Remarks to the Institute of Chartered Accountants in England and Wales: “The intersection of financial reporting and innovation"

The Securities and Exchange Commission (“SEC” or “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 the author and do not necessarily reflect the views of the Commission, individual Commissioners, or of the author’s colleagues upon the staff of the Commission.

Introduction

Thank you, Robert [Hodgkinson] for the kind introduction. Thank you, also, to the Institute of Chartered Accountants in England and Wales (“ICAEW”) for sponsoring this event. I am delighted to be in London and with you this afternoon.London continues to be recognized as one of the world’s leading international financial centers, along with New York and other highly globally connected cities. Whether in London or New York or my childhood town of Chambersburg, Pennsylvania, people in every walk of life are affected by financial reporting, the cornerstone on which our process of capital allocation is built.

An effective capital allocation process is critical to a healthy economy that promotes productivity, encourages innovation, and provides an efficient market for the purchase and sale of securities and the obtaining and granting of credit.

Such an efficient allocation process would not be possible without financial disclosures, because adequate and high-quality information helps investors to judge the opportunities and risks of investment choices accurately.

Good accounting and auditing may not readily grab the general public’s attention, but they are essential to our livelihoods. Whether a long-term Main Street investor[1], investment professional, or retiree, individuals make investment decisions—or rely on others to make decisions for them—based in part on audited financial statements. Recent business failures suggest we all benefit when we learn from and strengthen our system of business and financial reporting that underpins decision making within our financial markets.

High-quality financial reporting starts with companies. In companies subject to U.S. federal securities laws, management is required to keep and maintain books and records in reasonable detail.[2] From those books and records, management prepares financial statements according to a general purpose financial reporting framework, so that the reporting is comparable, verifiable, timely, and understandable by investors and others. If the starting point of the financial reporting process does not begin with management using high-quality financial information for its preparation of financial statements, then what could result are increased risks and costs in each subsequent phase of financial reporting.

When required, an annual audit or interim period review performed by an independent auditor provides investors with confidence that a company’s financial statements are presented in accordance with the financial reporting framework. The strength of financial reporting—and of our capital markets—depends on thorough and objective audits performed by auditors who are ethical, independent, skeptical, and who apply the diligence necessary to meet professional and regulatory standards.

When an audit committee is effective, each of management’s and the auditor’s functions is strengthened. The collective goal of all participants in the financial reporting architecture must be for the information to be reliable, the first time it is provided to investors.

It is in this context that the ICAEW, along with my fellow regulators and other leaders, serve such an important role. Founded by farsighted accountants in 1880, ICAEW is a world leading professional membership organization that promotes, develops and supports chartered accountants worldwide. You serve alongside and in collaboration with other professional organizations, such as the American Institute of Certified Public Accountants, in advancing financial reporting by providing qualifications and professional development; sharing knowledge, insight and technical expertise; and protecting the quality and integrity of the accountancy and finance profession.

And so, it is a privilege to speak to you this afternoon in the Chartered Accountants’ Hall about an appropriately tailored topic for this audience: the intersection of financial reporting and innovation.

I also acknowledge the importance of the discussion occurring in the U.K. about the role and relevance of financial reporting and the accountancy profession, with a recent report on Carillion published by select committees of the U.K. Parliament.[3] Among many other points to prompt discussion, the report offers recommendations relating to strengthening the external audit. The recommendations should stimulate critical dialogue and root-cause analyses covering each phase of financial reporting (that is, preparation, audit, delivery, and use), with possible solutions examined in the first instance according to their impact on the advancement of quality of audited financial statements upon which investors (and lenders) rely. Investor (and lender) trust, including in the numbers, impacts the extent and level of their participation in the financial markets. [4] Of course, there are other necessary considerations for sensible solutions, such as an assessment of the costs, benefits, and consequences (both intended and not) to the right expectations of investors and others.

Before I continue, let me remind you that the views expressed today are my own and not necessarily those of the U.S. Securities and Exchange Commission (“Commission”), the individual Commissioners, or other colleagues on the Commission staff.

Let me also express a word of gratitude to the entire OCA team for their work in providing advice to the Commission regarding accounting and auditing matters arising in the administration of the U.S. federal securities laws. I want to also acknowledge Emily Fitts for her valuable assistance in preparing me to make today's remarks.

