Speech by SEC Staff:
Continuing High Traditions
Lynn E. Turner
U.S. Securities & Exchange Commission
AICPA Bank and Savings Institution Annual Conference
November 6, 1998
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This article expresses the authors' views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It has been over twenty years since I started in the public accounting profession. During the past twenty years, I have had the good fortune of spending a significant amount of time within the banking and what is now referred to as the financial services industry. Initially my time was spent as an auditor. However for the past few years, I was a major customer of some of the U.S. and International banks in my role as a CFO of a business. During all those years, I have come to enjoy working closely with the banking community and look forward to continuing that relationship as the Chief Accountant of the Securities and Exchange Commission.
I value the input from those in financial management as well as from those in public accounting. I will note that a short time ago I contacted a representative of the ABA and requested a meeting with those in the organization who dealt with matters regarding financial reporting. We had our initial meeting in the past week and I found our discussions on issues facing the banking industry to be useful and beneficial. While we may not always agree in our viewpoints on various financial reporting issues, I think it is important that we keep open lines of communication. As a result, I look forward to many meetings on topics of mutual interest in the future.
I might note that the industry has offered me the opportunity to visit with some of the member banks so that I might become better acquainted with their operations, key management issues and systems. That is an offer I intend to accept in the near term.
During the past twenty-five years the banking industry has undergone phenomenal changes. Today, I view it in the context of a competitive financial services business. It has gone from an industry that simply took in deposits and made loans to one that is involved in a wide variety of businesses including investment banking, securities underwriting and insurance. Its competitors have gone from being simply other banks to including players such as investment companies, brokers and dealers in securities, insurers and financial subsidiaries of commercial enterprises. As a result of these changes, banks have had to make fundamental changes to their business and how they manage those businesses in order to survive. The banks that have been successful in managing these challenges in these changing times are bigger and stronger than they were twenty-five years ago. Those that have not kept up, have been swept away.
Those of us in our roles in public accounting and financial management have also seen tremendous changes in our profession and jobs. We have seen business, the accounting profession, users of financial statements and academia come together to create, fund and contribute to the work of the Financial Accounting Standards Board. The SEC has adopted an integrated filing approach that is once again evolving with the recent Securities Act Reform Release, often referred to as the Aircraft Carrier project. Changes in technology have changed the way we think about, process, disseminate and audit information. Our systems have had to change as they are now considered to be a competitive weapon, not just a bookkeeping system. Changes in the marketplace have also given rise to global markets, where we are all linked together not only from a product perspective, but also from an information sharing perspective. We can now share information on just about any subject, including many of the global businesses, on-line, real time.
The pace of these changes affecting our businesses, communications, and professions, will continue. Based on my past experiences as a CFO of a large high technology company, I believe the pace of the change will continue to increase. Given that as a fact today, I believe there are certain challenges we face that those of us in financial management, the public accounting profession and regulation must deal with in order to take us into the 21st century.
Major Challenges Ahead
I believe some of the challenges that we face have particular relevance to auditors and financial management professionals within the banking industry.
Supporting The Standard-Setting Process
I have found that when you put ten accountants in a room to discuss an accounting issue, even without the added pressure from analysts, budgets, boards of directors, or regulators, it is very difficult to get any sort of consensus. This is not dissimilar to what we see in the private sector standard-setting process today when the differing constituents of the Financial Accounting Standards Board ("FASB") and Accounting Standards Executive Committee ("AcSEC") provide their comments and viewpoints to the standard setters.
Not everyone agrees on the answers to each question, and in fact in the past, even I have had a different viewpoint on number of accounting standards. For example, despite the complexity of today's business, I wish a number of our rules today could be simpler, more practical, and more operational.
yet notwithstanding my personal viewpoints on individual standards, I believe that our standard-setting process works very well. The lack of transparency and the magnitude of the problems that we are seeing in many of the global markets provide definitive support for the quality of our processes and the standards we have. Given this support of our "best in class" process, it seems counter-intuitive to question the effectiveness of our private sector standard-setting process.
accordingly, I challenge those in the financial community to find a way to continue to support, contribute in a meaningful way, and defend the integrity and independence of the private sector standard-setters, including the FASB.
