“Current Developments in Financial Reporting: Perspectives from the SEC”

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. Sutton and do not
necessarily reflect the views of the Commission or the
other members of the staff of the Commission.
Introduction

Once again I appreciate the opportunity to be here today
and to share a few thoughts about current accounting and
financial reporting issues.

I will begin with an initiative that was just gaining
prominence when I came to the Commission and that has
taken on increasing importance and attention over time.
That initiative is international harmonization.

Then, I will offer a few comments about the role of
interpretation in standard setting and conclude with some
thoughts about auditor independence and the new
Independence Standards Board.

International Harmonization

In the United States, we regulate access to capital
markets based on a system that prescribes minimum initial
and continuing disclosures by companies who seek capital
from the investing public.  While most of us here today
are very familiar with this system in the context of our
respective
roles and responsibilities, sometimes I think many don’t
grasp the full implications of this regulatory approach.

Understanding our approach, however, is fundamental to
understanding why the Commission views high quality
accounting and disclosure standards -- and credible
financial reporting -- to be so critical to the
effectiveness of capital markets.

Under our system, investors or their representatives --
and not regulators -- assess the quality and suitability
of investment opportunities, based on public information
provided in the market place.  As regulators, we don’t
attempt to assess the merits of companies or offerings
that come to the market.  Our regulatory goal is to
promote informed investment decisions by pursuing full and
fair disclosure and by seeking to prevent misleading or
incomplete disclosure.

The disclosure rules in place today require domestic
registrants to file financial statements prepared in
accordance with US generally accepted accounting
principles. Foreign registrants are permitted to file
financial statements prepared in accordance with US, home
country, or international standards, provided that, if
standards other than US standards are used, a
reconciliation to US generally accepted accounting
principles also is presented.  These requirements have the
effect of producing a reasonably level playing field for
domestic and foreign market participants alike.

I think it is important to emphasize that our disclosure
system does not seek to impose higher standards for
foreign registrants than for domestic companies.  Rather,
it is designed to assure that all companies coming to US
markets provide disclosures that are useful to US
investors and protect their interests.

Recent developments in some international markets have
underscored the importance of high quality accounting and
disclosure standards to investor confidence and the
credibility of capital markets.  Press reports around the
world have commented on the short-comings of weak
disclosure systems.

A recent article from The Economist, for example,
discussed the collapsing confidence in the Japanese
financial system. That article reported that 13 of the 19
largest banks in Japan expect to report losses this year,
explaining that the write-offs taken put the worst of
their problems behind them.  But, the article goes on,
“(g)iven the opacity of the banks’ accounting . . . the
markets do not trust this.”

That lack of trust and other uncertainties about the
regulatory process has led to what has been described as
the “Japan premium” -- the extra rate at which Japanese
banks must borrow in dollars compared with their foreign
counterparts.

And, we have seen other reports about unreported off-
balancesheet losses that have surprised investors and
regulators alike.  These episodes are reminders that, as
we pursue efforts to harmonize, we must not lose sight of
the need to maintain investor confidence in the openness
and fairness of capital markets.

As you know, through the International Organization of
Securities Commissions (IOSCO), the SEC and other
securities regulators around the world are working with
the International Accounting Standards Committee (IASC) to
develop a core set of accounting standards that would
serve as a framework for financial reporting in cross-
border securities offerings.

In October, the Commission issued a report to Congress
that discusses the background and goals of those efforts
and progress to date.  That report is available to the
public through the Commission’s public reference room.
Today, I will review some of the background and comment on
a few of the remaining issues discussed in that report.

You may recall that, in 1994, IOSCO reviewed the IASC
standards that existed at that time and identified those
standards that needed to be improved.  IOSCO also
identified areas in which IASC standards did not exist
and, therefore, needed to be developed.  That review led
to the formulation of the IASC’s “core standards project”
in July 1995.

More specifically, the review identified what are called
“essential issues” -- issues deemed critical to the
success of the core standards project by some countries.
Other reservations, referred to as “suspense issues,” also
were identified.  Suspense issues are issues that would
not require resolution as part of the core standards
project, but yet are issues for which individual
jurisdictions might specify required treatments if
acceptable IASC standards are not developed.