Also in the spirit of acknowledgment, let me mention the valuable assistance of Ying Compton in preparing three charts that depict the overall financial reporting structure that frame the reference to the phases of the financial reporting system in the U.S.[5] The charts are available under the OCA section of the SEC’s website.

Our markets: highly connected global investing

Technology and trade have made our world considerably smaller. Issuers operate in a global market and seek capital globally. In fact, today in the United States, more than ever before American investors are investing directly in the securities of foreign private issuers and companies based outside the United States and registered in non-U.S. jurisdictions. At the end of 2016, U.S. investors have invested $9.9 trillion (of which U.S. mutual funds have invested over $4.3 trillion, and U.S. pension funds have invested over $1.3 trillion) in equity and debt securities listed in non-U.S. jurisdictions.[6] Also, as of the end of 2016, according to one industry ranking of the world’s largest asset managers, U.S.-based asset managers occupy the top four positions and eight out of the top 10 slots.[7]

This global capital market presents both opportunities and challenges to the securities regulators in executing their mandates to protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation. The possibilities include greater competition among markets. Also, investors may diversify their portfolio risk across borders more effectively and at less cost. And, companies may seek the lowest price of capital wherever it might be.

Of course, with greater opportunities come greater challenges. The same technologies that allow retail investors to look abroad for investment opportunities also allow fraudsters to look across borders for victims. Additionally, some of the risks that a globalizing capital market poses are not necessarily different from the risks the Commission faces domestically.

Financial reporting information in our markets

Fundamentally an investor (or investment advisor) is trying to decide whether a particular investment is likely to be worth more or less in the future than it is now. The decision-makers are not limited to the information contained within financial statements when making investment decisions. They use other types of information (in no particular order of significance) as well, such as:

• Company reputation, strategic direction, and goals;
• Company developments, outlook, and position in the marketplace, such as management changes, product introductions, and acquisitions;
• Company stock performance; and
• Risks to which the company is exposed and industry outlook.

As my illustrative list suggests, many investors consider, and absorb, information from a wide variety of sources for investment decision-making.

Those involved in financial reporting

Even though decision-makers rely on information other than the financial statements, audited financial statements are a vital element of the overall information architecture that underpins our capital markets. The quality and quantity of the available financial statement information in an economy influence the efficiency of resource allocation and the cost of capital.

We, in OCA, developed three renditions[8] of an overview of organizations involved in the structure of financial reporting in the U.S. markets[9] to help visualize and thereby understand the necessarily complicated system. The versions, of course, also contribute to an analysis of less-obvious aspects. For example, they help identify the multiple points of oversight, review, and advice that both preserve and advance general purpose financial reporting.

I encourage each of the organizations involved in the overall structure to consider how they might use the financial reporting information (or other information) to identify ways on an ongoing basis to prevent failures and add value for investors including by asking what we can do today to support the financial reporting of tomorrow, such as:

• How can we bolster coordination and collaboration among the organizations involved in financial reporting?
• What can we learn from previous financial reporting failures to evaluate whether and how each organization could more effectively contribute to the prevention of reoccurrences/future failures?
• What more could be done to understand and coordinate technological issues (and the technology languages used) within and across each phase of the financial reporting structure?
• What information should be provided in the financial statements to meet the needs of investors, lenders, and other creditors, even as the context of demographics, technology, and market structures change?
• Can more be done to help identify expectations and minimize expectation gaps, both globally and variations within particular markets?

What are expectations gaps?

Having just mentioned expectations gaps, let me discuss the topic further. Expectations are normative. An expectations gap is typically referred to as a difference between the levels of expected performance such as the differences in expectation between what some investors might expect from general purpose financial statements and what some accountants might be able to communicate within those same financial statements. The information in financial statements may also be of interest to other groups who are non-capital providers, but the information is not designed to meet their objectives.

The sources of expectations gaps are varied. For example, the sources may be in the design of the standards, their application by accountants or auditors, or invalid expectations. The expectations of investors and others reflect the realities that multiple groups of stakeholders have differing and competing informational needs and desired outcomes. The complexity of expectations only increase when accounting or audit standards are used across the diverse business, legal, social, cultural, and political environments in our world. These are the realities that should be at the forefront of identifying and managing expectations.

So with the framing of expectations gaps in mind, I would like to discuss next several of the conceptual underpinnings of general purpose financial reporting that provide further context to the charts. I aim to contribute to the broader awareness that can help minimize expectations gaps over time. Any similarity to the financial reporting conceptual frameworks is intentional.[10]

Whom do the standard setters consider when developing general purpose financial reporting?

