of accounting standards that seeks global acceptance to be shaped by the needs of investors. My remarks will focus on three points: · A US perspective on the role of accounting standards in capital market regulation, · The Commission’s involvement in international standard setting to date, and · My thoughts about the future. THE ROLE OF ACCOUNTING STANDARDS IN CAPITAL MARKET REGULATION The Securities and Exchange Commission was established in the wake of the greatest financial disaster the US has ever experienced. The stock market crash in October 1929 and its aftermath were times when substantial investments became worthless in a matter of hours and days and when investors and the public lost confidence in securities markets. In response, the Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which established a system of market regulation based on full and fair disclosure. The Securities and Exchange Commission also was created and given a mandate to protect investors in US capital markets. Those laws, and related rules and regulations subsequently adopted by the Commission, establish initial and continuing disclosures that companies must make if their securities are sold to or traded by the US investing public. The goals of this disclosure system are to prevent misleading or incomplete financial reporting and to facilitate informed decisions by the investing public. Financial statements are the centerpiece of this approach, and the quality and usefulness of those financial statements are directly dependent on the accounting principles used to prepare them. US 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.1 Yet, practically since its inception, the Commission has looked to the private sector for leadership in establishing and improving accounting principles to be used by public companies.2 This partnership with the private sector provides a way to build input into the accounting standard- setting process from all stakeholders in our capital markets, including preparers, auditors, users and regulators. 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 supplement, override, or otherwise amend private sector accounting standards. And the Commission staff, through its process of review and comment on financial statements filed with the Commission, is active in shaping how US accounting standards are interpreted and applied. Still, the overall role that the Commission has chosen has been one of oversight of the private sector processes. This is a different role from the one the SEC staff has taken internationally, because the current efforts to develop a core set of international accounting standards are limited to seeking endorsement of the resulting product, not the standard-setting process itself. As many of you are aware, the International Organization of Securities Commissions (IOSCO), of which the SEC is a member, has been working with the International Accounting Standards Committee (IASC) for the past several years on a project to develop a core set of standards that might become a framework for financial reporting in cross-border securities offerings.3 Because the Commission will need to assess the acceptability of the core standards for use in US markets, the SEC staff has been active in following the IASC project. For example, SEC staff members attend IASC steering committee and Board meetings as IOSCO observers, and the SEC staff provides detailed written comments on proposed standards. This participation does not mean that the Commission is obliged to accept the resulting product -- rather, it reflects a commitment to support this effort with timely input. The acceptability of the core standards will be decided after the project is completed, based on the substance of those standards and the degree to which they meet the key elements identified by the Commission. 4 Let me provide a brief review of the history of the Commission’s involvement in the international standard setting process. INVOLVEMENT IN INTERNATIONAL STANDARD SETTING TO DATE In 1994, IOSCO reviewed the existing IASC standards and identified standards that need to be improved before acceptance can be considered, including areas in which there are “essential issues” -- issues deemed critical to the success of the project by some countries. In July 1995, IOSCO and the IASC agreed on a core standards work plan,5 and in April 1996, the IASC announced an intention to try to complete that plan by March 1998.6 In April 1996, the Commission released a statement in support of the efforts of IOSCO and the IASC. That statement indicated that, if the IASC successfully completes the agreed-upon work plan, the Commission will consider accepting the core standards in securities offerings by cross-border issuers in the US.7 The statement identified three key elements that, in the Commission’s view, are necessary for the standards to gain that acceptance. Those three elements are as follows: 1. The standards should include a core set of accounting pronouncements that constitute a comprehensive, generally accepted basis of accounting. 2. The standards must be of high quality -- they must result in comparability and transparency, and they must provide for full disclosure. Investors must be able to meaningfully analyze performance across time periods and among companies. 