Speech by SEC Staff:
Implementing Continuous Improvement
In Financial Reporting
Lynn E. Turner
U.S. Securities and Exchange Commission
At The SEC Speaks in 1999,
Sponsored by the Practising Law Institute,
February 27, 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 Practising law Institute for inviting me to speak before you. I am honored given the outstanding list of panelists that has been assembled. And certainly each year this is one of the most distinguished conferences covering securities matters.
Towards Continuous Improvement in Financial Reporting
In the business community today you often hear the buzzwords "continuous improvement." One of the reasons for this is that business is rapidly changing today, on a daily basis. Competition and customers have become global. Geographical and financial borders are becoming blurred or being removed by electronic commerce and the changing technologies affecting communication.
Charles Handy once wrote:
"Change is not what it used to be. The status quo will no longer be the best way forward. The best way will be less comfortable and less easy, but, no doubt, more interesting a word we often use to signal a mix of danger and uncertainty."
The book, Managing The Change Process, notes that all businesses are going through change, either on their own initiative or because of external forces that compel them to do so. This is certainly also true for those of us involved today with financial reporting and the capital markets. We are faced with compelling reasons to ensure our markets remain not only competitive on a global basis, but the very best. Certainly the worldwide events in 1997 and 1998 clearly pointed out that maintaining transparent financial reporting to users of financial information is an important part of the process.
But to maintain that competitive edge, we must look for ways to ensure continuous improvement in our processes. This reminds me of the story about the tall, strong oak tree and the thin green reed that battled in the forceful storm of a hurricane. The oak tree thought that with its broad trunk, strong fiber and deep roots it would withstand the fiercest storm. At the same time, the reed, as it was battered by the rain and the wind, concentrated on bending and moving to and fro so that it would not break. And on the morning of the next day, it was indeed the reed that was still standing as the Oak had fallen.
We too must be flexible and willing to initiate change on a continuous improvement basis if our capital markets are to maintain their preeminent position in the world. This continuous improvement approach must ensure our standard of having high quality transparent financial reporting and disclosure, with high quality audits performed on a worldwide basis by auditors with only the highest degree of integrity and objectivity. Anything less may result in our having good capital markets, but perhaps not the best. Anything else raises the question of whether we want to be the leader in the race, or just one of many within the pack of runners. As business visionaries, do we strive through continuous improvement to become market leaders or just another market participant?
Continuous Improvement Through the Earnings Management Initiative
In response to the need for continuous improvement in our financial reporting system, the SEC staff had meetings with many of its various constituencies last year. We listened as we were told of ways in which our systems and processes could be improved. And in the end, much of what we heard was included in Chairman Levitt's speech regarding earnings management last September.
In that speech the Chairman challenged the financial community, including business people, financial management, the accounting profession and regulators alike. That challenge included a call for a number of initiatives to ensure the continuous improvement in financial reporting.
To date, the response has been tremendous. Business leaders, attorneys, academics, analysts, financial executives, CEOs of the major accounting firms, and the American Institute of Certified Public Accountants ("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 who are members of 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 some we have heard before, including:
- That the stock exchange listing rules require the audit committee 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.
I highlight these recommendations because we have seen them put forth by other highly respected Commissions or Committees in the past. For example, the Public Oversight Board in their report entitled "Directors, Management, and Auditors: Allies in Protecting Shareholder Interests," noted that issues raised by the report of the "Advisory Panel on Auditor Independence," also known as the Kirk Panel, merited consideration by corporate directors, executives and chief financial officers. It stated:
"The central suggestion of the Panel is that corporate boards and audit committees should expect to receive and independent auditors should deliver forthright, candid, oral reports in a timely manner on the quality-not just acceptability-of a company's financial reporting. That quality assessment should be based on judgments about the appropriateness or conservatism of selected or contemplated accounting principles and estimates and judgments about the clarity of disclosures."
The SEC Practice Section of the AICPA, composed of the leading auditing firms in the United States, published a report with essentially the same conclusion.
The National Commission on Fraudulent Financial Reporting, commonly referred to as the Treadway Commission, whose members included the Executive Vice President and General Counsel of Paine Webber, the retired chairman of the New York Stock Exchange, and the retired chairmen of the Boards of NCNB and Bethlehem Steel, recommended in 1987 that:
"Audit committees should oversee the quarterly reporting process."
"The SEC should require independent public accountants to review quarterly financial data of all public companies before release to the public."
"All public companies should be required by SEC rule to include in their annual reports to stockholders a letter signed by the chairman of the audit committee describing the committee's responsibilities and activities during the year."
"The audit committee should review management's evaluation of factors related to the independence of the company's public accountants. Both the audit committee and management should assist the public accountant in preserving his independence.
Before the beginning of each year, the audit committee should review management's plans for engaging the company's independent public accountant to perform management advisory services during the coming year, considering both the types of services that may be rendered and the projected fees."
The point here is that the time is now for the financial community and regulators to implement these recommendations that have been outlined above, including those that have been outstanding for some time. These improvements are important in order to maintain the competitive advantage the U.S. financial reporting system and process has over the rest of the world.