General purpose financial reporting is a core element of the disclosure of business and financial information to investors. Its objective identifies the decision makers. The objective is “to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.”[11] While other parties, such as those charged with governance, regulators, and members of the public other than investors, lenders, and other creditors, also may find general purpose financial reports useful; those reports are not primarily directed toward these other parties.

Special purpose financial reports, by contrast, are prepared using a particular framework to address specific needs of specific users who intend to use it which can include, among other things, aiding members of a board or regulatory supervision team. They have more specific purposes and uses than general purpose financial reports.

I make the distinction between general and special purpose objectives to emphasize the value of keeping and maintaining general purpose financial reporting free from other objectives. Standard-setters for general purpose financial reporting are concerned with, among other things, the qualities of information that relate to broad classes of investment and credit decision makers rather than to particular ones.

When formulating standards for general purpose financial reporting, the IASB and the FASB do not seek to influence the outcome of investor capital allocation decisions or actions taken by management; instead, the boards’ design standards that provide better information to inform those decisions and actions. The alternative, whereby standards are designed to privilege specific objectives, economic activities, financial products, or market participants, could diminish confidence in the accuracy or quality of reported information, which could thereby impair capital formation, and in turn, negatively impact economic activity. Again, by keeping general and special purpose financial reporting objectives distinct, without merging the two, each can serve best their respective purposes and minimize expectations gaps among the parties involved.

As I have mentioned, the need for information on which to base investment, credit and similar decisions underpins the objectives of financial reporting. Each decision maker judges what accounting information is useful, and that judgment is influenced by factors such as, the decisions to be made, the methods of decision making to be used, the information already possessed or obtainable from other sources, and the decision maker’s capacity (alone or with professional help) to process the information.

And yet, the baseline is broad, comprising needs of investors and investment advisers. That is, the optimal information for one user will not be optimal for another. Consequently, management with responsibility for making decisions and judgments about how to prepare information – and standard setters with responsibility for establishing standards to guide management’s decisions -- must try to find the balancing point among many different users. This work of preparing information (or writing standards for preparation of information) is one of walking a fine line between preparing (or requiring) disclosure of too much or too little information for inclusion in general purpose financial information. This point arises in particular because information does not come to the preparer and user without costs or benefits, both direct and indirect.

This suggests the importance of financial literacy

Similarly, because information is not useful to a person who cannot understand it, financial education and literacy among all members of the financial reporting structure is critical. It also reinforces the importance of considerations regarding the relevance of accounting information regarding the capacity of information to influence investment decisions.

Information provided by general purpose financial reporting should be comprehensible to those with a reasonable understanding of business and economic activities who are willing to study the information with reasonable diligence.

This is to say that financial information is a tool and, like most tools, is of direct help to those who are able and willing to use it.

And, so what does general purpose financial reporting not address?

No matter how well we succeed in addressing the continued advancement of general purpose financial reporting, there will inevitably be limitations.

For example, it is highly unlikely that we could ever produce a balance sheet from which an investor could read off a figure and say: “that is what my shares are worth.” This is because the market capitalization of a company depends on a mixture of information. For example, if the shares of a company are being bought by a group that is determined to secure a controlling interest, the price of its shares can rise above what the value of the net assets on the balance sheet would suggest. Similarly, the liquidation of a large block of shares can drive the market price down below what might be expected from an analysis of even the best of financial information.

These expectations and any gaps are best addressed when the best thinking is shared

The involvement of everyone in the financial reporting structure in supporting the work of the accounting and audit standard-setters is critical. In doing so, standard-setters can maintain a long-range vision, mission, and strategic goals that are consistent with continued advancement of general purpose financial reporting.

Additionally, the collaboration of everyone involved in the financial reporting structure should transcend geographies. In my view, it is essential to continue a policy of ongoing coordination and collaboration on national and international standards, practices, and needs so that the best thinking is identified, shared with each other, and can prompt action. In the same sense, we also should redouble our efforts for coordination within and across each phase of the financial reporting system – preparation, audit, delivery, and use.

These steps will allow us to continue to advance quality in financial reporting.

Critical Role of Audit Regulators and Audit Standard-Setters

Still, there is a second phase of the overall structure of financial reporting: the audit. When it comes to advancing audit quality and related expectations, prevention (as a complement to detection) is a worthy investment so that investors receive reliable financial information the first time. It is critical that all key stakeholders, including the audit standard-setters and audit regulators, assist in the advancement of audit quality.