In April 1996, the Commission issued a statement of
support for the objectives of the core standards project.
That statement indicated that, if the agreed-on work plan
is successfully completed, and if the core standards
satisfy the conditions for acceptance described by the
Commission in that statement, the Commission would
consider accepting those standards in securities offerings
by foreign registrants.

When the Commission considers changes to its current
accounting and disclosure requirements, it will have to
evaluate the impact of potential changes on capital
formation, including the possible impact on the cost of
capital and, critically, on investor protection.  The
Commission’s April 1996 statement articulated the key
elements that will guide its assessment of the
acceptability of the IASC core standards.  Specifically,
the Commission will consider whether the standards
constitute a comprehensive basis of accounting; whether
they are of high quality; and whether they can be
rigorously interpreted and applied.

Some additional issues that the Commission will have to
consider include transition issues, specialized industry
practices, suspense issues, and supplemental disclosure.

Transition Issues

Although, when completed, the core standards may be judged
acceptable, historical financial statements prepared in
accordance with prior international standards will not
reflect the improvements achieved through the core
standards project.  Thus, transition rules for acceptance
of international standards will need to be addressed, and
those
decisions will be affected by the transition provisions
adopted by the IASC for the core standards.

Specialized Industry Practices

Another issue arises because the core standards project -
and IOSCO’s agreement -- does not cover specialized
industry accounting practices.  Those practices are
expected to be addressed as suspense issues, which means
that individual jurisdictions can be expected to continue
to specify the required accounting and disclosure for
specialized industries.

Suspense Issues

With respect to other suspense issues, although generally
they are relatively narrow, the number and significance of
items not addressed may impact the overall assessment of
the quality of the core standards, particularly if their
number is large and the issues collectively are
significant. Further, because IASC standards tend to
provide less explicit guidance than US standards, some
additional guidance for filings in US markets is likely to
be needed.

An open question is whether the additional guidance needed
will be so extensive that the core standards will not be
operational because they will not be uniformly interpreted
or applied from country to country.  If that should be the
case, the use of international standards may not
significantly improve the cost or efficiency of cross-
border filings.

Supplemental Disclosures

Currently, the Commission’s supplemental interpretive and
disclosure requirements, such as the minimum line item
requirements specified in Regulation S-X, apply to both
domestic and foreign registrants.  As the Commission
evaluates the IASC core standards, it will need to
consider whether those supplemental requirements should
continue to be required without regard to the source of
the accounting standards used.

Accomplishments and Prospects

Clearly, the work of IOSCO, both independently and through
the IASC core standards project, has been an important
effort to improve capital market reporting around the
world. Because of the importance of this initiative, the
Commission has devoted significant resources to these
efforts and expects to continue to do so.

I believe that it is essential, however, that efforts to
increase the access of foreign companies to US capital
markets not be pursued in ways that could compromise the
interests of US market participants, both investors and
those competing for capital at the lowest cost.

At this point, we can’t predict what final decisions about
the acceptability of the core standards either IOSCO or
the Commission will reach.  There are a number of
significant components of the project that are not yet
complete, and the technical issues that remain open are
among the most complex and controversial.

Nevertheless, I think it is important to say that the
efforts of the IASC and IOSCO to date already have
contributed significantly to raising the level of
accounting standards worldwide and to reducing the number
of differences between international standards and
standards used in countries with developed capital
markets, including the US.

Going forward, the staff expects to continue to provide
its input as the process goes along so that the IASC has
an opportunity to consider our concerns during its
deliberations.  We will continue to encourage the IASC to
develop international standards that will yield the
transparency, comparability and disclosure that US
investors expect.

I emphasize that one of the key conditions for the
Commission’s acceptance of IASC standards is that those
standards constitute a comprehensive, generally accepted
basis of accounting, and accounting for financial
instruments is a critical element of what in 1995 was
agreed to be a comprehensive core set of standards.  In my
view, any set of standards that does not address financial
instruments, including derivative instruments, would not
be comprehensive.

