Speech by SEC Staff:
Quality—Tomorrow and Today
Lynn E. Turner
U.S. Securities and Exchange Commission
AICPA National Conference on Banks and Savings Institutions
November 9, 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 the other members of the Commission's staff.
Today, over 65 years after the Securities and Exchange Commission was created, our objective continues to be the protection of investors through the fair and orderly operation of the markets. In satisfying its objective, the SEC has long relied upon transparent financial reporting, based on full and fair disclosure, to promote honest and efficient markets and allow for informed investment decision making. Transparency in financial reporting—that is, the extent to which financial information about a company or bank is visible and understandable to investors, other market participants, and regulators—has played a fundamental role in making our markets the most efficient, liquid, and resilient in the world.
As the financial services industry evolves and becomes more complex, I believe that transparent financial reporting will take on an even greater role in the regulation of financial institutions. I’m not alone in this view. The Federal Reserve Board’s Director of Supervision and Regulation recently stated:
"[T]he key to effective supervision in the next millennium...seems to me to depend on... [s]ubstantial improvement in public disclosures by banks and greater reliance on financial markets to discipline and ‘regulate’ bank risk-taking."
Transparency in a Changing World
The global world we live in today is quickly transforming how business is conducted, how markets react to economic events, how investors trade, and how regulators regulate. From a manufacturing-based economy, we have spawned the service and high technology industries, including the explosive growth in e-commerce. In banking, we have seen the introduction of drive-up banking, automated teller machines, electronic banking, and now Internet banking.
The lines dividing commercial banks, thrifts, investment banks, brokerages, insurance companies and finance companies are fading. Going forward, these lines will continue to blur and even to disappear. Many believe that the convergence that we have seen in the past year in the financial services industry will accelerate as a result of the financial reform legislation.
Clearly, advancements in technology have also contributed to the evolution of the banking industry. For example, in today's financial markets, modern technology allows institutions to move funds anywhere in the world at lightning speed, more than $1.5 trillion every day—a sum equal to world trade for four months. New breakthroughs in technology have fundamentally changed the ways in which banks and financial services companies communicate with customers, competitors, investors and regulators.
And with these changes, we have also come to see some of the accompanying transformations such as greater product and investment risks, use of greater leverage by some institutions, increased volatility in the worldwide capital markets, and markets where liquidity can disappear overnight, creating international financial instability.
I believe that with these changes in business, we must continue to explore ways to improve the transparency of our public disclosures and business reporting model. We need to focus on understanding what are the key drivers of value in a business. We need to be identifying the significant risks affecting businesses today as well as into the future. And we need to convey this information in a transparent way to investors, markets, and regulators on a timely basis.
This will certainly be a guiding light to the staff as we consider ways to improve our current disclosures in Guide 3 and address allowances for loan losses. We also expect it will provide the framework for the AcSEC task force. For example, we will be asking if appropriate risks, such as in the credit quality of the loan portfolio, those resulting from products and leverage, and those resulting from securitizations all have been made transparent to investors in a meaningful manner.
Last month, Chairman Levitt asked Professor Jeffrey Garten, Dean of Yale's School of Management, to assemble a group of leaders from the financial community to examine, in an expeditious manner, whether and how our current business reporting framework can more effectively capture these momentous changes in our economy. This group, and others that have been convened, will continue to address innovations in accounting and reporting to match innovations in business so that we can maintain transparency. Accounting standards must continue to evolve—standards and disclosure requirements that may have been acceptable in the past decade may no longer serve well in the future.
Quality of Financial Reporting Today
But let’s move back from the future to today, and look at the status of financial reporting in 1999. A little over a year ago, Chairman Levitt highlighted the need to improve the quality of financial reporting. Chairman Levitt feared that emerging trends, if not reversed, would lead to a lack of investor confidence in the "numbers" they have come to rely on for making investment decisions.
Oprah Winfrey said that "Lots of people want to ride with you in the limo, but what you want is someone who will take the bus with you when the limo breaks down." Well, that’s just what we have found in fellow Commissioners, staff, and many in the business community who have taken up the charge against abusive practices that include not only fraud, but also financial reporting in what I label the "gray zone." These practices mask economic reality. Rather than managing the business and letting the numbers reflect reality, some are managing the numbers to reflect an imaginary business. This is a battle about doing what is right for investors and markets, and ultimately the American economy.