3. The standards must be rigorously interpreted and applied. 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 rigorous interpretation and application of those standards. Otherwise, the comparability and transparency that are the objectives of common standards will be eroded. Let me give you a few illustrations of these points. High quality accounting standards produce financial statements where events are reflected in the period in which they occur, not before or after. This means that there are no extra “rainy day” reserves, no deferment of loss recognition; and actual volatility is not “smoothed away” to create an artificial picture of steady and consistent growth. But high quality standards alone are not enough -- they cannot be sustained if they are undermined by weak interpretations. For example, IAS 22, Business Combinations, limits the application of uniting of interests accounting to “the rare situation ... when an acquirer cannot be identified.” Clearly, this requires that the two entities are of equal size and value, and that ownership of the combined entity is shared equally. These points are made in the standard itself. Yet, the SEC staff has been asked to accept uniting of interests accounting when the relative size and value of the two entities approached a 70:30 split. This type of interpretation undermines the effectiveness and acceptability of the underlying standard. A call for rigorous interpretation and application of accounting standards is not a demand for a US-controlled rule book. Yes, we do seek rigorous interpretation and application of accounting and disclosure rules. That is because accounting standards must be written and applied to provide relevant and reliable information to investors. These are two examples of the representational faithfulness that investors need from disclosures, from financial statements -- and therefore, from accounting standards. I urge you, as auditors of major German companies, to support the development of standards that are complete and uncompromising, and to rigorously interpret and apply what ever set of accounting standards your clients are using. You are the gatekeepers for our capital markets, and you should be confident that these efforts will be supported. THOUGHTS ABOUT THE FUTURE Having described the Commission’s role in setting US accounting standards, and its involvement in international standard setting to date, I turn to some thoughts about the future. Recently, a financial officer at a major European company commented on his perception of the Commission’s registration and listing requirements. He was reported as saying, “People at the SEC are like civil servants .... They have their rules, and when something does not comply exactly, then it’s unacceptable. You may be very healthy financially, but they can’t judge that unless it is set out in a particular way.”8 This statement suggests that, at times, the Commission may be perceived as resistant to approaches other than US GAAP, or that we are unable to see that US GAAP has its own shortcomings. This is not true. Our objective is comparable and transparent reporting -- reporting that provides a solid basis for individual and institutional investors to make their own evaluation of a company’s financial health. In US capital markets, investor protection is achieved not through merit regulation -- allowing only “healthy” companies to trade their securities -- but by market regulation -- ensuring that all who seek access to US markets provide full and fair disclosure of the risks to investors. Underlying that approach is a strong belief that the success of US capital markets is due in large measure to the high quality of the accounting and disclosure standards used by US public companies. Those standards give investors confidence in the credibility of financial reporting in the US, and without investor confidence, capital markets will not thrive. As the process of harmonizing financial reporting continues, the desire to increase the access of cross-border registrants to US markets cannot be allowed to take priority over the interests of investors. For the Commission to consider reducing or eliminating its requirements for US GAAP financial information, I believe that it must conclude that the alternative standards deliver to the capital markets what US standards provide -- credible information that is grounded in transparent, comparable financial reporting. This determination, which will be made after receiving appropriate public input, will depend on the acceptability of those standards to investors. In the final analysis, I believe that even those who view US standards as too rigid or too demanding -- or imposing too many reporting obligations on management -- recognize that the US system has been shaped to meet the needs of investors and capital markets. This orientation differentiates US accounting and disclosure from systems developed in many other countries -- and is a reason for its attractiveness to capital market participants and regulators. It is this characteristic of US accounting standards that must be replicated in any harmonized international standards that seek to serve global capital markets. We also should keep in mind that completion of the IASC core standards project is not the sole yardstick for measuring the success