Speech by SEC Staff:
Remarks before the 2003 Thirty-First AICPA National Conference on Current SEC Developments
by
Scott A. Taub
Deputy Chief Accountant
Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 11, 2003
As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Introduction
Good morning. I'm happy to be here again to speak to this large audience. Although this marks the 5th year in a row that I've be on stage at this conference, I haven't actually been up here delivering prepared remarks in the main session since 2000. In 2000, I was a PAF, and I spoke mostly about issues raised by the internet bubble involving revenue recognition and income statement classification. Since that time, the internet bubble has burst, and I've gone through the demise of Arthur Andersen, been the Deputy Chief Accountant to three different Chiefs, and, for a while, to no Chief, and somewhere in there, I became a father. So if you see me looking bewildered or confused — well, it's just a constant state of being for me these days. And given that, it is even more important than usual that I remind you that my remarks are my own, and don't necessarily represent the views of my colleagues on the SEC staff or of the Commission.
As the Deputy Chief Accountant for the past 15 months, my main focus, and the main focus of the office, has been working to improve confidence in the financial reporting system. All of you in the audience have been affected by those efforts in one way or another, and many of you have taken part in them. I think there's been a fair amount of progress. The new rules related to certifications and non-GAAP measures have been effective for some time now; the PCAOB is up and running, with some 700 firms registered and ongoing inspections of the largest firms; new rules on auditor independence are in place; audit committees are taking their increased roles and responsibilities seriously; and, although the reputation of the profession may not be what we'd like it to be, it is improving, and nobody says accounting is boring anymore.
Clearly, however, there is a lot more to do. Internal control reporting begins in mid-2004; new accounting standards on consolidation of SPEs and distinguishing liabilities and equity are just now being fully implemented; and the accounting profession continues to battle image problems, a recent example being the report on tax shelters issued a couple weeks ago by the Senate Permanent Subcommittee on Investigations. And, of course, there are a few longer-term projects being worked on. In that vein, I'd like to update you on a few things that I believe we all need to be focusing on as we continue to improve the financial reporting environment.
International Convergence
Let me start with a subject I'm asked about everywhere I go — International Convergence. I always say that, at a conceptual level, supporting convergence is pretty easy. Whatever transaction we're dealing with, it seems obvious to me that the best accounting for it is the same, whether the reader of the financial statements is in the US, the UK, Japan, or wherever. Similarly, the auditing procedures that are the most effective in the US are likely to be just as effective in Canada, China, or France. Disclosures relevant to investors in Italy, Greece, or Spain, are likely to be just as useful to investors in the US. And having one set of high-quality standards in any or all of these areas would benefit investors and reduce the administrative costs of accessing the capital markets around the world. For all of these reasons, the SEC staff really is, contrary to skepticism I've heard in my travels, in favor of global convergence.
That being said, getting from where we are to where we would all like to be with respect to convergence is not easy. In order to realize the benefits of truly global financial reporting, we need convergence in all of the areas I just mentioned, accounting, auditing, and disclosures. And we need to work to enhance cooperation and consistency in regulatory review and enforcement, and to enhance training and interpretive mechanisms as well. The amount of coordination necessary to do all of this is daunting, and much still needs to be done. But a lot is already happening.
The Work of International Organizations
By now, I expect everybody is aware of the work of the IASB, which was reorganized into a fully independent standard-setter several years ago, and is now gaining credibility, as it issues International Financial Reporting Standards, or IFRS. IFRS will become mandatory in the European Union in 2005. Partially in recognition of this, all of the large accounting firms have developed IFRS training programs and they all have IFRS expert groups, much like the US GAAP technical practices, or national offices, that we're all familiar with. The commitment to building IFRS knowledge and expertise has been strong, and needs to be, if IFRS is to be implemented and interpreted in a high-quality, consistent manner.
A couple of other international organizations are also making progress towards convergence. IFAC, the International Federation of Accountants, an organization whose members are the AICPA's of the world, recently approved some fundamental changes to its structure in order to incorporate effective public interest oversight into its activities, which include the setting of International Standards of Auditing. The IFAC reforms were necessary, as having the profession set auditing standards without strong public interest oversight is really not viable in today's environment. In addition, and perhaps more directly relevant to convergence, IFAC has invited the PCAOB to have an observer, with speaking privileges, at the meetings of its audit standard-setting Board, the IAASB.
Through IOSCO, the International Organization of Securities Commissions, securities regulators have been working on many other aspects of financial reporting convergence. IOSCO has recently issued statements of principles or standards in areas that include auditor oversight, auditor independence, management's discussion and analysis, ongoing disclosures, and disclosures to be used in cross-border equity offerings. These documents identify principles that, if applied by all jurisdictions, will promote consistency without compromising quality. Much of IOSCO's financial reporting work is performed by its Standing Committee No. 1 on multinational accounting, auditing, and disclosure. SC1 is also working to get ready for widespread adoption of IFRS in 2005. Having many countries using one set of high quality accounting standards could have great benefits, but not if the application of IFRS is inconsistent from country to country. To guard against this, SC1 is working to encourage regulators to consult on interpretive matters, work together on enforcing accounting standards, and provide input and views to the IASB. Indeed, SC1 has recently provided very detailed comment letters on several IASB exposure drafts.