Since we began our initiative to address the "Numbers Game" concerns, the results have been extremely encouraging. First of all, many in the financial community have joined together in a partnership that is improving the quality of financial reporting.
In one instance, a group of investors, business executives, CEOs in the accounting profession, and leading legal experts formed the "Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees." In just four months, this Committee produced ten recommendations. Those recommendations, and just as important, the best practices included in the report, are beginning to be used by audit committees. The stock exchanges have proposed changes to their listing standards as recommended to them by the Blue Ribbon Committee, with some minor modifications.
The Auditing Standards Board ("ASB") recently issued a very good proposal in response to the recommendations of the Blue Ribbon Committee to the auditing profession. I strongly support this proposal which would require a discussion between the auditor, the audit committee, and management regarding the quality of the Company’s financial reporting. These discussions, which I believe must involve all three members of what I call the "three legged stool," will provide an open dialogue amongst its participants that cannot be anything but healthy. The ASB and its hard-working staff also have issued an outstanding toolkit on revenue accounting and auditing issues that every CFO, controller, and auditor should read. Additionally, the ASB is preparing a revenue audit guide and is undertaking to provide further guidance on auditing loss accruals—that is, "reserves."
At the SEC, the Commission has issued proposed rules to implement certain of the recommendations made by the Blue Ribbon Committee. The proposals follow the Committee’s recommendations with a couple of exceptions. First, we did not include a proposal to require the audit committee to disclose whether it had complied with its charter. We were concerned that such a requirement would lead to watered-down, meaningless charter provisions. Second, we modified the requirement to have the audit committee, based on input from internal and external financial professionals, report on whether the financial statements were in compliance with generally accepted accounting principles ("GAAP"). We heard the concerns of those who wondered whether an audit committee had the expertise to make such a report. As a result, we met with members of the legal, accounting, and financial management communities. We asked them for their best thinking on alternative approaches. We received some very good input from the legal community as well as from the accounting profession. The legal profession supplied us with an idea for a negative assurance type report that we had already been thinking about internally. In addition, Ernst & Young prepared a very good survey of audit committee practices and worked with other members of the profession on this issue. They met with us and suggested an alternative type of report. This proactive leadership and participation has assisted us in crafting what we put into the final rule proposal. I want to thank those who have shown such leadership on this critical issue.
We also heard concerns about the possibility of increased exposure for audit committee members. We share that concern. Accordingly, we have included a safe harbor in our rule proposal. In addition, I am told that a good process—one that properly informs the board—goes a long way in providing insulation from liability under both the business judgment rule and traditional duties of care. As a result, an audit committee that follows a reasonable process, based on the best practices and recommendations set forth in the Blue Ribbon Committee’s recommendations, should enjoy less, rather than more, liability exposure.
In addition to the rule proposal on audit committees, the staff recently issued Staff Accounting Bulletin ("SAB") No. 99 on materiality. That SAB reiterates, and brings into a retrievable format, the guidance currently found in legal case law, and in accounting and auditing literature. We hope it will level the playing field for those of you who work hard to prepare high quality financial reports.
As noted in the SAB and in existing guidance, both qualitative and quantitative factors must be considered when assessing materiality. The SAB also notes that intentional errors made to manage earnings are not considered appropriate and are unlikely to comply with the Foreign Corrupt Practices Act ("FCPA") requirements to maintain books, records, and accounts which, in reasonable detail, accurately and fairly reflect transactions.
One question I often am asked is whether any adjustment that is not booked is an illegal act. The answer to that question is no. As a former CFO, I clearly understand that there are adjustments that arise as a result of the normal closing process which, depending on the facts and circumstances, may not always be recorded. As noted in footnotes 18 and 50 of the SAB, insignificant errors and omissions that may occur in systems and recurring processes in the normal course of business would need to be assessed against the various factors and criteria set forth, such as those on aggregating and netting, in determining whether such adjustments would need to be recorded.
While we have made some initial progress towards improved financial reporting, there are still troublesome issues we continue to confront. Let me address a few of those that relate specifically to financial institutions.
