Speech by SEC Staff:
Initiatives for Improving the Quality
Of Financial Reporting
Lynn E. Turner
U.S. Securities and Exchange Commission
To the New York Society of Security Analysts, Inc.
New York, N.Y.
February 10, 1999
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 other members of the Commission's staff.
I want to thank the New York Society of Security Analysts for inviting me to speak before you. As a CFO, I always found the security analysts I worked with to be extremely useful sources of information that helped us in the management of our business.
Issues Affecting the Quality of Transparency
In Financial Reporting
Let me start today by noting I recently read where a former member of the SEC Senior Staff was quoted in public as having said that 1999 would be the year of the accountant. I guess that since just about everyone else has had their year, we accountants ought to have ours too. After all, the investing public has given financial management, auditors, and audit committees, a tremendous responsibility for ensuring the quality of financial reporting in our public markets.
That reminds me of a story I recently read. Winston Churchill once attended an official ceremony. Several rows behind him, two gentlemen began whispering. "That's Winston Churchill. They say he is getting senile. They say he should step aside and leave the running of the country to younger, more dynamic and capable men." Churchill sat facing forward, but when the ceremony was over, he stopped by the row where the men were seated. He leaned forward and said, "Gentlemen, they also say he is deaf."
Churchill could withstand this criticism because he took action based on what is right, not expedient. That's integrity.
Peter Scotese, a retired CEO of Spring Industries also defined integrity. He said, "Integrity is not a 90 percent thing, not a 95 percent thing, either you have it or you don't."
My belief is that the vast majority of those in the business and financial community have it and are working hard and diligently to produce high quality financial reports. However, articles in the press, surveys and research presented during 1998 have given rise to a concern that we as a financial community are facing trends in earnings management that, left unchecked, could damage the confidence of investors in public disclosures and financial reporting. Indeed, the press has constantly focused on major financial frauds uncovered in the past years, as well they should.
For example, in the NY Times on January 17th, an article was published with the heading, "If Ignorance Is Bliss, Why are Stocks So Shakey"? The article cites research performed by Baruch Lev of NYU and his colleague, Paul Zarowin, regarding the correlation between earnings and stock returns. The article states: "Mr. Lev thinks that volatility has risen because investors are increasingly uninformed about their holdings, thanks largely to huge writeoffs and other accounting practices that muddy financial reports." Mr. Lev's research supports his views and shows that over the past 20 years, the correlation between earnings and stock returns have declined significantly.
Yet, we must all make sure we take a balanced view of the issues that confront us and focus our efforts on timely and effective solutions. Dwelling on the past will not change the future. Rather, we must all be visionaries who constantly move forward in developing a better way. There are many in the business and financial community who are doing just that.
In the Chairman Levitt's speech regarding earnings management 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, analysts, CEOs of the major accounting firms, and the AICPA have all commended the Chairman for undertaking this bold initiative. We at the SEC must in turn commend those in business and the accounting profession for their tremendous efforts and accomplishments in just the five months since the Chairman's speech.
Let me summarize for you a few of those accomplishments.
The NYSE and NASD 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 was comprised of the chairs of the exchanges, leading CFOs from the FEI, managing partners from two of the five largest accounting firms, and executives of an institutional investor and of the business community.
On February 8, 1999, this panel proposed ten outstanding recommendations and some well thought out and invaluable best practices to the business community, accounting profession, regulators, and the exchanges. These recommendations are designed to strengthen the role and performance of audit committees. I believe the SEC staff will carefully consider these recommendations and make recommendations to the full Commission on a very timely basis.
Included in these recommendations are the following:
- That the stock exchanges adopt new definitions of independence for purposes of service on the audit committee.
- That the stock exchanges require listed companies with market capitalization above $200 million to have audit committees comprised solely of a minimum of three independent directors, each of whom is literate in financial matters.
- That the stock exchanges require the audit committee of each listed company to adopt a formal written charter that specifies the scope of the committee's responsibilities, and how it carries out those responsibilities including structure, processes, and membership requirements.
- That the SEC require audit committees to disclose in the company's proxy whether the committee has adopted a formal written charter, and if so, whether the committee has satisfied its responsibilities during the prior year in compliance with its charter. The charter is to be disclosed in the annual report or proxy at least once every three years or when there is a significant amendment to the charter.
