Speech by SEC Staff:
Challenges To Be Met
Lynn E. Turner
Chief Accountant, U.S. Securities and Exchange Commission
At the Ninth Annual Conference on Financial Reporting, University of California, Berkeley
October 30, 1998
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. Turner and do not necessarily reflect the views of the Commission or of the other members of the Commission's staff.
Thank you for the kind introduction and opportunity to speak at this distinguished conference. As a CFO of a high technology company, I have visited the San Francisco area frequently. It is a pleasure to come back and see a number of friends in the audience once again.
Back To the Past
Speaking of a return trip, it was certainly thrilling and with great pride that I watched the space shuttle and Senator John Glenn return to space. It rekindled a spirit of pride and had me reminiscing about the days of John Kennedy, the race to the moon and the victory, if you will, when Neil Armstrong took that one large step for mankind on the lunar surface.
A lot of years and changes have transpired since the 1960s. At that time, there were no desktop computers, no cellular phones, no minivans, and no titanium golf clubs. Instead we had one-car families, we drove cars referred to as goats, hermis, or a bug, and homework involved a lot of work with a no. 2 pencil, a pad of paper, and a big thick pink eraser.
Changing Times in Financial Reporting
Many changes in financial reporting have occurred in the past 25 years as well. Business, the accounting profession, the preparer and user community, and academia have joined 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 evolving once again with the recent rule proposal for registrations. In addition, the AICPA has created an oversight board to oversee the audit work of those member firms who audit the public companies in our capital markets.
At the same time, there are some similarities between the issues in financial reporting today and those that existed 25 to 30 years ago. For example, in the 1960s and 1970s there were those who were dissatisfied with the Accounting Principles Board and who wanted the accounting standards-setting process taken away from the AICPA. There were several spectacular fraud cases reported by the press such as equity funding and Penn Central. The problems with the ethics of management of these business and the numbers they were reporting caused the public to wonder if they could be relied on. Finally, there were hearings in the halls of Congress in which the professionalism, independence, integrity, and objectivity of the accounting profession was critically questioned.
Today, once again, we have those who strive to take the standard-setting process away from the private sector, the FASB, and put it into the hands of our government. We see article after article in the daily press and business journals citing and listing restated financial statements; some of the errors are reported to exceed half a billion dollars. These same articles raise the legitimate question of the role of the audit committees, CEOs, CFOs, and auditors in these financial issues. The investors also wonder what is happening when in a single instance their losses have exceeded $20 billion dollars.
The Time and Place for a 21st Century Response
John Glenn and NASA have rekindled a spark of pride in America, and those of us in the financial community must find a way to do likewise. We must come together as a team, to address our issues, answer the questions we face, and find and implement effective solutions. And as my mother always use to say when I was eyeing that no. 2 pencil and pad of paper, there is no time and place like here and now to do it!
We must step up to this challenge if we are to be ready for and meet the public's expectations in the 21st century. We must also do it to assure that our capital markets maintain their number one competitive ranking in the world and provide our businesses with access to the lowest priced capital in the world. I must also add that I believe very strongly that with a renewed and dedicated effort of the brightest minds we have in business and financial management, in the public accounting and legal professions, among the investment and financial analyst community, and from the standard setters, academia, and the regulators that we can master the challenges we face and develop the solutions to our problems.
The Challenge Ahead
Let me take some time now to lay out what I believe to be the challenges that we face, and that must be addressed.
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 FASB and 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 different views on a number of accounting standards. For example, I wish a number of our rules today could be simpler, more practical, and more operational.
Yet notwithstanding my viewpoints on individual standards, I believe 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 to the quality of our processes and our standards. Given this support of our "best in class" private sector standard-setting process, I sometimes question the motivation of those who appear to be seeking its demise or to drastically limit its effectiveness.
Accordingly, the first challenge that I will issue today is:
The financial community needs to find a way to continue to support, contribute in a meaningful way to, and defend the integrity and independence of the private sector standard setters, including the FASB.