Effective Internal Controls
For the past couple of years, the SEC staff and banking regulators have identified issues and expressed concerns particular to the banking industry. Our three interagency announcements issued during this past year highlight a number of our joint concerns.
One of the specific concerns expressed by the banking regulators is the need for appropriate underwriting standards and internal controls related to the accounting for and financial reporting of the allowance for loan losses. I must strongly echo those views and also note that we have recently seen questions raised in the press regarding other activities such as money laundering, basic account reconciliations, and misappropriation of funds to manage earnings. These press accounts raise fundamental questions about the adequacy and effectiveness of an institution’s internal accounting controls and the quality of work being performed by the independent auditors.
An institution’s internal accounting controls for loan loss allowances should assure compliance with the authoritative accounting guidance contained in accounting and auditing pronouncements, including Statements of Financial Accounting Standards ("SFAS") 5 and 114, and the recent FASB Staff Viewpoints article included in Emerging Issues Task Force ("EITF") Topic D-80. The accounting controls should assure timely and accurate reporting for financial reporting purposes including for losses and changes in the credit quality of the loan portfolio in accordance with GAAP. Auditors should also assure that there has been compliance with Statement of Auditing Standards ("SAS") 54, Illegal Acts by Clients, and SAS 82, Consideration of Fraud in a Financial Statement Audit, the FCPA, and Section 10A of the Securities Exchange Act of 1934.
In the course of reviewing registrant filings in the past year, the staff noted certain instances in which creditors did not appear to have adequate controls in place to assure that loan loss allowances and provisions were determined and reported in accordance with GAAP. In some cases, institutions did not have adequate documentation and clear, concise internal communication of their policies and procedures related to loan loss allowances. As an example, we noted instances where there was a distinct disconnect between an institution’s credit administration function and its financial reporting group in the accounting for loan loss allowances.
I encourage financial institutions and their auditors to put renewed focus and emphasis on the existence and effectiveness of internal controls to assure compliance with the FCPA and on the determination of loan loss provisions and allowances in accordance with GAAP. Additionally, institutions, and their auditors, should assure that appropriate supporting documentation exists for the policies, procedures, and methodologies used, as well as for the amounts in the financial statements.
I would also remind you of particular disclosures the staff expects to see in filings by financial institutions which are set forth in the letter on this topic at our website, http://www.sec.gov/divisions/corpfin/guidance/banklla.txt.
SFAS 131 requires companies to report financial and descriptive information about their reportable operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available, and that is evaluated regularly by the "chief operating decision maker" in deciding how to allocate resources and to assess segment performance.
In some cases, however, financial statements of public companies have not conformed with these requirements. We have seen instances where: (1) the internal reporting package included operating information on more segments than were disclosed in the financial statements; (2) those additional segments were discussed in MD&A or analysts’ reports; and (3) the company’s executives also discussed the additional segments in press releases or business periodicals.
When reviewing segment information as part of its normal filing review and comment process, the staff is not reticent to ask registrants for a copy of the internal reports or other materials supplied to the "chief operating decision maker" of the company, as well as analysts’ reports and press releases. Assuring quality implementation of SFAS 131 on segment disclosures is clearly in the interest of investors. Consequently, if the segment information provided in the financial statements does not reflect a similar breakdown of company segments as is evident in the internal reports and other materials, the staff will seek amendment of the registrant’s filings.
Special Purpose Entities
Another example of an area in which we have seen problems in financial reporting is the use of special purpose entities ("SPEs"). SPEs have legitimate uses and the Financial Accounting Standards Board ("FASB") and the EITF have issued guidance to account for certain transactions involving SPEs. For example, SFAS 125 and EITF Issue 96-20 provide the relevant accounting guidance for qualifying special purpose entities ("QSPEs"). The appropriate accounting guidance for other SPEs is provided in EITF Topic D-14 and Issues 90-15 and 96-21.
