Speech by SEC Staff:
Remarks before the 2009 AICPA National Conference on Current SEC and PCAOB Developments

by

Paul A. Beswick

Deputy Chief Accountant, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 7, 2009

Introduction

Good morning. It is a pleasure to speak to this group. This is the third year that I have had the opportunity to speak at this conference. Conferences such as this are valuable because it not only allows us to share our views on issues we see in practice but also, and in my view more importantly, allows us to get feedback on the issues you are seeing in practice and lets the staff know how we can improve our interaction with the reporting community.

When I was thinking about speech topics, I was canvassing the field to determine what would be the best issues for me to address. I thought for awhile of responding to some of the more interesting blogs I have read on accounting recently, but ultimately decided that I would have needed more time than I was allotted here today. Therefore, I decided to focus on some policy level issues regarding loan loss provisioning, use of assumptions in the current market, and accounting judgments. Additionally, I wanted to share my thoughts on an independence matter we have considered recently.

Loan Loss Provisioning

So let me start with the Financial Accounting Standards Board's (the "FASB" or "FASB's") financial instruments project and more specifically, the portion addressing the accounting for loan loss provisioning. While I am sure you will hear more about the project at this conference and in the coming months, I wanted to share my perspective on the interaction of this project and any regulatory capital regime.

Let's start with a quick history lesson related to this project. In October 2005, the FASB and the International Accounting Standards Boards (the "IASB") (collectively, "the Boards") discussed the future of reporting for financial instruments and established objectives to improve and simplify the reporting for financial instruments.¹ Since then, the Boards have met numerous times individually and collectively on this project.

During the recent economic crisis, the accounting for financial instruments became a focal point for many and in fact was cited by some as a contributor to the financial crisis. Now, personally I question whether lax underwriting standards, poor risk management polices, and misaligned incentives were among the more significant factors, but that is probably a different speech. However, there were two aspects of the project that were proving to be vexing for some; first, when should changes in fair value be recognized in the financial statements, and second, whether improvements to the determination of the provision for loan losses were necessary. I would like to focus on the latter issue for a minute or two.

In December of 2008, I was asked to be a co-technical chair on a working group of the Financial Stability Forum that was examining the forces that contribute to procyclicality² in the financial system and how the accounting standards for loan loss provisioning might affect procyclicality. Now at this point I have to admit to something — I was personally a little skeptical of the process. A working group comprised principally of prudential regulators, both domestic and international, was a formidable prospect. Having worked at the FASB for two years as a FASB practice fellow, I strongly believe that one of the greatest strengths of the U.S. capital markets is the independence of the accounting standard-setting process. But my preconceptions were quickly alleviated because it became apparent to me that the group was trying to use its collective experience to identify weaknesses in the current accounting standards and provide insight to the accounting standard setters, but not dictate answers.

One aspect of the process that was particularly beneficial to me, and hopefully to the FASB and IASB representatives, was the investor outreach that the working group undertook. While investors could not agree on a single model, they indicated that the current loan loss provisioning accounting standards could be improved. The investors the group met with indicated that companies should use a broader range of credit information in determining their provision for loan losses. The working group provided a recommendation that was ultimately included in the FSF report to the G-20.

At this point you may be wondering why I have decided to give you a history lesson on such things. Well, if I have to compare the current situation to a movie, I would have to use Sergio Leone's The Good, the Bad and the Ugly, starring Clint Eastwood. (If I only had a music clip right now. I am sure you can all hear the theme music from the movie.)

So the good. The FASB and the IASB are working together toward a common goal. The Boards have formed an expert advisory panel that will provide input to the Boards on the operational issues surrounding the Board's approaches. I feel that there is a genuine commitment to reach common ground on these issues and the results will improve information provided to investors.

Next, the bad. I continue to meet with groups and individuals that are almost apoplectic that the Boards currently are exposing differing models. My response to those individuals is to remind them that these are only exposure documents and not the final decisions. Both Boards will receive a tremendous amount of input during the exposure period and through the expert advisory panel. The FASB and the IASB have agreed to meet on a monthly basis to discuss the convergence projects, including financial instruments. My honest belief is that the Boards will be able to work out their differences through this process.

Finally, the ugly. I am beginning to hear voices from both sides of the Atlantic, commenting that the FASB and the IASB did not go far enough in providing management discretion in their proposed models. While I would direct them to "the bad," I am concerned for another reason. These comments make me believe that they are expecting the FASB and the IASB to potentially satisfy policy objectives that go beyond transparent financial reporting. But we need to remember the purpose of accounting standards and what we heard from investors in our outreach as part of the working group. The purpose of accounting standards is to provide investors with credible, transparent, and comparable financial information they can rely on to make sound investment and credit decisions.³ If this information is also useful to prudential regulators, that is all the better. If not, they already have the mechanisms to make changes to the regulatory capital regime similar to how changes in fair value for available for sale securities are addressed in the capital regimes.

I am sure there will be more to come on this subject in the upcoming months.

Use of Assumptions in the Current Environment

Now I would like to turn to my next topic. I am about to make the biggest understatement of the entire conference. These past two years have been challenging. But let me focus you a little bit. Many have said that accounting is an art not a science. One of the reasons is that accountants are required to utilize assumptions about the future in the preparation of financial statements.