I know many in this industry have not always agreed with the FASB. In particular the FASB's standard on derivatives and its project on fair value have been a source of controversy for the industry. However, this does not mean that the standard-setting process is broken.
we need to focus efforts on how to seek "continuous improvement" in the standard-setting process. As a businessman and former CFO, I know the need to seek continuous improvement in each process, to ensure the process provides world class results in a timely and effective manner.
However, we must come to realize we will not always agree on each issue, that due consideration and respect must be given to differing viewpoints; and that at the end of the day, if a reasonable answer is arrived at that we individually might disagree with, that disagreement in and of itself does not warrant the condemnation and destruction of our system.
I should note that chairman of the FASB has recently brought in a consultant to review the process the FASB uses in its projects with an eye toward making the process more timely and efficient. In addition, the Board with strong support and funding from its constituents, has commenced a project to examine the U.S. financial reporting model. I view these as two very positive steps indicative of a commitment to improving our standard setting.
In supporting the standard-setting process I would also challenge you to take the high road in implementing new accounting standards. In particular, financial institutions will be implementing SFAS No. 131 this year and SFAS No. 133 in the Year 2000.
The SEC staff is closely monitoring the implementation of these standards in its review of filings with the Commission. We have indicated to the accounting profession that we expect SFAS No. 133 implementation questions and issues to be taken to the Derivatives Implementation Group or Emerging Issues Task Force ("EITF") a proactive and timely basis. Unusual or complex transactions, that have not been addressed by these groups, and for which there is no clear answer should be addressed with the SEC staff on a prefiling basis, as opposed to trying to address the issue in the context of a comment letter.
Chairman Levitt issued a challenge on earnings management to the financial community in September. The Chairman's speech highlighted the SEC's concerns regarding a practice we refer to as "Earnings Management". This practice involves the use of inappropriate accounting to manipulate reported earnings. The SEC believes that if not addressed, earnings management issues, and the forces that create them, can undermine the integrity and reliability of the financial information that is the lifeblood of healthy capital markets.
Some of the more popular inappropriate accounting methods used to manipulate earnings include:
Big Bath Charges
These include improper liability accruals often made under the guise of a restructuring or merger or in the name of conservatism. Some of these charges include the improper write off of assets to avoid future charges to earnings. We have seen instances where changes to business plans, strategies and technologies were made and, instead of properly adjusting asset depreciable lives, the registrant took a large asset writedown at a later date.
Creative Acquisition Accounting
The high level of merger activity has left us with companies charging off almost the entire purchase price of a business. Some of the merger transactions also have resulted in large liabilities being added to the companies' balance sheets with equal amounts of goodwill being created. These accounting entries clearly appear to lack business or economic sense.
Misuse of Materiality
You will find very few instances in generally accepted accounting principles (GAAP) where materiality is defined as a specified amount. Instead, both the legal statutes and accounting literature spell out clearly both qualitative and quantitative factors that must be considered when assessing materiality. This is an area in GAAP where professional judgment is required. But it is also an area where the Commission staff has seen numerous instances of non-GAAP entries, in some cases intentionally made, that changed earnings trends or perhaps allowed the company to make the earnings forecast for the quarter. The argument we have heard to justify these entries, both from companies and their auditors, is that the amounts are less than a rule of thumb 5% or 6% of net income, or whatever test they use for materiality.
Cookie Jar Reserves
Simply put, these are reserves set aside in good times or under the guise of a large one time charge. Later on they are often bled back into earnings when needed.
As you are probably aware from recent press articles, the SEC staff has some concerns regarding the accounting by a very limited number of financial institutions for the allowance for loan losses. A concern that I have is that some of these news articles imply that our concern in this area is a new development which is not the case. In fact, the staff has been raising concerns about the allowances for loan losses for over a year. The prior Chief Accountant raised the issue at this conference last year.