With respect to derivatives accounting more broadly, on a
number of occasions I have expressed my concerns about the
shortcomings of the US accounting model and its failure to
keep pace with developments in the market place.  Others
will be speaking about the FASB’s derivatives accounting
project during the next two days, and I will just
reiterate my belief that this project is critically
important and needs to be completed as soon as possible.

Role of Interpretation in Standard Setting

As with national standards, a key success factor for
international standards will be the ability of
practitioners and regulators to interpret and apply those
standards with consistency and rigor.  The IASC has
approached that issue by establishing an interpretive body
called the Standing Interpretations Committee (SIC).

During the IASC’s deliberations that led to the Committee,
some Board members expressed concern that, if the
Committee were allowed to address emerging issues and
diversity in practice without Board oversight, it might
undermine the Board’s standard-setting role.  As a result,
the current IASC structure requires that each of the
Committee’s consensuses be ratified by the same super-
majority of the Board that is required to adopt a new
standard.

This debate about the role and authority of the Committee
highlighted for me not only the importance of effective
mechanisms for interpretation, but also the importance of
recognizing the sometimes gray distinctions between
standard setting and interpretation.

In the US, we have long recognized that an effective
interpretive mechanism is essential to maintaining high
quality accounting standards.  Our interpretive group, the
EITF, has been an important element of standard setting
for over 10 years.

From my perspective, the role of SEC Observer at Task
Force meetings is one of the most demanding and
challenging
responsibilities that my Office has.  I say this because
the issues are always complex and the qualities that make
the process successful are sometimes fragile and difficult
to preserve.  Those qualities include candor and
objectivity as well as technical competence.  Some recent
experiences of the staff have caused me to reflect on the
factors that I see as being important to the continuing
success of the Task Force.

First, troublesome issues are best dealt with if they are
recognized and brought to the table at the earliest point
possible.  Failure to do so tends to encourage diversity
in practice and makes it more likely that bad practice
will take root.

Second, the process is only effective when Task Force
members bring their expertise and independent judgment to
bear on issues under consideration, without deference to
or pressure from their industry organization, their
employer, their firm, or their clients.

Third, credible consensuses are faithful applications and
extensions of existing authoritative standards.  They
don’t skirt the intent of the literature by relying on
legalistic readings or the absence of an explicit
prohibition.

Fourth, the Task Force works best when it recognizes and
accepts the institutional constraints on its ability to
formulate new guidance.  For the EITF to work effectively
as an integral part of the FASB’s standard-setting
process, it should seek to resolve issues within the
context of the authoritative standards and resist the urge
to amend or override those standards.  If the Task Force
believes that existing standards produce sub-optimal
results, the need for reconsideration of the standards
should be discussed with the Board.

I do not suggest that the Task Force has been ineffective.
I think it has been effective in many respects.  But I do
find disturbing, for example, indications that an issue
may have been deliberately kept off the table.  When this
happens, the result can be to allow bad practice to become
embedded practice and create resistance to efforts to
achieve appropriate application of the standards.

Also, I am troubled when alternative treatments are put
forward, in the name of completeness, when those
alternatives seem to be clearly inconsistent with existing
authoritative standards.  I am especially troubled when
the discussion of those alternatives ignores strong views
expressed by the FASB staff.  The FASB staff has an
important responsibility for advising the Task Force about
the consistency of proposed solutions with existing
literature, and the Task Force should consider their
advice carefully.

As I prepare for Task Force meetings and listen to the
discussion around the table, my acid test is, will this
proposal put investors at risk?  Investor protection can
be an issue, for example, when a specific proposal could
permit or encourage abusive accounting or when a proposal
could create conflicting guidance that might promote
rather than limit diversity in practice.

Having voiced these concerns, I will say again that the
EITF, when it is at the “top of its game,” can be an
effective instrument of the US standard-setting process.
But, I think it is healthy to remind ourselves of the
objectives and constraints of the process and to make
adjustments as necessary to keep all the elements working
in harmony.

Auditor Independence

Since we were together last year, the Commission worked
with the AICPA to create the new Independence Standards
Board, an independent, private-sector body that has been
charged with addressing auditor independence issues and
establishing appropriate standards for auditors of public
companies.