One crucial preventive measure is the development of high-quality audit standards, which aid, but can never wholly replace, the role of decision making and judgment by auditors. Both local and international audit, assurance, ethics, and education standards (“audit-related standards”) are relevant to the U.S. and its capital markets participants.[12] The quality of international audit-related standards, for example, is relevant to U.S. investors and asset managers that hold or manage foreign equity and long-term debt securities.

The quality of international audit-related standards is also relevant to U.S. based multi-national companies. For example, in many cases, U.S.-based multi-national companies have local country statutory and other reporting obligations in jurisdictions outside of the U.S. that are met by the audit reports from audit firms that applied international audit-related standards as a starting point for the execution of the consolidated audit. Moreover, the U.S. based audit team may also use the results of the statutory audits as part of their audit risk assessment for the audit of the consolidated financial statements.

Many U.S. accounting firms are members of various global networks that incorporate international audit-related standards as part of a common audit methodology, training, and governance, with an aim to increase the consistency of audit execution and reduce the risk of audit failure.

Additionally, the U.S. accounting profession through the American Institute of Certified Public Accountants Auditing Standards Board (ASB) has a strategic objective to converge its standards with those of the IAASB for audits that are not conducted using the PCAOB standards.[13] The standards of the ASB may be used in conducting governmental and pension plan audits, as well as audits of individual entities with SEC filing obligations, such as in the following instances:

• Examination engagements under the Custody Rule;
• Review and audit engagements under Regulation Crowdfunding; and
• Audit engagements under Regulation A.

High-quality audit standards make audits—and the work of audit committees and others that oversee the audits of companies on behalf of investors—considerably more effective.And so, we all have an interest in the accountability and inclusiveness of the international audit-related standard-setters.

Role of Monitoring Group in advancing international audit-related standards

Given the importance of international standards to the expectations of the U.S. and its capital markets participants, the importance of the Monitoring Group, and the risk of fragmentation, I was honored to be asked to serve as an IOSCO representative to the Monitoring Group. I look forward to this new role and advancing our shared goal of fostering quality judgments and decision making by auditors through high quality international audit-related standards.

Last year, the Monitoring Group issued a consultation paper on strengthening the governance and oversight of the international audit-related standard-setting boards in the public interest. I look forward to working with the other Monitoring Group members to find a way forward on the potential changes to the structure through an inclusive discussion about the issues and choices.

The Monitoring Group’s work is important to the oversight of the development of international audit-related standards, in part since international audit standards are not binding of their own accord. The standards are advisory, but these standards can and do affect audits by obtaining general acceptance among practitioners, by influencing the content of binding standards adopted by local jurisdictions, or by being used in part or whole as binding, local standards.

Role of the PCAOB in protecting investors through audit oversight

I want to pause here to touch on advancements at the PCAOB. Earlier this year, SEC Chairman Clayton and I congratulated incoming PCAOB Chairman Bill Duhnke and Board Member Kathleen Hamm, as they began to serve in those roles as the PCAOB continues its vital mission to promote investor protection through oversight of audits.[14] Then, in February, Jay Brown joined as a new board member, and Jim Kaiser followed in March. Finally, in April, with the arrival of Duane DesParte, the five member board became complete.

Collectively, their backgrounds span the entire spectrum of the financial reporting process and include public company preparer, auditor, governance, investor, and oversight experience. This breadth of knowledge will help advance the board as a body with fresh and diverse thinking. More importantly, each board member has affirmed his or her commitment to promoting audit quality and, in so doing, to protecting investors and furthering the public interest in the preparation of informative, accurate, and independent audit reports.

While the continuity of the PCAOB's core activities remains one of the Board’s highest priorities, they are focused simultaneously on defining the pillars of the Board's vision, strategy, and operational plans for the next five years.

Notably, the Board has decided to reach both within and beyond its own four walls for input into what strategic direction to take to improve audit quality through surveys, interviews, and other outreach. The Board is demonstrating a belief, which I also hold, that consistent and meaningful engagement with key constituencies is critical to effectively shaping the PCAOB’s future direction.[15]

Critical role of auditors

The quality of an auditor’s interim reviews and annual audits are also crucial to meeting investor expectations. Auditing is about confidence and trust in financial information. Trust in the audit is nurtured as the profession consistently delivers audit quality and value to audit committees and the investing public. Trust can be nurtured or broken—it is neither static nor assumed.