Before I discuss this topic, it may be helpful if I review what is GAAP in this area and why the staff believes it is important that GAAP be followed.
Generally Accepted Accounting Principles
GAAP for loans and the allowance for loan losses can be found in FASB Statements No. 5 and 114 and in the AICPA Audit Guide for Banks and Savings Institutions (Audit Guide). The basic premise in this guidance is best summarized in paragraph 7.29 of the Audit Guide which states: "The allowance for loan losses should be adequate to cover probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date" (emphasis added). GAAP does not permit providing losses for future events.
Guidance in this area is also provided by the banking regulators. For example, OCC ADVISORY LETTER 97-8 states that "Unallocated reserves....must not be used to obfuscate the determination of the overall allowance adequacy, mask significant deteriorating trends in asset quality, or "manage" earnings." Additionally, Financial Reporting Release ("FRR") No. 28 requires the application of a systematic methodology and rationale in determining the allowance for loan losses.
The recent events in the world's markets have been a painful experience for the securities market. However, from this experience we have learned the value of having transparent financial reporting that provides investors, lenders, and regulators with a clear picture of the true economics of a business.
The SEC staff and other regulators have had similar concerns in the past with respect to transparency of the financial statements of financial institutions in the United States. For example, in the late 1980's and early 1990's, many institutions were challenged on the accounting for their investment and loan portfolios. The staff was concerned at that time that the amount of loan losses being reported did not reflect on a timely basis the actual economic losses being incurred by the institutions. Instead, filers often argued that they should be able to look forward and anticipate a recovery in the market place that was inevitable. Notwithstanding that argument, we all know too well the number of bank and savings and loan failures and resulting losses of investors that occurred. For those, the turn around in the economy came too late.
Today we are faced with similar and yet different circumstances. The staff is concerned that once again we will not have transparency in the financial reporting of some financial institutions. The banking regulators have indicated that they are concerned that some banks may not have adequate allowances for loan losses, especially in light of some of the turmoil in foreign markets and current bank underwriting standards and controls. In some instances, we share their concerns in light of the current marketplace. However, at the same time the staff has highlighted for me a limited number of institutions that appear to have recorded allowances for loan losses that do not seem supportable in light of the accompanying disclosures made to investors with respect to the underlying economics of the loan portfolio, and trends therein.
For example, we have seen instances where financial institutions have allowances for loan losses amounting to 35 times average annual charge-offs. We have seen allowances amounting to 700% of non-performing loans. We have seen where there have been no, and I repeat no, loan loss provisions for a period of several years. In some cases we have also seen that the unallocated allowance for loan losses has represented more than 50% of the total allowance and where the justification for the allowance is based on vague factors such as a belief that there will changing economic trends in the future.
As a result, the staff will question those registrants where it appears that the information provided to investors through the financial statements and disclosures in management's discussion and analysis, with respect to the loan portfolio and allowance for loan losses, is not consistent or appears unreasonable or without adequate support. This would include both where the allowance for loan losses appears to be too low as well as those that appear to be too high.
In the final analysis, giving due consideration to the judgmental nature of the determination of loan losses, we expect financial institutions to follow GAAP. Loan loss provisions should be recognized for probable losses that exist as of the balance sheet date, applying a rational methodology that is documented consistent with FRR No.28 and that are consistent with full disclosure in Management Discussion and Analysis of the applicable trends, events, and uncertainties. For example, if factors exist such as deterioration in an industry segment, like the agriculture industry, or there is a concentration of loans in an economically depressed region such as Asia, or there is an indication of increasing trends in losses, such as with consumer loans, and those factors and trends are the reason for the necessity in a larger allowances for loan losses, then those factors must be disclosed in MD&A. You cannot have it both ways; significant issues requiring higher levels of allowances require full and fair disclosure of those issues to investors.
In the Chairman's speech in September, he stated a belief that abusive earnings management practices are a financial community problem that calls for a financial community response. To date, the response has been tremendous. Business leaders, attorneys, academics, managing partners of the major accounting firms; and the AICPA have all commended the chairman for undertaking this bold initiative.