The panel also recommended the SEC adopt a safe harbor with respect to these disclosures.
- That the stock exchange listing rules require the charter to specify that the outside auditor is ultimately accountable to the board of directors and the audit committee and that these shareholder representatives have the ultimate authority and responsibility to select, evaluate, and where appropriate, to replace the auditor.
- That generally accepted auditing standards, GAAS, require that auditors discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the company's accounting principles, as well as the clarity of the company's financial disclosures.
- That the SEC require companies to include a letter from the audit committee in the company's annual report, disclosing whether or not (i) management has reviewed the audited financial statements with the committee, including a discussion of the quality of the accounting principles applied and significant judgments, (ii) that the auditors have discussed with the audit committee the quality of the accounting principles and judgments, and (iii) that the audit committee, based on its review and discussion with management and the auditors, believes the financial statements are prepared in accordance with GAAP.
- That the SEC require timely reviews of companies interim financial statements by auditors pursuant to Statement on Auditing Standard No. 71 and that SAS 71 be amended to require the auditor to discuss with the audit committee, or its chair, matters such as significant adjustments, management judgments, accounting estimates, significant new accounting policies and disagreements with management.
- In addition to these ten recommendations, the Blue Ribbon Panel set forth a number of best practices that I believe are just as important and useful. A sample charter is also provided.
One of the recommendations of the panel on audit committees makes reference to a new Independence Standards Board ("ISB") rule. In January of this year, the ISB adopted a rule requiring a discussion each year between auditors and audit committees regarding auditors' relationships with the client that might affect the auditor's independence. This new rule, which both the SEC staff and the Public Oversight Board strongly support, should result in a robust discussion about the auditor's fees and services and how those impact the independence of the auditor. I would expect the staff will follow closely, and with great interest, the actual implementation of this standard by the profession and by audit committees.
The Accounting and Auditing Standard Setters
The AICPA recently posted to their website an outstanding tool kit on revenue recognition and the related audit issues. The AICPA also recently issued Practice Alert No. 98-3, Revenue Recognition Issues.
The AICPA, and in particular its staff, should be highly commended for preparing these two very useful and high quality documents, on a very timely basis. Every CFO, controller, and auditor will find these documents provide relevant guidance that should be given careful consideration. The Auditing Standards Board ("ASB") also has been asked to reexamine the auditing standards related to auditing revenue and liabilities for loss accruals in light of the development of the tool kit.
The AICPA also formed a Task Force in November of last year to provide guidance for the valuation of in process research and development. This is a multifaceted task force comprised of industry representatives, valuation experts, analysts and auditors. This Task Force has had ongoing meetings and is expected to develop additional guidance on this topic by the end of the second quarter of 1999.
The Big Five accounting firms have also prepared an excellent "White Paper" on materiality. This project was undertaken in very timely fashion to respond to concerns expressed by the SEC staff that materiality was being misapplied by certain companies. This White Paper sets forth a number of factors that companies should consider when assessing materiality. I understand registrants and their auditors may obtain a copy of this paper from the AICPA website.
The White Paper and its recommendations have been submitted to the ASB for its consideration. I would encourage the ASB to incorporate the recommendations of the White Paper into GAAS. I understand the ASB is in fact discussing this issue at their February meeting.
We are also monitoring closely the Financial Accounting Standards Board's ("FASB") projects, currently underway, which will define more clearly what transactions should be recorded as a liability. We have urged the Board and its staff to provide timely guidance on this important issue.
The Public Oversight Board has established 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, 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 1999.
The Audit Effectiveness Panel and its staff have held their initial meeting and commenced their work. The panel and its staff have developed a tentative work program that encompasses a wide ranging review of the way audits are conducted today. If the panel continues with this program, I believe their review of the audit process will be the most in-depth review to date of how auditors can best serve to protect the interests of investors.
We have urged this panel to seek input from the public, including such groups as forensic auditors, plaintiff's bar, academics, and big and small accounting firms. Certainly, the financial analysts have a unique view as users of financial statements that should be considered.
SEC Action Plan
The SEC's action plan is comprised of informal letters, rulemaking activities and further staff guidance.