We need to focus efforts on how to seek "continuous improvement" in the standard-setting process. As a businessman and a former CFO, I understand the benefits that derive from seeking continuous improvement in each process, that is, we assure that the process provides top notch results in a timely and effective manner. However, we must also realize that 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 a person individually might disagree with, that disagreement in and of itself does not warrant a condemnation and destruction of our system.
I should note that the 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 our financial reporting model. I view these as two very positive steps indicative of the commitment to improve our standard-setting process.
Improving the Effectiveness of Audits and Audit Committees
Any time the press and media report that investors have lost over $20 billion of their money in a single instance of alleged financial fraud involving errors in the hundreds of millions of dollars, I am concerned and I lose sleep at night. I am concerned for the single mom or the blue collar worker who just lost the money they have worked hard to save. I am concerned for those in the public accounting profession who receive a black eye and whose reputations are tainted by these situations, and I am concerned about questions of investor confidence in our markets when these events occur. Trust me, as I lay awake at night, I am also asking, "Where were the auditors?" That question then brings us to my second challenge.
We must reexamine the effectiveness of how we do audits today. This must be an in-depth review that starts with a clean sheet of paper and asks if our current audit model really works. The specific types of procedures we perform, how and who performs those procedures, the timing of when the work is done, the effects of our electronic age, the knowledge and training of those conducting the audit, the quality controls used by the profession, and the profession's peer review process must all be carefully considered. This review should also become a continuous, ongoing process.
A third challenge goes along with the second.
We must improve the quality and effectiveness of audit committees. I believe this in turn will have a positive effect on the quality of financial reporting.
We must seek out and find ways to assure that we have competent, independent committees that carry out their duties and responsibilities with a high degree of vigor. They need to ask the tough questions regarding a company's financial reporting practices, whether high quality internal controls not only exist on paper, but also and more importantly are functioning as they should be, and whether the services the independent auditor provides might impair its independence.
No longer should the audit committee just ask how cheap are the audit fees. They need to ask if the audit is of a high quality and assess whether the fees are commensurate with the value provided.
Keep in mind, $20 billion in investor losses would probably cover adding 20 percent to the fee of each audit in the U.S. for the next three to four years. Audit committees need to look at the budget for the finance and accounting departments and consider if the funding is at a sufficient level to assure good internal controls and quality financial reporting.
With respect to these challenges related to our auditing processes, I must note and commend the NYSE, NASD, and POB for organizing blue ribbon panels to address these issues.
The stock exchange panel, made up of a team of outstanding leaders of the legal, accounting, investment, and business communities already has had their initial meeting. On December 9th in New York, the panel will hold public hearings and solicit comments on ways to improve audit committees. I urge each and every one of you to play an active role and provide your comments and recommendations to the committee. Those comments may be sent to:
The Blue Ribbon Committee on Audit Effectiveness
c/o Paula Lowitt
Weil, Gotshal & Manges LLP
767 Fifth Avenue
New York, New York 10153
The POB also 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 whom are from outside the auditing profession, undertaken such an important task. This panel, which includes 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, is expected to complete its study in the next twelve months.
I challenge both of these panels to truly think "out of the box" during their studies. In the past, people have found reasons why we could not improve our audits or audit committees. This time I challenge the committees to go beyond thinking why things can't be done, and rather ask what barriers must we remove to achieve our goals and objectives, and how, and then provide the recommendations and achievable action plan for getting the job done.
My fourth challenge echoes the challenge on earnings management which Chairman Levitt gave to the financial community in September. In summary, our challenge is:
For the financial community to respond to the concern that an ever growing number of companies is using inappropriate accounting to manage the numbers they are reporting to public investors. That response needs to address not only the improper accounting practices that have developed, but also the roles analysts, auditors, business executives, and boards of directors have played in contributing to this problem. In fact, a significant part of the challenge is to change the culture in the financial community that has contributed to this problem.
The staff of the SEC is taking a very active role in meeting this challenge. We currently expect to issue three staff accounting bulletins addressing some of the abusive accounting practices that have developed. These SABs include guidance on revenue recognition, restructuring and impairment charges, and materiality.