The structure of the new Board has been designed to
provide safeguards to assure that the process will operate
in the public interest.  An especially important feature
is the commitment and participation of strong leaders from
outside the accounting profession.  I refer, for example,
to William Allen, former Delaware Court Chancellor and now
Professor at New York University, who agreed to be the
Board’s first Chair; John Bogle, retired Chairman of The
Vanguard Group; Robert Denham, CEO of Solomon; and Manuel
Johnson, former Vice Chair of the Federal Reserve and
Chairman of the Financial Accounting Foundation.  Also
important will be an open, public decision-making process
and active oversight by the Commission and its staff.

Most of you are aware that the AICPA prepared a “white
paper” on auditor independence that was presented to the
Board in October.  Chairman Allen asked the SEC staff to
review that paper and to provide its commentary to the
Board for discussion at its December 15 meeting.  We have
been working on that request and plan to respond to
Chairman Allen very shortly.

Without attempting to capture the full scope of the
staff’s comments and views, I will make a few observations
today.  I am sure it will come as no surprise that these
observations reflect the Commission’s concern for
maintaining investor confidence in the independent audit
and the capital markets.

First, all agree with the acknowledgment in the white
paper that auditor independence is an important issue.
Independent audits add credibility to the financial
reporting process, which gives investors greater comfort
that they will be treated fairly as they put their savings
into the capital markets.

While many factors arguably affect the efficient
functioning of capital markets, it seems obvious that
credibility is the foundation, and it is the independent
audit’s contribution to market credibility and factors
that affect that credibility, that should be first and
foremost on the Board’s agenda.

As the Board takes up the issues that lie ahead, it must
keep the investor’s point of view sharply in focus.  As it
considers the issues, it should ask whether a reasonable
investor, with full knowledge of all of the facts and
circumstances, would have confidence that the independent
auditor would put the interests of investors first and
that those interests would not be compromised by any
conflicting interest of the auditor or the auditor’s
client.  Only affirmative answers to those kinds of
questions will assure the market credibility that is so
essential.

Second, most would agree with framing the discussion in
the context of the changing business and professional
environment.  The application of some rules that worked
well decades ago is less clear today.  Conversely, some
more recent, and important, issues are not addressed in
the rules at all.  The Board will be expected to fill
those gaps.

Third, although investors’ expectations of the independent
audit have been the focus of the Commission’s rule-making
from the beginning, it is clear that we all could, and
should, learn more.  The white paper suggests that the
Board may want to sponsor research in certain areas.  I
believe that the Board will need wide-ranging research
focused on identifying and gaining a better understanding
of the issues that affect investors’ confidence in
financial reports.

And fourth, we can expect that changes in the framework
will take time -- a reasonable period of time.  The white
paper proposes one approach, presented from the point of
view of the practicing profession.  But there are other,
important considerations, and judging the issues will take
objective analysis, deliberation, and substantial public
dialogue.

From the Commission’s perspective, the goals of
strengthening  the quality and independence of audits are
clear and unambiguous -- it’s all about maintaining
investor confidence in our securities markets.  That was
the objective of the securities laws that require an
independent audit, and it is the fundamental focus of the
Commission today.

Without a high level of confidence that an independent
audit produces a totally unbiased look at a company’s
financial statements, investors could lose confidence in
the information they receive and use for making investment
decisions.  And, if investors do lose confidence in the
information they are provided, they, in turn, would lose
confidence in the fairness and impartiality of our capital
markets.

Capital markets are built on trust and confidence, and
maintaining that trust and confidence has been and will
continue to be a critical priority for the Commission.

Conclusion

The topics I addressed today, and most of those I have
talked about during my tenure, are unified by one theme:
the important role that financial reporting plays in our
capital markets and the important roles that independent
standard setters, independent auditors, and regulators
play in seeing that investors receive the most relevant
and reliable information the system can provide --
information that will have the greatest possible utility
for making investment decisions and that can be trusted to
reveal all that it should reveal.

Financial reporting must continue to improve and continue
to focus on meeting the needs of investors, whether the
guiding principles are national or international.  Only by
doing that can we be assured that future generations will
receive the benefits of the vibrant capital markets that
were passed to us and that we enjoy today.

                       * * * * * * *

Thank you again for asking me to share my thoughts with
you and for your attention.