I will note that the staff recently sent a letter to a number of filers who in 1998 reported large charges for asset writedowns, restructuring charges and writeoffs of acquired research and development. That letter identifies required and commonly requested MD&A and financial statement disclosures that may be applicable to the registrant. Not only had the staff noted this issue, but users of financial statements, including analysts, also had informed the staff, that some registrants may not be complying with the existing disclosure rules. This obviously could create an unfair, unlevel playing field for those companies who do comply with the applicable rules. So rather than reviewing filings after the fact and perhaps having to require amendments to disclosures, the staff spent considerable time developing a comprehensive list of the required disclosures, and provided this list to a number of registrants reporting the applicable charges. A copy of the letter is available at the SEC website http://www.sec.gov/rules/othrindx.htm.
The staff is also 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 shortly, 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.
Finally, we have provided the AICPA with a letter, which is available on their website at AICPA.ORG and our website SEC.gov/offices/Account/ACLR1009.htm, that identifies issues the staff expects to be looking at closely in the course of our reviews of this years' filings.
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 fraud, including earnings management.
I want to wrap up my discussion of the current status of the earnings management initiative by thanking all of those who already have contributed many hours in a very diligent, timely and comprehensive fashion. I want to say thanks to those from the analyst community who have provided us valuable input. I say many thanks to those members of the Blue Ribbon Panel on Audit Committees, the AICPA staff and members of the Big Five Task Force on Materiality. I look forward with high expectations to the results of the efforts of those who must undertake the recommendations made to date, as well as the Panel on Audit Effectiveness, the AICPA Task Force on IPR&D, the FASB, and the Auditing Standards Board.
Current Focus on Financial Reporting Issues
Let me now switch from the earnings management initiative to some additional financial reporting and accounting topics that are receiving the attention of the staff.
Non-GAAP Industry Practices
The first focuses on the need for the rigorous and proper implementation of accounting standards. Every once in a while I see circumstances where GAAP has not been followed and a practice has developed that is inconsistent with the written literature. In some industries, it has appeared that such practices developed under the guise that their effect was initially immaterial. Later on when the effect become material, financial management claimed the accounting was an established practice and therefore justifiable, notwithstanding the fact that the practice varied from GAAP. Quite often registrants will say the staff is changing the rules, notwithstanding what GAAP says. In such circumstances, I would beg to differ and wonder how such practices were permitted to start in the first place.
Let me cite for you, an example, of a company and CFO and auditors who recently dealt very appropriately and effectively with such a situation. The CFO of a larger financial institution was doing a significant financial transaction for the first time. He and his auditor's surveyed practice and determined there was a diversity in practice developing. As a result, the CFO consulted with the staff on a prefiling basis on this complex and difficult issue. The staff was able to visit with the private standard setters on the issue. Consequently, we agreed to the proposed accounting given the thorough and helpful submission prepared by the registrant. In addition, to ensure consistent accounting in practice, the staff has referred the issue onto the EITF.
Accounting for Business Combinations
Another issue that continues to spark controversy is mergers and acquisitions accounted for as poolings of interests. Corporate managers favor pooling accounting because poolings allow a carryover basis of all assets and liabilities without recording goodwill for the premium paid in excess of the net assets. Consequently, future earnings are more robust than if purchase accounting is used.
Many times during the past ten years, as a partner in one of the then Big Six firms, or a CFO, and as a member of the SEC staff, I have heard the rumor that the SEC is trying to stop poolings. I would like to put that rumor to rest. As Chief Accountant, I do not have a preference under the existing rules as to whether a merger is accounted for as a purchase, where the assets are recorded at their fair value or as a pooling. However, I do strongly believe that for a merger to be accounted for as a pooling the existing crieria must be met. Paragraph 45 of APB 16 states that the pooling of interests method is intended to present as a single interest two or more previously independent common stockholder interests and the combined risks represented by those interests. Stockholder groups may neither withdraw or invest assets. The exchange must be done through the issuance of common stock and cash can only be used for dissenters rights. A part cash, part stock pooling is prohibited. Paragraph 48 notes that financial arrangements for the
benefit of former stockholders of a combining company which in effect negate the exchange of equity securities is also prohibited.
