"A Declaration of (Accounting) Independence" Remarks by Arthur Levitt, Chairman United States Securities and Exchange Commission The Conference Board New York, NY October 8, 1997 It's a rare privilege to speak before a group that has done so much to raise the profile and standing of business in the world today. As one of the largest business membership organizations in the world, the Conference Board has been a consistent leader in economic research and business education. You are the world's most frequently quoted private source of business information. Time after time, you have confronted the most vexing issues facing our economy, and responded with compelling insights and reasoned analysis. Your extraordinary reputation was confirmed by the U.S. Department of Commerce when it appointed the Conference Board official custodian of the Index of Leading Economic Indicators -- a stewardship you have fulfilled with distinction. Just as you seek to improve the relationship between business and the general public, so the SEC tries to preserve trust between businesses and investors. The keystone of investor trust is accurate financial information. The ability to produce such information depends in turn on high quality accounting standards. Our nation is immensely fortunate to have an independent process that sets those standards. That process may be the single most important reason why virtually everyone agrees that the American financial reporting system is the world's best. I want to speak to you today about the urgent need to keep that standard setting process independent. In Federalist Number Ten, James Madison describes perhaps the most important safeguard for preserving a just government: "No man is allowed to be a judge in his own cause, because his interest would certainly bias his judgment, and, not improbably, corrupt his integrity." Mindful of Madison's maxim, Congress has often seen fit to protect important public responsibilities from the powerful tides of self-interest and political special pleading. In many instances, our elected representatives have ceded a portion of their authority in an area to an independent body, for the common good. True statesmanship lies in recognizing that preserving the independent decision making process can be far more important than who wins, loses, or breaks even on any given issue. Nevertheless, it sometimes happens that, after creating these independent bodies, those who established them yield to pressures by seeking to tamper with them and influence their operation. Recent history is filled with examples of attempted interference and pressure. Consider the effort to reform entitlement programs. The need for reform has been clear for some time. As baby boomers retire, these programs will either face bankruptcy or will "explode" the federal budget deficit. Neither outcome is tolerable. More important, neither outcome is inevitable. In 1994, President Clinton appointed a 32-member Bipartisan Commission on Entitlements from both houses of Congress. Yet any hope of meaningful reform soon foundered. Members of the Commission were apparently unable to withstand the relentless pressure of powerful interest groups. The White House subsequently formed a 13-member commission composed of private citizens ostensibly immune to such political exigencies. While the commission made several recommendations, it lacked the authority to make its proposals anything more than exhortations. Campaign finance reform is another area that cries out for nonpartisan, independently crafted solutions. Recent hearings seem only to have highlighted the entrenched positions of the political parties. The urgent recommendations of various blue- ribbon commissions have been acknowledged but not enacted. Such a politically intractable problem may be most responsibly approached by the formation of an independent body. It is more likely to reach an objective conclusion and, if empowered, to put it into effect, because it is protected from political fire and brimstone. * * * I like to think that James Madison would be proud of the independent process we've established for regulating the securities markets. The Securities and Exchange Commission is an independent agency with a strongly non-partisan tradition. It is a rare day when we receive a call from the Oval Office. The Commission deals with Capitol Hill far more frequently, and this is proper. We must be held accountable to the American people for the tax dollars we receive, and the services we provide in return. While we must fight for our budget, on the whole, we are shielded from the day-to-day push-and-pull of partisan politics. This is one of the key reasons why investors trust the SEC and the markets we regulate. They understand that we hold the interests of investors supreme, above the special interests of any political party or organized group. Congress created the SEC to protect investors, and structured the agency in a manner so that it could accomplish that objective. Early on, commissioners debated whether the SEC should use its authority to set uniform accounting standards, or instead, should build upon the expertise developed by the profession itself. The conclusion reached nearly 60 years ago still makes abundant sense to me today. The Commission noted that professional accounting bodies existed in the private sector whose mission was to serve the public interest. It decided to look to these private entities to provide leadership in establishing and improving accounting standards. SEC staff would oversee the overall process. And the Commission retained ultimate legal authority over the content and presentation of financial statements. Accounting standards are, of course, the foundation of fairness in financial reporting. Without such rules, the investor would stand unprotected, uninformed, and unaware of misleading or deceptive disclosures by those who may seek to distort financial reality. All of us understand that new rule proposals will often be perceived negatively by the businesses that will be subject to them. We also know to expect that, in at least some instances, the temptation to try to influence or derail the rules will be enormous. If the decision-making process that creates these rules is not independent and is not protected from undue influence, the standards are bound to lose their credibility and legitimacy. It is compellingly clear to me that the objectivity and fairness of standard-setting can only be guaranteed if the process is insulated from political agendas, special interests, and bureaucratic convenience. If that independence is compromised, or perceived to be compromised, we would pay a heavy price in declining investor confidence