The audit profession continues to evolve and, as a recent IFIAR survey suggested, deficiencies cited in regulatory inspections remain high but are decreasing.[16] The audit profession must continue to focus, and in some respect do more to meet expectations.

In previous remarks, I have discussed the role of audit firm governance and culture in continuing to advance the quality of annual audits and interim period reviews.[17] Audit firm governance serves a vital purpose in maintaining an effective, proportionate firm-wide (enterprise) risk management system, as a framework to anticipate and mitigate the risk of breakdowns and failures.

Auditor choice

Audit quality is a touchstone to our capital markets. Secondary to audit quality, there are also considerations regarding whether with increased concentration of audit firms there may be a lack of choice among audit firms. While the number of available firms remains higher in the private company, not-for-profit, and governmental sectors, the same is not true in the public company markets. These issues mostly go beyond the scope of my remarks today and are evolving, particularly in the U.K. While acknowledging the importance of scale so that audit firms can audit the largest public companies, I also believe analyzing sensible ways to foster the growth of smaller firms is also worth considering. For example, would collaborations across firms of all sizes on people development, methodologies, and technology build capacity and competitiveness among audit firms of all sizes in the public company markets, thereby increasing auditor choice for audit committees? Collaboration is just one approach in an evolving discussion, of which I am sure there are many questions.

The integrity with which auditors, as well as all other stakeholders in the financial reporting process, execute their responsibilities is foundational to the enduring confidence of the investing public in our capital markets, and maintaining the confidence of investors is vital. The counterpart to this point is that even in meeting the rightfully high expectations and needs of investors, lenders, and other creditors, audits are not capable of providing absolute assurance—a guarantee—of the integrity of management’s financial statements or the viability and soundness of a business model. It is essential for all of us to fully understand what audited financial statements can provide and not suggest that audited financial statements provide investors with more information than such statements are designed to provide.

Auditors of tomorrow

We must also keep an eye on the talent required to sustain the role and relevance of the audit. In this room, some of you went through college with limited or no exposure to computers. Others of you, how can we forget, learned computers using punched cards. Then there is also among us the first generation who had to buy a personal computer for college. Moreover, today, even my six-year-old son is adept at using a smartphone to send me emails.

Today’s students – tomorrow’s investors – are going to require faster, more timely dissemination of quality information, on a global basis. Tomorrow, in fact, may be here now. In that regard, audit firms and others should consider the impact of technological developments to this ever-changing profession. For example:

• While audit firms hire some of the brightest graduates, are the audit firms planning sufficiently for retention and succession planning so that the skillsets needed for a changing profession are available at the right time in the future?
• What mechanisms are in place to promote sufficient technical expertise, including within critical quality control functions such as a national office?
• What is the best way to reward auditors for high-quality work?
• How will the audit profession identify and find ways to respond to the quickly changing needs of investors and the technologies they use?

These are illustrative questions. I believe the profession’s ability to attract and retain the best and brightest talent will continue to be impacted by how well leaders identify solutions that inspire the best candidates to invest in a career of adding trust and integrity to the financial information that underpins the world’s capital markets.

Addressing these questions requires all stakeholders—including academics—to take an active role. For example, as I said in another forum last year, the research that accounting academics perform has made (and will continue to make) significant contributions to the accounting and reporting practice.[18] Additionally, academics help foster the necessary skills that the auditors of tomorrow will need, and help determine how audit firms can attract and retain the best professionals. The most useful academic research, in my opinion, identifies solutions to problems, more than just suggesting a problem itself.

Even as we work to safeguard the public’s confidence in financial reporting, we must also position ourselves and future generations of accountants, auditors, standard setters, and regulators to innovatively identify and solve the challenging and complex issues facing investors. It is critical for the livelihood of the profession for all members of the profession to take an active role in defining the profession’s future.

Conclusion

Let me close. It has been my pleasure to speak with you today. In our time together, I have provided thoughts on how we can continue to give investors quality financial information for their use in making informed investment decisions.

The financial reporting system’s strength is the result of the shared and weighty responsibility of all stakeholders in providing investors the right financial information the first time.

We are witnessing a whole succession of technological innovations, but none of them will do away with the need for integrity in the individual or the ability to think.

Thank you.