The financial community also has commenced work on the action plan outlined by the Chairman. Let me summarize for you that action plan and the progress to date.
The NYSE and NASD have formed a blue ribbon committee co-chaired by Ira Millstein, one of the most experienced corporate governance attorneys of our time, and John Whitehead, former co-chairman of Goldman Sachs and Undersecretary of State. This 11 person panel is comprised of the chairs of the exchanges; leading CFOs from the FEI, managing partners from the five largest accounting firms, executives of institutional investor, and the business community. This panel is expected to propose recommendations to the business community, regulators, and the exchanges for strengthening the role and performance of audit committees. On December 7th in New York, the panel will hold public hearings and solicit comments on ways to improve audit committees.
The Independence Standards Board also tentatively has agreed to recommend a full discussion each year between auditors and audit committees regarding auditors' services, fees, and independence. This new proposal, which both the SEC staff and Public Oversight Board strongly support, should result in a robust discussion about the auditor's independence.
I firmly believe that the role of the audit committee in corporate governance is important. I believe that e audit committees must work closely together with financial management and auditors, as a team, to ensure the quality of our financial reporting. The audit committee meetings should focus on matters such as the quality of financial reporting, the quality of internal controls, and the adjustments, both booked and unbooked, arising from the audit. That is why I now ask the question of each registrant who visits with us, "have you discussed this issue with your audit committee?"
The media has reported on a number of alleged spectacular earnings management cases in 1998. Articles have included headlines such as "Pick A Number, Any Number," " Abracadabra," and "10 Reasons Numbers Lie." In these articles, the question has been raised "where were the auditors?" This is a very serious question; especially given that the magnitude of some of the financial statement errors are reported to have been in the hundreds of millions of dollars. In one single instance, investors lost $20 billion dollars.
Personally, I wonder if the audit process has kept pace with the quickly evolving and changing ways we do business. While the auditing firms hire some of the brightest graduates from our universities; I wonder if these new staff, who typically have zero to six years of auditing or business experience, and who perform more than 80% of the audit work, have an adequate understanding and knowledge of both auditing procedures and business operations to dig deep enough into a complex business, its operations, and the resulting numbers.
To address this concern, the pob has announced the creation of a committee to investigate the effectiveness of audits. Never before has a committee comprised of such distinguished individuals, a majority of which are from outside the auditing profession, undertaken such an important task. This panel, comprised of a former CEO of one of the major accounting firms, a former executive of AMEX, two former SEC Commissioners, representatives of the academic community, and a ceo from industry are expected to complete their study in the next twelve months.
Needless to say, the very integrity of the auditing profession rests on the objective review of the numbers prepared by financial management, and an ability to stand tall when the difficult issues and questions arise. We do not need any more articles with the question, "Where Were The Auditors?"
The Accounting and Auditing Standard Setters
The AICPA is already in process of developing a tool kit, for accountants and auditors alike, on revenue recognition. This tool kit will be completed before the end of the year. Subsequent to the development of the tool kit, the Auditing Standards Board will reexamine the auditing standards related to auditing revenue and liabilities, such as those for restructuring charges.
Many of the concerns about earnings management will be highlighted in upcoming AICPA audit risk alerts, to be published soon. I recommend that you review that document once it is available. We have provided the AICPA with a letter, which is available on their website at AICPA.ORG, that identifies issues we expect to be looking at closely in the course of our reviews of this years' filings.
Also, we are monitoring closely the FASB's projects, currently underway, which will define more clearly what transactions should be recorded as a liability. The Board and its staff met recently on this issue and are actively working on a timely decision.
SEC Action Plan
The SEC's action plan is comprised of both rulemaking activities and further staff guidance. We are working on a rule proposal to expand the required disclosures of loss accruals, sometimes loosely referred to as reserves. This is most likely to come in the form of a recommended change to the current Regulation S-X schedule for valuation and qualifying accounts.