In August 1996, the FASB opened a project to re-evaluate accounting for mergers and acquisitions. In addition, standard setters in the international community are taking a hard look at the use of poolings. In December 1998, a group known as the "G4+1," which includes representatives from standard-setters in the U.S., U.K., Canada, Australia, New Zealand, and the International Accounting Standards Committee, issued an invitation to comment on accounting for business combinations. One possible outcome of this paper and effort to harmonize international standards, is the elimination of poolings in favor of purchase accounting. The proposal points out that it makes no sense to account for acquired assets and liabilities using prices paid years ago when you just paid the current fair value. Instead, fair value is the most relevant measure. I would note that in my position as a CFO, we would evaluate potential acquisitions and rates of return based on the amount we are paying for the company, not what the target company paid for their assets in the past. Furthermore, certain countries have already rejected the use of poolings. Many companies in those countries believe that American companies have an unfair advantage in mergers and acquisitions because the U.S. continues to permit poolings. This proposal would harmonize international standards and level the global playing field on this important issue.
However, until the FASB and the G4+1 complete their projects, we continue to apply APB 16 that requires either purchase accounting or pooling accounting, depending upon whether all 12 specific conditions are fully met.
However, I often see transactions that are engineered to meet the letter of the rules, but clearly do not meet the spirit or the intention of a pooling. For example, I see transactions where cash is taken out of the combined company, where treasury stock is repurchased in excess of acceptable limits, and where contracts exist requiring the combined company to sell assets. These transactions are problematic; we will continue to require companies to comply with all 12 conditions to qualify for pooling.
For those mergers that do not qualify for pooling of interests accounting, the assets must be recorded at these fair values. In some mergers, significant amounts of goodwill are recorded. Some of these involve companies in industries that have been and are undergoing major changes in their regulatory environment, technology, and markets. Some of these are the result of a shift to a consumer based market where quality is a given, and from a manufacturing driven economy to one where services and technology play more important roles. Notwithstanding that, some registrants are still determining a useful life for their goodwill based on what other companies had been using in past years, prior to these changes in the industry environment.
Accounting Principles Board Opinion No. 17 provides guidance on accounting for intangible assets such as goodwill. Interestingly enough, APB 17 does not include a methodology based "on what other companies are doing" in the guidance it prescribes for determining an estimated useful live. Rather, registrants are required to consider such factors as the (1) current regulatory environment, (2) legal and contractual provisions, (3) ongoing and expected technological changes and obsolescence, (4) trends in markets and customer bases, (5) expected actions of competitors, (6) product lives, and (7) service life expectancies of individuals or groups of employees.
These considerations and the resulting conclusions should be contemporaneously documented at the initial date of the accounting for the acquisition and provide a reasonable basis for an estimated useful life chosen for an intangible asset. The conclusions reached also should be consistent with disclosures made elsewhere to investors and the financial analysts' community and in filings with the SEC. In addition, a change in the useful life of an asset occurring due to a change in business strategies, economic factors, expected profitability and cash flows, etc. should also be reported on a timely basis, in accordance with the appropriate literature, including SFAS 121 and/or APB. 20.
Allowances for Loan Losses
GAAP (FASB 114) specifies that loan losses must be established for specifically identified loans that are deemed impaired by comparing the carrying value of the loan to the present value of expected future cash flows, the loan's observable market price, or the fair value of the collateral. In addition to the allowances for specifically identified loans, GAAP (FASB 5) requires that allowances be established for probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date. Such allowances should be determined using a well supported systematic methodology which is consistent with FRR 28. This methodology should ensure that allowances are prudent and conservative, but not excessive.
I have heard from some that they understand the SEC is looking at the allowances for loan losses at a large number of banks and requiring the amounts of allowances reported in the financial statements be rediced. Let me clarify what reality is with respect to this issue. First of all, the Staff has only reviewed a very small, limited number of banks. Those banks were selected based on a review of their disclosures, a comparison of those disclosures and historical activity in the loan loss allowance and provision, and certain industry wide statistics.
The concern of the staff has been focused on situations where the internal supporting documentation, analysis and disclosures were inconsistent with the amount recorded in the allowance for loan losses. The staff has this concern both when the allowance appears to be lower or higher than the documentation and disclosures support. Information the staff has looked at includes, among other things, loan grading, internal credit committee minutes, reports to the Board of Directors and audit committees, and FAS 114 analysis. As a former auditor of financial institutions in the Southwest in the 80s, I certainly share the banking regulators concerns about the need for conservative and prudent reserves. However at the same time, those reserves should not be excessive, should not be used to smooth or manage earnings, and should provide transparency on a timely basis with respect to the changing credit risks and quality of the loan portfolio.