That is not to say that continuous improvement has not occurred. Indeed, changes have been made in response to the recommendations of the Cohen Report in the 1970's, and the Treadway Commission recommendations in the 1980's. For example, the AICPA has recently implemented a new fraud auditing standard that responds to concerns and recommendations of the Treadway Commission, the New York and NASD stock exchanges now require audit committees, and many corporations now include management reports on internal controls in their annual filings with the Commission. However, we must be ever vigilant in improving our "world class" systems, procedures and policies.
One question that has been raised is the potential for additional litigation due to implementation of the recommendations of the panel. I think the POB perhaps best answered this question when it was raised when the Kirk Panel published their recommendations. The POB wrote:
"The POB does not believe this will be a likely outcome. First, the procedures recommended will reduce the possibility that the financial statements are in fact misleading, thus reducing the danger of finding directors in fault. Second, the additional steps taken by board members should be persuasive in convincing courts and juries that the financial statements were prepared with care and that every measure was taken to avoid the statements being misleading. In time, as the increased care becomes apparent, plaintiffs' attorneys should be less willing to undertake the risks involved in making claims that financial statements were faulty."
Indeed, the best way to reduce litigation is to have an effective process resulting in high quality, transparent financial reporting and disclosures to investors.
Perhaps the POB summarized much of what has been said in the past twenty-five years with respect to improving financial reporting when it said:
"In summary, three steps are needed to further improve the credibility of financial reporting. (1) The board of directors must recognize the primacy of its accountability to shareholders. (2) The auditor must look to the board of directors as the client. (3) The board, and its audit committee, must expect and the auditor must deliver candid communications about the quality of the company's financial reporting."
I would add but one item to the POB's conclusion. That is I strongly believe that the "Three Legged Stool" mention in the Blue Ribbon Panel's Report, based on the active participation of the CFO, the independent auditor and audit committee is a must. In this time period of increased pressure from within and without to make earnings estimates, the discussions that are recommended must be an open and frank dialogue among all three participants and be directed toward supporting and assisting one another. It is through that cooperative effort that we will improve the quality of each company's financial reporting.
One additional recommendation 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 the auditor's relationships with the client that might affect the auditor's independence. This new rule, which is similar to the Treadway recommendation, 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 web-site (aicpa.org) an outstanding tool kit on revenue recognition and the related audit issues (entitled Audit Issues in Revenue Recognition). 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 in-depth consideration.
The Auditing Standards Board ("ASB") also has been asked to reexamine the auditing standards related to auditing revenue in light of the development of the tool kit. In addition, the ASB has been requested to provide additional guidance on auditing of loss accruals, such as those for restructuring liabilities and asset impairments.
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 a 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 web-site.
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 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.
Effectiveness of Audits
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, Shaun O'Malley, 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 those who can contribute valuable information that may improve the effectiveness of how audits are done. In fact, it is interesting to note that those businesses who are most successful at improving their own business policies, procedures and processes, often look to other businesses, industries and disciplines for ways to gain a competitive edge and add value to their product. In addition, many of the consulting divisions of the major CPA firms assist businesses with this process by providing valuable information and best practices that are employed by businesses located globally. It seems as if the profession could benefit from a similar approach. Accordingly, the staff has urged the O'Malley Panel to actively seek input from such groups as leading thinkers in the business world, forensic auditors, plaintiffs' bar, academics, and big and small accounting firms.
Some of the Big Five Firms are affiliations of international firms, operating under a common international name. Some of the group we have talked with have raised questions regarding the quality of the audits performed by the international affiliates or offices of the major accounting firms. This is in part because the auditing and independence standards vary greatly by country. In foreign countries, the audits may be based on auditing and independence standards that are of a much lower quality than those in the United States. That is why the SEC requires foreign registrants to have their audits done in accordance with U.S. auditing and independence standards.
To start to address some of the quality issues related to audits performed on an international basis, the AICPA has formed a Task Force whose focus is specifically on U.S. firms' quality control systems that affect audits of financial statements of international companies filing with the SEC.
In response to enforcement actions the Commission has taken, the AICPA, within its SEC Practice Section, has formed a Concurring Partner Review Task Force that is considering strengthening and improving guidance on the key and important role concurring partners play in ensuring that high quality audits are performed.
SEC Action Plan
The SEC's action plan is comprised of informal letters, rule making 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 write-downs, restructuring charges and write-offs of acquired research and development. That letter identifies required and commonly requested disclosures in the financial statements and Management's Discussion and Analysis 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 that 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. Contrary to what has been reported in the press, it is hoped this letter will result in a staff objective of increased focus by filers and their auditors on the appropriate disclosures and accounting, thereby accomplishing a goal of zero restatements of financial statements and filings with the SEC. A copy of the letter is available at the SEC web-site 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 web-site at AICPA.ORG and our website www.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 year's 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 involving financial reporting and disclosures, 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.
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.