in the markets. The Financial Accounting Standards Board has filled the role of impartial standard-setter admirably for a quarter century. As you know so well, these same years have witnessed an astonishing evolution and expansion in the techniques of raising capital in our markets. In a climate where change has become a constant, the FASB has consistently sought to ensure the accuracy of financial information, protecting the basic rights of the investor and strengthening public confidence in our markets. Resolute enforcement of these standards by the SEC is, in large part, responsible for the flourishing markets we see today. Nonetheless FASB critics are working hard in Washington to limit its independence. They sometimes take the ironic tack of arguing that the Board is anti-business. To me, that's like suggesting the College of Cardinals is anti-Catholic. It is hard to imagine a more accomplished group of capitalists and free market advocates than the roster of past and present trustees of the FASB's parent, the Financial Accounting Foundation. Included in this group are * the former Vice Chairman of the Federal Reserve and Co- Chairman of Johnson Smick International, Manuel Johnson; * Michael Cook, the Chairman and CEO of Deloitte & Touche, and Nicholas Moore, Chairman and CEO of Coopers & Lybrand, firms formerly part of the Big Six but soon to be part of what we will no doubt call the Fabulous Five; * Philip Duff, President and CEO of Van Kampen American Capital, one of the nation's largest mutual fund complexes; and * Thomas Jones, an Executive Vice President at Citicorp. The trustees choose who will serve five-year terms on the FASB board, and this group too is one that has served American businesses with great distinction. If anyone doubts the huge difference that accounting standards can make, consider the example of Daimler-Benz. In 1993, it became the first German company to register securities in the United States. Under German accounting standards, Daimler had reported a profit of 168 million Deutschmarks in 1993; under more telling American standards, the company reported a loss of almost a billion Deutschmarks for the same period. It's as if two different cameras, aimed at the exact same object at the exact same time, produced completely different pictures. I don't think there is any question that American accounting standards provided a sharper, more focused and more accurate snapshot of Daimler than did their German counterparts. Closer to home, in 1992, the FASB required companies to record retirement health benefits as liabilities. This was an undertaking that, at the time, may have been more controversial than the derivatives proposal. As a result of this new standard, the balance sheet of General Motors, for example, revealed for the first time its liability for its retirees' health care costs. Without the new standard, total shareholder equity at GM would have been reported as $27 billion. With the new standard, shareholder equity was actually shown to be $6 billion -- a huge difference in value that investors had the right to know. Ironically, many of the corporate officers who complained about this standard have now conceded that it has produced much important and useful information. The controversy over marking securities to market provides perhaps the most dramatic example of how accounting standards can make a difference. Prior to 1993, securities often were carried on balance sheets at their historical cost, regardless of their current value. That's like always keeping your watch set to the time you first bought it -- it doesn't help you get to work on time. Under the historical cost standard, for example, the American S&L industry showed a positive net worth of $36.2 billion in 1980. This was at a time when Congress was considering whether to deregulate the thrift industry. S&L assets consisted more of loans than securities, but the key point still applies. S&Ls were not required to mark those assets to market. The industry had pressured its regulators and received a special exemption from complying with generally accepted accounting principles. The resulting positive net worth for the industry in fact was an elaborate fiction. Many of the loans were in default, and undercollateralized to boot. Had S&Ls been required to mark those assets at their actual fair market value, the industry's real condition would have been evident -- a collective negative net worth of between $78 and $118 billion. I can't say whether Congress would have refrained from deregulating the industry had these figures been widely known. But we would have approached the question of deregulation with our eyes wide open. And I can say that fact, by itself, would have given us a better chance of averting the S&L crisis. Considering these examples and their impact on investors, the case for the independence of the accounting standard-setting process would seem clear. Almost from its inception, the FASB and its pronouncements have been criticized by corporate interests. There's nothing wrong with criticism -- much of it is necessary and expected -- indeed, it's what I used to do when I was on the corporate side. A frank dialogue between those who make the rules and those who must abide by them is healthy. Part of the responsibility of the rulemakers is to be certain that the independent decision-making process not become an insulated or unresponsive one. Responsiblity cuts both ways, however. Recently, some groups have ceased to offer constructive criticism to the FASB, focusing instead on attempts to undermine the Board and its independent decision-making process. One of this nation's leading bankers recently suggested taking standard setting out of the private sector's hands. He wants to assign the responsibility to government officials -- the same people so often derided as bureaucrats. I don't know about you, but I find this argument rich with irony. Here, after all, is a bank CEO -- urging the government to immerse itself in the details of technical accounting rules that are important to the bank's business. I wonder if the theory is government officials would develop better rules because they are much more reasonable, practical, thoughtful, and flexible than their rigid, insulated and unresponsive brethren in the private sector. I am looking forward to the next great idea: maybe somebody will suggest that Congress start setting interest rates. The latest skirmish about accounting standard setting was set off when the FASB proposed that companies measure and disclose their derivatives exposure. This is an issue that has particular poignancy for me. Those of you with businesses sensitive to interest rate movements no