Some of the issues the staff has noted in the review of the allowance for loan losses of certain financial institutions that are of concern include:
- Allowances for credit losses established for trading account assets. Since GAAP requires such assets to be reported at fair market value, any such adjustment should clearly be based on recording the specifically identified asset at its fair market value and not as a credit allowance. Likewise, the associated expense or credit associated with such a fair value adjustment should not be reported as a provision for loan losses in the income statement.
- As indicated above, the guidance in FASB 114 provides that the creditor should make its best estimate of the impairment by comparing the carrying amount of the loan with the present value of future cash flows, the loan's observable market price or the fair value of the collateral securing the loan. We have seen several instances where a creditor has provided allowances on specifically identified laws and evaluated the impairment of those loans to be in excess of amounts determined using the methods specified by FASB 114. This is not consistent with GAAP.
- The staff recently has noted instances where financial institutions have maintained allowances that were in excess of their range of documented credit losses inherent in the portfolio, which is similar to the situation in the 80s when allowances were maintained below acceptable levels for documented credit losses. The staff's findings are also consistent with those a 1994 GAO report to Congress entitled, Divergent Loan Loss Methods Undermine Usefulness of Financial Reports. While the staff understands that the determination of the allowance is a process that involves judgment, we believe that there should be documentation, prepared contemporaneously with the determination of the amount of the allowance, which clearly supports the estimated range of credit losses inherent in the portfolio. We would question instances where the recorded allowance is outside (higher or lower) of this estimated range of probable credit losses.
I would note that the AICPA's Accounting Standards Executive Committee ("AcSEC") is forming a task force that is expected to provide guidance to financial
management and auditors of financial institutions that will hopefully provide enhanced guidance on the accounting for allowance for loan losses.
The disclosures in filings with the Commission should be consistent with the documentation supporting the adequacy of the allowance. These disclosures generally should include a description of the systematic analysis and procedural discipline, required by FRR-28, for determining the amount of allowance for loan losses. These disclosures should provide useful, transparent information to investors and generally they should explain:
- How the bank determines each element of the allowance;
- Which loans are evaluated individually, which loans are evaluated as a group and how a bank's accounting policy defines an impaired loan;
- How the bank determines both the allocated and unallocated portions of the allowance for loan losses;
- How the bank determines the loss factors applied to graded loans to develop a general allowance; and
- What self-correcting mechanism is used to reduce differences between estimated and actual observed losses.
We have also asked banks to explain, in their MD&A, the reasons for changes in each of the elements and components of the loan loss allowance, even if the total provision for loan losses did not change materially from period to period, so that a reader can understand how changes in risks in the portfolio during each period relates to the loan loss allowance established at period-end. Additionally, the staff have asked banks to explain:
- How changes in loan concentrations, quality, and terms that occurred during the period are reflected in the allowance;
- How changes in estimation methods and assumptions affected the allowance;
- Why reallocations of the allowance among different parts of the portfolio or different elements of the allowance occurred;
- How actual changes and expected trends in risks associated with cross border outstanding affected the allowance, and
- How the level of their allowance compares with historical net loss experience.
Finally, we have asked banks to describe their accounting policy for the allowance for credit losses that specifically describes how they determine the amount of each element of the allowance. This generally includes a disclosure of the policy for what constitutes an impaired loan under FASB 114.
A sample letter the SEC staff has sent to some bank holding companies to assist them in meeting their disclosure requirements is available at the SEC website http://www.sec.gov/rules/othrindx.htm.
A few comments are in order for other types of loss accruals such as restructuring liabilities. Such liabilities require that there be a reasonable basis for the estimated liability that is recorded. Often this liability is based on a plan established by management. I would expect that such a plan and its key assumptions would be well documented in sufficient detail to identify and quantify all the related costs and the expected timing of the incidence of such costs, prior to the recording of the restructuring charge. I also would expect the plan to have been approved at the appropriate and necessary levels in the corporation, prior to the recording of the charge. In addition, the plan should provide a sufficient basis to hold accountable those responsible for its successful implementation.