In the best of times that can be difficult, but at least in the best of times you can place greater reliance on historical trend rates to give you an indication of future performance. In the current environment many of our assumptions have changed about how markets behave, as has been the complexity in trying to predicate how changes in the regulatory environment will impact markets.

So let me give you two pieces of advice. First, do your homework. An assumption based on reasoned analysis generally should include at a minimum the incorporation of current market data, consideration of what the experts in the industry are forecasting, and an evaluation of what others in the industry are doing, among other things. Your assumptions should be reasonable and consistent with the objectives of the accounting standards. If you have an assumption that was particularly tough, consider disclosing it (even if it's not already required), but more importantly explain to investors how you made the determination. This can be just as critical.

Second, don't get cute. If you find yourself rationalizing overly rosy forecasts, making changes to the models or assumptions to achieve a specific result, not being consistent with the objectives of the particular accounting standards, or other things, you might want to take a step back and consider the implications. For example, we have heard that some companies may be inappropriately resetting the health care cost trend rate every year to "manage their retirement liabilities." This would be an example of practice that is not consistent with the objectives of the particular accounting standard. Ultimately, no one, principally investors, benefits when approaches intended to manipulate the outcome are used by management.

Accounting Judgments

On a related subject, I would like to spend a minute discussing the reasonableness of accounting judgments. The Commission's Advisory Committee on Improvements to Financial Reporting (CIFiR) recommended that the Commission issue a statement of policy that articulates how the Commission and its staff evaluate the reasonableness of judgments regarding accounting matters and include factors considered when making this evaluation.⁴ Last year, two staff members at this conference highlighted the importance of judgment and our willingness to accept reasonable judgments.⁵ This was not the first time, nor do I suspect the last time, judgment will be discussed at this conference.⁶

When I consider what has been said at this conference in past years regarding judgment, I think some of my predecessors have given you some very good advice on the staff's views on accounting judgments. I think you would be well served to listen to their suggestions on this matter. However, there is one area of concern I would be remiss if I did not address. We are aware of a few instances where individuals have asserted they used their accounting judgment, but did not want to, or said they could not, discuss with the staff the manner in which they reached their conclusions. CIFiR's recommendation and past statements from SEC staff are not a shield from the Commission's staff asking questions to understand the thought process used to arrive at an accounting conclusion.

I understand this is a delicate balance I am walking right now. Any standard about judgment would not limit the staff's necessary and appropriate evaluation of a registrant's judgment on an accounting matter individually on the merit of its own particular facts and circumstances. The best piece of advice I can provide you is to avoid developing a "checklist" mentality, and take careful, good faith consideration of the individual facts and circumstances in reaching a conclusion regarding an accounting matter.

Independence Matters

Frequently, OCA is consulted on audit independence matters. I thought it would be helpful to share some insight with you on one issue we were asked about recently.

PCAOB Rule 3526

PCAOB Rule 3526 — Communication with Audit Committees Concerning Independence, requires that a registered public accounting firm, prior to accepting an initial engagement pursuant to the standards of the PCAOB, describe, in writing, to the audit committee of the issuer, all relationships between the registered public accounting firm or any affiliates of the firm and the potential audit client or persons in financial reporting oversight roles at the potential audit client that, as of the date of the communication, may reasonably be thought to bear on independence.

As we are seeing an increase in the number of initial public offerings, I want to remind you that this PCAOB Rule requires, and we therefore expect, that the written communication to the audit committee occur prior to the firm accepting the IPO engagement; that is, prior to the start of the professional engagement period for an audit under PCAOB standards. Therefore, to the extent an audit firm has an existing private client now preparing to go public, the firm will have to reevaluate its relationships with the audit client under the PCAOB and the SEC independence rules as a necessary step prior to being engaged or beginning any PCAOB audit procedures. Of course, this would include a robust process to identify any engagements, services, or other independence matters that impact the firm's independence as the audit firm is now subject to SEC and PCAOB independence rules.

Closing

In closing I would like to address one final point. Later this morning, the staff from the Office of the Chief Accountant will be updating you on some accounting and auditing issues. I know this is discussed every year, but I want to reiterate one point regarding their speeches. The goal of these speeches is to inform participants on current issues and hopefully improve practice. If you find that as a result of something that is said, you are concerned that you will need to change your accounting or your auditing practices, consider talking to us first.

Thank you for your time and I believe we have some time for questions from the audience.

ENDNOTES

¹ http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1175801889654#background

² As stated in the Report of the FSF on Addressing Procyclicality in the Financial System, 2 April 2009 ("FSF Report"): "The term 'procyclicality' refers to the dynamic interactions (positive feedback mechanisms) between the financial and the real sectors of the economy. These mutually reinforcing interactions tend to amplify business cycle fluctuations and cause or exacerbate financial instability." FSF Report, page 8.

³ http://www.fasb.org/facts/index.shtml#mission.

⁴ See Recommendation 3.5 in the Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission, issued August 1, 2008.

⁵ http://www.sec.gov/news/speech/2008/spch120808jlk.htm and http://www.sec.gov/news/speech/2008/spch120808rgf.htm.

⁶ http://www.sec.gov/news/speech/2006/spch121106sat.htm.

http://www.sec.gov/news/speech/2009/spch120709pab.htm