doubt recall the events of 1994. Americans saw millions of their investment dollars vanish as major derivatives positions went sour when interest rates spiked upward. Enormous losses at well-known companies such as Eastman Kodak, Gibson Greetings, and Procter & Gamble shocked many investors because they seemed to have so little to do with sales of film, greeting cards, and soap powder. The problem was not just that the losses were large, but that they happened so suddenly and took so many knowledgeable analysts by surprised. Upon further study, it became clear that the risks companies took in derivatives were not adequately described in annual reports and other disclosure documents. Indeed, sometimes they weren't described at all. Obviously, there were serious shortcomings in the guidelines for derivatives accounting and disclosure. Derivatives were propelled into the headlines. Each new loss brought forth calls to the SEC to restrict their use -- including from powerful members of Congress on both sides of the aisle. Leading newspapers called for the SEC to take action. But the Commission resisted calls for more regulation. We chose instead to focus on how to ensure that derivatives and their potential risks could be more meaningfully communicated to American investors. After three years of inquiry, the Commission adopted market risk disclosure rules that will provide a reasonable amount of information to investors at a reasonable cost to companies. At the same time, the FASB proposed a framework for derivatives accounting, a proposal that was the culmination of a decade's worth of study and research. That is the proposal that has since come under such heavy fire. Of course, the substance of any criticisms must be assessed and weighed carefully. But we are in a situation today in which the notional amount of derivatives outstanding worldwide has reached $70 trillion -- a figure that is nearly 10 times our gross domestic product. Accounting has simply failed to keep pace with this exponential growth. The FASB believes that the truest and most relevant picture of a company's derivatives position is fair value. Zero is most certainly not fair, although that is how many derivatives are reported today. My lifetime of work in the securities industry tells me that the FASB has gotten this about right. Their proposal is a thoughtful and reasonable solution that meets the test of significantly improving current practice. That said, however, I am not really here to persuade you of the rule's technical merits. I am here instead to defend the independence and the validity of a standard-setting process that is needed and wanted by investors, and crucial to the future health of our markets. Few fully appreciate the careful and painstaking deliberations that led the FASB to propose the rule. A decade of study; thousands of hours of staff time reviewing hundreds of comments and analyzing dozens of alternatives; field tests; and more than one hundred open meetings and public hearings. It is extremely significant to me that, as a result of this process, the FASB modified its proposal. Those changes led companies like General Motors, McDonalds, and Berkshire Hathaway -- and institutional investors like T. Rowe Price, Vanguard, and the nation's largest pension fund, TIAA-CREF -- to declare their support for the rule. Ironically, the FASB's responsiveness in making these changes is now cited by opponents as reasons for further delay. Other critics have suggested that further study is necessary before the FASB races ahead with its proposal -- a proposal preceded by 10 years of study and debate. These delaying tactics are inconsistent with the way the standard- setting process should be conducted. The SEC, the accounting profession, and the business community acted wisely and selflessly in forming the FASB as an independent body that could objectively set accounting standards. The FASB is an outstanding example of an independent institution that has worked as intended, largely free from political interference. It made a carefully considered but difficult judgment about how to account for derivatives. However, it now faces some of the same attacks on its authority and legitimacy that have stymied efforts to reform other complex issues, like entitlements and campaign finances. Hearings are being held on Capitol Hill. The SEC has traditionally resisted its power to second-guess a FASB rule. Now Congress, under pressure from some in the business and banking community, is thinking of intervening in this non-partisan process and second-guessing us both. That effort may bring us to a troubling crossroad. There's no going halfway on this. It's not enough to respect FASB only when its decisions go in your favor. And it's not acceptable to claim the process is unfair every time they do not. The true test of a democratic institution is whether it is respected even by those who disagree with its decisions. If we don't abide by FASB's decisions when they go against our interests, then we will seriously undermine, and ultimately destroy, the institution. I say to you today that that is too high a price to pay. The value of FASB's independence is incalculable. If investors don't trust the numbers in a company's financials, we've lost more than dollars -- we've lost a measure of hope. We have to work hard not to allow a process to be undermined that has, time and again, proven to be a unique source of rational, unbiased judgment. Let past efforts to reform entitlements and campaign finances serve as warnings: we tamper with independent processes at our peril. The FASB is not immune to criticism and change. But there is a world of difference between advice and intimidation. Changes that would make the Board more responsive to critical issues are absolutely welcome. Changes that would undermine its independence are not. In protecting FASB's autonomy, the Congress and the SEC should be stewards of a profound trust, the covenant between citizens and a government sworn to protect them and keep them fully informed. Our capital markets must remain among our nation's most spectacular achievements -- not only in their accomplishments, but also in their fairness. Those markets, and investors' confidence in them, are a rich legacy we have inherited, but do not own. They are a national asset we hold in trust for our children, and for generations of Americans to come. On behalf of those future generations, we must preserve that trust, and even expand it. That means working together to improve FASB's process, by all means; and working together to preserve FASB's independence, by any means. Thank you again for the honor and privilege of joining you here this evening. # # #