We all realize that actual results may vary from original estimates and that, the original liability or loss accrual may require adjustment after it is initially established. The staff would expect a registrant to review the propriety of these accounts at each balance sheet date, and make an adjustment, increasing or decreasing the liability or loss accrual, pursuant to GAAP. For example, if a restructuring reserve initially was recorded based on a set of facts, and in a later period the facts changed, and therefore it is no longer probable a loss has been incurred, then the loss accrual should be reversed on a timely basis in that period, in the proper income statement category.
Another example of this is a liability initially established for a probable current liability for income taxes that is no longer necessary due to the settlement of a tax audit. It would be inappropriate to continue to maintain the liability in periods after the tax audit settlement, when a loss is no longer probable. Amortizing immaterial amounts of the liability into income after the settlement would be indicative of inappropriate earnings management. Similarly, maintaining a loss accrual and offsetting or reducing it in a later period for a charge for an unrelated item would be inappropriate.
The SEC's involvement in international accounting standards has been largely through the International Organization of Securities Commission, or IOSCO. IOSCO has looked to the efforts of an existing private sector group, the International Accounting Standards Committee (IASC). In order to give you a sense of where we are and how we got there let me give you a brief history of this project.
The core standards work program identified 12 major projects, some of which involved more than one standard. In December 1998 the IASC approved the substance of the last major project in the work program, a standard on financial instrument recognition and measurement. In 1999, IOSCO and the SEC began their assessment of the completed core standards, while the IASC is working to finish two clean-up projects that remain in the core standards "to do" list.
- In 1994, IOSCO reviewed the existing IASC standards and identified those that needed to be improved before IOSCO would consider endorsing those standards for use in cross-border offerings.
- In July 1995, IOSCO and the IASC agreed on a core standards work plan, and in March 1996 the IASC announced an intention to try to complete that plan in 1998.
- In April 1996, the Commission released a statement in support of the efforts of IOSCO and the IASC. That statement articulated the key elements that will guide the SEC's assessment of the acceptability of the IASC core standards.
- Specifically, the Commission will consider whether the standards
- Constitute a comprehensive basis of accounting;
- Are of high quality that is, whether they result in transparency and
- comparability and provide for full disclosure; and
- Can be and will be rigorously interpreted and applied.
As part of its work on the core standards project, IOSCO, as well as individual members, have been providing comments on each of the documents published by the IASC. The objective has been to provide input into the standard setting process at an early stage, rather than waiting to raise these issues when the core standards have been completed by the IASC.
Now that the main components of the core standards are completed, IOSCO will assess the status of each of the issues originally identified, as well as the standards subsequently issued by the IASC, to determine how these concerns have been addressed.
Assessment by the SEC staff is expected to overlap with and build on the IOSCO assessment.
Now let me walk through possible SEC responses.
The SEC currently requires foreign private issuers registered with the Commission to provide financial statements prepared in accordance with or reconciled to
If, after assessment of the completed core standards, the SEC staff concludes that the current reconciliation requirements should be reduced or removed, the staff will need to bring a rule proposal to the Commission to amend the current filing requirements for foreign private issuers.
The Commission then could publish proposed amendments for public comment.
If it did so, the staff would analyze the comments received and develop final recommendations for the Commission, which then would be issued, if approved by the Commission, in an adopting release.
This procedure is mandated by U.S. law and applies to any SEC rules or regulations.
One step that is being planned, is a concept release to seek public input regarding some of the key issues that have been identified to date. Let me talk for a few moments about some of those issues.
When the Commission considers changes to its accounting and disclosure requirements, it must evaluate the impact of potential changes on capital formation, including the possible impact on the cost of capital for domestic companies, and, critically, on investor protection. These basic concerns helped shape the three criteria for assessment of the completed standards identified in the SEC's April 1996 press release.
Some of the issues that will have to be considered in the SEC's assessment process include:
- Supporting Infrastructure: are IASC standards adequately supported so that they can be rigorously interpreted and applied?
- Transition Issues: how to deal with historical financial statements that apply "unimproved" IASC standards.
- Interpretive and Application Issues: consideration of whether the IASC's focus on articulation of principles rather than application guidance will create issues.