of international harmonization. Cooperative efforts by a number of entities, including national standard setters as well as the IASC, are producing tangible benefits. Financial reporting around the world is becoming more oriented to the needs of investors -- placing those needs ahead of the policy objectives of tax authorities or the interests of private creditors -- and each time that happens, the potential for harmonization increases. Thus, while the IASC’s efforts to complete a core set of accounting standards is an important goal, it is not the end game. As we contemplate the next steps, let me suggest some guideposts that I believe are important for longer-term success: · The process for developing harmonized accounting standards for global capital markets should, itself, be based on a harmonious relationship among the national and international standards setters. The goal should not be to replace or eliminate the need for national standards or national standard setters. · The national standard setters should be fully engaged in and lead those efforts -- they should be the primary players in the standard-setting process. · The process must be independent and shielded from unwarranted pressure from special interests. · The sovereignty of national standard setters and regulators must be respected. It is likely that the need for national tailoring of accounting and disclosure rules will continue, and national capital markets must be free to decide the needs of their investors. CONCLUSION In closing, let me emphasize my belief that the US can make, and is making, a constructive contribution to the development of international accounting standards. At the SEC, we are devoting significant resources to this and other projects to reduce barriers to efficient movement of cross border capital flows. I see current efforts to develop international accounting standards as an opportunity to utilize the experience of the world’s major capital markets and, most importantly, to help assure that investors everywhere receive the financial information they need. Thank you very much for your time and interest. You are gathered to discuss important issues that arise as companies adjust to the increasing integration of the world’s capital markets. Accounting standards and accountants have a large role to play in this process, and I look forward to working with you as colleagues in this endeavor. Bibliography Accounting Series Release No. 4. 1938. Securities and Exchange Commission (April 4). Accounting Series Release No. 150. 1973. Securities and Exchange Commission (December 20). Andrews, Edmund L. 1996. “Making Stock Buyers of Wary Germans.” The New York Times (October 17) D1, D6. Bayless, R., J. Cochrane, T. Harris, J. Leisenring, J. McLaughlin, and J.P. Wirtz. 1996. “International Access to US Capital Markets.” Accounting Horizons (March) 75 - 94. Cochran, Thomas N. 1996. “Germany’s Biggest Deal.” Barron’s (November 4) 20. Lowenstein, Louis. 1996. “Financial Transparency and Corporate Governance: You Manage What You Measure.” Columbia Law Review (June) 1335 - 1362. Meek, Vicky, “Big is Beautiful.” Accountancy (June 1997), pp. 30 - 31. Schweikart, J.A., S.J. Gray, and S.B. Salter. 1996. “An Interview with Sir Bryan Carsberg.” Accounting Horizons (March) 110 - 117. Securities Act of 1933, 15 US Code Section 77a, et seq. Securities Exchange Act of 1934, 15 US Code Section 78a, et seq. Securities and Exchange Commission Regulation S-X. 17 Code of Federal Regulations Section 210. Securities and Exchange Commission Rule 144A. 17 Code of Federal Regulations Section 230. 144A. Sutton, Michael H., 1997. “Financial Reporting in US Capital Markets: International Dimensions.” Accounting Horizons (June) 96 - 102. _______________________________ 1 See, for example, Sections 7, 19(a) and Items (25), (26), and (27) of Schedule A of the Securities Act of 1933, and Sections 12, 13(b)(1) and 17(e)(2) of the Securities Exchange Act of 1934. The Commission also was given the authority to define accounting terms. See Section 19(a) of the Securities Act of 1933, and Section 3(b) of the Securities Exchange Act of 1934. 2 Early Commission reliance on the private sector for setting accounting standards is found in Accounting Series Release No. 4. 3 See Bayless, et. al. (1996) for more information about IOSCO and the IASC. That paper also discusses the various ways in which foreign registrants are currently meeting the US reporting requirements (pp. 78 - 81). One role of the Commission in international financial reporting is to provide guidance to foreign companies that want to offer securities in the US. 4 While the Commission is unwilling to accept financial statements prepared using IASC standards at this time, it has allowed companies to use certain elements of IASC standards without reconciliation to US GAAP (Bayless, et al. 1996. 83). 5 A discussion of the IASC work plan can be found in Schweikart, et. al. (1996). 6 The announcement is contained in a press release by the IASC titled, “IASC Accelerates Work Programme,” dated April 3, 1996. 7 The Commission statement appeared as a press release titled, “SEC Statement Regarding International Accounting Standards,” dated April 11, 1996. 8 “Big Is Beautiful,” Vicky Meek. Accountancy, June 1997, 30 - 31, quoting Bernd-Joachim Menn, Bayer.