The SAB on revenue recognition will provide guidance on some of the general, broad recognition principles that exist today. The broad principles in our accounting literature, such as the recently issued statement of position on software revenue recognition, are that revenue should not be recognized prior to:
The staff has and will continue to challenge revenue recognition when:
- The persuasive existence of a final sales agreement;
- Delivery of the product to the end user's site;
- Reasonable assurance of collectibility is; and
- A fixed or determinable price.
- A bill and hold arrangement exists;
- There is insufficient available information to allow for reasonable estimates of sale returns, such as the channel stuffing we have seen in some instances;
- Unusual or complex transactions have terms that have not been fulfilled or that permit the buyer to terminate or cancel the agreement unilaterally and receive a refund;
- The seller has continuing involvement, explicitly or implicitly, with the transaction.
I urge auditors to ensure the appropriate engagement personnel are carefully examining these transactions, gaining a clear understanding of the arrangements, and confirming all of the significant terms of the sale directly with the buyer.
The SAB on restructuring charges and asset impairments is likely to address (1) the specificity required in plans before an accrual can be made pursuant to EITF Issue No.94-3, (2) the length of time within which restructuring activities must be completed in order to provide a basis for a reasonable estimate, (3) the types of costs that can be accrued for, (4) guidance on determining reasonable lives for intangible assets, and (5) a notice that asset impairments will be challenged where there was not a timely review and adjustment of depreciable lives.
Finally, the SAB on materiality will remind the profession of the need to consider qualitative factors in assessing materiality, and the danger of relying on quantitative "rules of thumb."
Preparers and auditors of financial statements should be considering:
- Changes in earnings trends;
- Impact of misstated earnings when those earnings are compared to the consensus estimate;
- Changing reported earnings from a profit to a loss;
- The impact on segment information;
- The effect on earnings-based compensation plans;
- The cost of correcting the misstatement; and
- The likelihood of additional undetected efforts.
The staff also is working on a rule proposal that would build upon and expand the disclosure requirements of the currently required schedule for valuation and qualifying accounts.
The areas of focus of this additional guidance from the staff and Commission is addressed in much greater detail in the letter in your handouts, addressed to the AICPA director of audit and attest standards. I would encourage you to review that letter as it also highlights areas in which staff comments may be focused in future filings. I understand a copy of the letter can also be found at the AICPA website [www.aicpa.org].
International Accounting and Auditing Standards
My fifth and final challenge today regards the need to continue to move towards a harmonization of international accounting standards.
We must all contribute to the evolution of the international accounting and auditing standards while at the same time assuring:
- A comprehensive set of standards;
- A set of high quality standards that result in transparency for the underlying economics of the businesses; and
- The rigorous interpretation and implementation of the final standards.
This is no longer a project that public accountants and CFOs in America can ignore. It is very relevant to all of us.
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, this is an area that results in a very difficult U.S. GAAP reconciliation for foreign filers. 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 could 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:
Is there a sufficient infrastructure worldwide today, including quality international auditing and independence standards, to ensure the rigorous implementation of the IASC standards?
If the SEC endorses the use of IASC standards for use by foreign issuers in cross-border offerings, should we permit U.S. filers to change to IASC standards or continue to require them to follow U.S. GAAP?
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?
Needless to say, there are plenty of challenges facing those of us involved with financial reporting. The five challenges I have set forth today for the accounting profession and financial community, involving the support of our standard-setting process, improving the effectiveness of audits and audit committees, elimination of improper earnings management, and actively pursuing high quality international standards, are critical to moving financial reporting into the 21st Century. Other challenges, such as the ongoing review of auditor independence rules by the Independence Standards Board, are equally important but time does not permit me to address them today.
As the Chief Accountant, I am frequently asked for my impressions of the accounting profession today. Yet, I wonder isn't it more important to ask what investors' perception will be in the future? Their impressions will no doubt depend on the responses to these challenges. People will measure our profession by the challenges that are not met as opposed to those that are. I look forward to a return trip in the future so that I might report to you on our profession's success in meeting the challenges.