I'd like to focus today on the infrastructure issue. For a discussion of the other points, let me refer you to a Report to Congress issued by the SEC in October 1997 addressing progress with harmonization of international accounting standards, which addresses these points in some detail. It is available on the SEC website.1
High quality financial reporting in the United States is not just a product of high quality accounting standards. It also is dependent upon a supporting infrastructure that works to ensure that these standards are interpreted and applied in a rigorous fashion, and that issues and problems are identified and resolved rapidly. This infrastructure includes:
- high quality auditing standards
- strong audit firms with national quality controls
- profession-wide quality controls for the audit profession
- SEC oversight of standard setting; and
- SEC involvement in interpretation and application through the Corp. Fin. review and comment process.
IASC standards are a relatively new product. Many are new and have not even been implemented yet. In addition, there is no single group that has ownership and responsibility for building up the necessary infrastructure. Questions we are trying to answer include:
- whether preparers and auditors (and regulators) have enough training in, and experience with, IASC standards to work effectively with them.
- whether the standards are capable of being rigorously interpreted and applied an issue that will be addressed, in part, by the technical assessment that IOSCO is undertaking currently.
- whether preparers and auditors will follow the principles and spirit of IASC standards, or try to justify diverging national practices within the IASC framework. On this point, it will be critical to see how the 16 standards that have been developed or substantially rewritten during the core standards project are applied. The IASC has tried to develop high quality standards, eliminating both explicit and implicit options wherever possible. Will financial managers and auditors live up to that challenge?
- whether there are auditing, quality control and independence standards that will result in high quality audits on a worldwide basis. Recently as you are probably aware, the World Bank, as a user of financial statements, has appropriately raised concerns regarding this issue.
These are not easy issues, and that's why I expect the assessment process to be time consuming and thorough. Capital markets especially ones that are as successful as those in the United States are not something you experiment with lightly. Yet we can't let our markets be left behind by ignoring pressures to harmonize requirements in many different areas. Instead, we must work to ensure that harmonization is accomplished at the highest quality level, and not based on a lowest common denominator.
Before I close, I would like to turn to another topic that is a major issue for the accounting profession and the Commission--auditor independence.
It is important to our markets that investors perceive that auditors have a high degree of integrity and objectivity. That is why today the staff and Commissioners at the SEC are following closely, with a great deal of interest and concern, the work of the Independence Standards Board. With many firms undergoing fundamental changes and auditing revenues now accounting for just 36% of the total firm revenues, we are seeing increasing pressures to relax the current independence requirements.2 We also have seen instances where auditors did not follow even the most basic rule prohibiting investments in clients, causing certain registrants to have to retain new auditors who were independent.
It is also why the staff is very concerned with certain developments in the way public auditing firms are conducting their business. For example, we have seen alternative forms of practice set up whereby much of the audit work is done by "rented" staff employed by an enterprise that does not sign its name to audit reports. This raises a serious question as to whether or not investors fully understand who is performing the audit.
There have also been press reports by auditing firms citing their expansion into providing legal services. However, some are asking how can a firm be a legal advocate for their clients' interests and then argue they are objective and independent auditors?
In addition, in many of the cases where the staff has commented on the proprietary of the valuation of IPR&D, the auditors have performed the appraisals that become the basis for the numbers used in the financial statements. CFOs have made statements to the staff indicating it was the auditors who "ran" or came up with the numbers, not the CFO. This raises a very serious question as to whether the auditors are auditing their own work. I must highly commend Four of the Big Five auditing firms who have ceased to provide such valuations for their audit clients.
As a result of these concerns, the staff recently sent a letter to the ISB requesting they add these and other issues to their agenda. We also asked the ISB to request public input on these important topics.
As members of the analyst community, I suggest that you may have interest in the various ISB projects. As the ISB exposes its proposals for public comment, your input will be important.
Our capital markets are the best in the world. Transparent financial reporting is one of principal reasons behind their continued success. Through the continued team efforts of financial management, auditors and audit committees, high quality financial statements will continue to provide the necessary information required for investors to make informed decisions.
I hope I have addressed some of the financial reporting issues of interest to you, as well as questions you might have.
1Report on Promoting Global Preeminence of American Securities Markets;http://www.sec.gov/news/studies/acctgsp.htm
2See The CPA Letter, February/March 1999, page 4.