We also expect to issue by the end of the year, staff accounting bulletins addressing (1) revenue recognition, (2) recognition of loss accruals, such as restructuring charges and asset impairments, and (3) materiality. This additional guidance is expected to focus on general revenue recognition concepts; the specificity needed in plans in order to recognize a restructuring charge; a time frame in which those plans must be completed if an accrual is to be made; greater delineation of the types of costs that can or can not be accrued for; guidance on proper adjustment of asset lives; and factors that should be considered when assessing materiality.
In addition, the Division of Corporation Finance has formed an earnings management task force to coordinate and focus our filing reviews on abusive financial reporting practices. The Division of Enforcement also has stepped up their focus on earnings management; and currently has several significant cases under investigation.
Change In Culture and Business Ethics
Finally, and perhaps more importantly, we are calling for a change in our business culture and how all of us interact with the different members of the financial community.
Analysts and investment bankers need to reexamine how they react to narrow misses in quarterly earnings. CEO's need to be sure the focus is on numbers that reflect the underlying economics of the business and stop putting pressure on CFO's to move the numbers around to meet analysts' quarterly earnings forecasts. Likewise, CFO's need to step it up to ensure the quality of our financial reporting provides investors with all the information they need on a timely basis.
We have all heard people from time to time discuss the topic of business ethics. The universities have courses on it, companies have ethics officials, and auditors certainly focus on the topic. Yet, I think the notion of business ethics is misleading. It conveys a sense that those of us who are in or have been in business have a different level of ethics than others. I certainly hope that is not the case. I believe we can have only one level of ethics, and that is a standard of the highest level. Nothing less should suffice.
International accounting and Auditing Standards
Let me switch for a moment from the challenges facing us with respect to earnings management, to a more global issue; that of harmonization of International Accounting and Auditing Standards.
we must all contribute to the evolution of the international accounting and auditing standards while at the same time assuring:
this is no longer a project that public accountants and CFOs in America can ignore. It is very relevant to all of us.
- A comprehensive set of standards;
- A set of high quality standards that result in transparency for the underlying economics of the businesses;
- That the final standards are rigorously interpreted and implemented.
i offer as an example the accounting rules for business combinations worldwide. Some people believe, and I think with some justification, that some of the standards used in other countries are of a higher quality than those currently used in the U.S. In addition, it is difficult for foreign filers to reconcile the differences between U.S. GAAP and the GAAP they use to report in their home countries. As a result, it makes all of the sense in the world, no pun intended, for the FASB to work closely with other national standards setters to come up with a global, harmonized standard addressing this issue. One potential outcome of harmonizing the various worldwide standards would be to eliminate the use of accounting alternatives and pooling accounting.
accordingly, I encourage you to become engaged in the debate on international accounting standards. I am actively seeking the financial community's perspectives on the issues and would certainly welcome your input on the tough decisions I will face shortly such as:
- What will be the impact on U.S. filers if IASC standards are adopted?
- Do investors benefit from the information in the current U.S. GAAP reconciliation? Does this reconciliation provide a useful tool for "leveling" the competitive playing field for U.S. and foreign companies?
- Is there a sufficient infrastructure worldwide today, including quality international auditing and independence standards, to ensure the rigorous implementation of the IASC standards?
Let me close by saying that I firmly believe that those of us in the banking industry and public accounting profession have had a proud tradition in the past. We have had a rocky road to travel at times, yet we have always found a way to overcome the obstacles we faced, traveled the higher ground, and found ways to improve on the past.
Yet we must face the new challenges I have described that confront us. To meet these challenges there will need to be leaders who rise to the occasion to take on the tough issues, find ways to bring the financial community together to find solutions to the questions that have been poised, and find compromise where differences in viewpoints exist. We will need people in public accounting and financial management who can think outside the envelope to find new and innovative ways to improve how we conduct our business, do financial reporting, and serve the public sector as auditors. We will need professionals who ask not how can I get around the rule, but rather how can I improve the rules to provide for better management, regulation, and financial reporting to investors and the public markets.
I for one look forward to the challenges we face, the opportunities they provide us, and what I believe will be a proud continuation of our traditions from the past.