While we know that legitimate SPE transactions exist, we have also become aware of SPE transactions that have not complied with all of the relevant accounting requirements specified in EITF Topic D-14 and Issues 90-15 and 96-21. We have seen what appear to be contrived, structured transactions that defy transparency, and we are prepared to challenge registrants in instances where they have not complied with the appropriate accounting and reporting guidance. For example, there is specific and very clear guidance in Issue 90-15 that discusses the minimum substantive amount of real equity needed by an SPE. SPEs that do not comply with these rules, such as when they use subordinated debt rather than equity, or do not have the minimum amount of equity as discussed in the staff’s announcement in Issue 90-15, will be required to be consolidated. In an effort to improve the guidance in this area, we have asked the FASB to address the consolidation of SPEs in its consolidation project. In the interim, those who do not comply with existing rules may be feeling like a long-tailed cat in a room full of rocking chairs.
Implementation of SFAS 133
Last year at this conference, I challenged financial management and the accounting profession to take the high road in implementing new accounting standards, and I specifically mentioned SFAS 133. As you know, the FASB deferred the effective date of SFAS 133 for one year, and this standard will now be effective for fiscal years beginning after June 15, 2000. This deferral should help assure a high quality implementation of this standard. Both the Financial Executives Institute ("FEI") and the American Bankers Association ("ABA") noted in press releases announcing the deferral that the additional year would be used to prepare for implementation of the standard, make necessary systems changes, and allow for an orderly transition to the new accounting requirements. As a result, we do not expect any further deferral of the effective date of this pronouncement. In this context, we continue to encourage registrants and the accounting profession to bring issues and questions to the Derivatives Implementation Group ("the DIG") on a proactive and timely basis to help promote an effective implementation.
The SEC staff will also continue to closely monitor the implementation of this standard in its review of filings with the Commission. During this past year we have observed that certain early adopters of SFAS 133 have not complied with the relevant requirements of this standard and, as a result, we have requested restatement. In particular, the standard requires contemporaneous documentation for transactions that are to be accounted for using hedge accounting. I emphasize that the documentation must be prepared contemporaneously on the date of initial adoption or, if later, at the inception of the hedge and not at a later date, such as at the end of a subsequent quarter or at year-end. Accordingly, I urge companies to assure that the policies, procedures, and internal controls they put in place to implement SFAS 133 are appropriate. In addition, auditors will need to assure that their audit programs include appropriate and timely tests related to SFAS 133 implementation. I once again challenge auditors and management to take the high road in helping achieve a quality implementation of this standard.
The last issue I want to touch upon is hedging with intercompany derivative instruments. In December 1998, the SEC staff advised registrants that, under GAAP, an intercompany derivative designated as a hedging instrument should be supported by documentation, prepared contemporaneously, which demonstrates that the notional amount, duration, interest rate risk, currency risk, commodity risk, and other risks associated with such intercompany derivative contracts have been laid off to unrelated third parties. The staff indicated that for hedging instruments designated after January 1, 1999, the staff expects registrants to comply with GAAP. The SEC staff has become aware that, in some instances, practice may continue to diverge from GAAP; the staff intends to challenge the appropriateness of the accounting in these instances. In such instances, a registrant will be required to eliminate the impact of intercompany derivative contracts in preparing consolidated financial statements in accordance with ARB No. 51. Additionally, in accordance with SFAS No. 80, these intercompany derivative contracts may not qualify as hedging instruments in the consolidated financial statements.
Lord Kelvin, a noted English scientist and president of the Royal Society who lived from 1824 to 1907, once said: "Radio has no future; heavier-than-air flying machines are impossible; X-rays will prove to be a hoax. I have not the smallest molecule of faith in aerial navigation other than ballooning." So here we are today, a century older and wiser. The dawn of a new millennium is upon us. If we are to succeed, to accomplish what those before us could not foresee, we must be willing to think beyond the outer limits that serve as a glass wall to what no doubt lies beyond.
Today, I challenge those of you who comprise the accounting profession and who reap the benefits of the world’s greatest capital markets to seek out ways we can improve the quality of financial reporting. In that regard, I’ve outlined a number of important issues. We need to maintain and adjust our high quality accounting standards as technology changes business activities. Managers and audit committees need to work together to assure that financial statements provide full and fair disclosure to investors and others. And auditors need to work to maintain the public’s confidence in their integrity and in the credibility of the financial statements that they audit. By working together, we can continue to enjoy the rewards of our collective endeavor—new and expanded business opportunities, more jobs, and a better future for those who invest their hard-earned dollars for a child’s college education, for retirement, or for a rainy day.