The work the SEC staff is doing with IOSCO and IFAC has really forced me to determine how deep my commitment to convergence goes. This is largely because I have been serving as Chair of Standing Committee No. 1 since earlier this year. And while all of the regulators on SC1 are in favor of convergence, we do not easily agree to recommend provisions that are not consistent with the ones in use in our own markets. In order to truly make progress, however, we must be willing make changes when somebody else has a better idea. It isn't easy to do, but we're learning.
Reconciliation of IFRS to US GAAP
Of course, the biggest question about international convergence is — are we going to do away with the requirement to reconcile IFRS financial statements to US GAAP, and when? As a reminder to those unfamiliar with the requirements, current SEC rules allow foreign issuers to file financial statements based on other bases of accounting, so long as they include an audited reconciliation of income and equity to US GAAP. Although this reconciliation is difficult, these rules really do provide a fair amount of freedom to foreign issuers. To give a full response to the question about whether and when we would eliminate the reconciliation from IFRS to US GAAP, I need to explain some changes in the Office of the Chief Accountant. First, we now treat IASB projects very similar to the way we treat FASB projects. We follow the projects, keep updated on the status through various means, discuss issues with the IASB staff, and basically seek to understand the proposals in detail. We also provide input to the IASB on issues to address. We comment on proposals, either through IOSCO or with an SEC comment letter, and we participate in IASB field studies as appropriate. I serve as an Observer to the IASB's Standards Advisory Council, and a member of the Office of the Chief Accountant sits at the table at meetings of IFRIC, the IASB's interpretive body. We also commit substantial resources to IOSCO and SC1, whose focus is solely on international matters, including, as I mentioned earlier, interpretation and enforcement of IFRS. In short, we are making sure we understand IFRS so that we can enforce it as effectively as we do US GAAP, and we are helping to ensure IFRS are of the highest quality possible.
So why are we doing all of this? There is really only one explanation -- we are preparing for a time when IFRS financial statements can be accepted without reconciliation to US GAAP. I absolutely believe that, if things continue as they have been going — if the IASB continues as a strong independent standard-setter in the manner that it has been, if the commitment to quality application of IFRS remains, etc. — we will at some point eliminate the reconciliation. The trickier bit is when. And I'll be honest — I don't know. But now that it is clear that the IASB is capable of and committed to putting out high-quality standards, and has the same type of expertise, independence and process we're all used to with the FASB, the SEC staff is moving on to consider other issues that might stand in the way of dropping the reconciliation. One of the obvious issues is that there are currently less than 50 registrants that use IFRS for their primary financial statements today. Obviously that will change in 2005, when all European companies adopt IFRS in their own markets, and we need to be ready to address that, and to take advantage of the knowledge that can be gained from looking at such a large number of IFRS-based financial statements. We have committed resources to working on these issues, and plan to continue to work on all aspects of international convergence.
Short-Term Convergence in Accounting Standards
Very soon, however, many of you will have a chance to help in the international convergence effort. As most of you know, the IASB and the FASB agreed in October 2002 to work towards convergence in accounting standards. The two Boards are now working together on several major projects; they plan to coordinate agendas; and they are helping each other come up with good solutions to difficult questions and issues. In addition, they have been working on "short-term convergence", which involves converging in certain areas to whichever Board's standard is better. Although some might quibble about whether 14 months really qualifies as short-term, we are about to see some tangible effects of this effort, as the FASB plans to issue in the next week or so its first exposure drafts that result from the short-term convergence project. The goal is to have the same treatment for these items under IAS and US GAAP by 2005.
I know that there is a lot going on in US GAAP right now, but I hope that the short-term convergence project doesn't slip under the radar screen. That isn't because the changes being proposed in the exposure drafts next week are going to be earth-shattering. In fact, the EDs cover some pretty narrow issues. However, these ED's are the first time the US will really have to contend with the results of supporting convergence. I say that because these ED's will propose changes to areas that were not priority issues in their own right. Thus, we face the potential of changes to US GAAP that wouldn't have been made right now if not for the convergence effort.
I believe the proposed changes could have significant benefits in two ways. First, of course, the benefits of having consistent global accounting for the issues addressed. But perhaps more importantly, each of them should also increase the quality of US GAAP in its own right. Remember that the way the short-term convergence project works is that the two Boards examine their respective guidance on each identified issue, and choose the higher-quality answer. Therefore, even looked at from a US-only perspective, this project represents a great opportunity to make incremental improvements in our accounting literature by leveraging off of the work performed in London.
My understanding is that the proposals will have a fairly long comment period, partially in recognition of the fact that so much is going on right now. I hope that during that long comment period, you all have a chance to consider the proposals and provide your thoughts to the FASB as to whether the combined benefits of incremental improvement and incremental convergence exceed the costs of making the changes proposed.
Principles-Based Accounting Standards
Let me move on to a topic that has just about become a buzzword these days — principles-based standards. Although I think of the issue of principles-based standards separately from international convergence, many people think of them together. This is because, to some, it is accepted that the US system is rules-based, and international systems are principles-based. If fact, when I'm working with those from outside of the US, and ask questions about their standards or regulations, it is not uncommon for the recipient of my question to respond by saying — "Well, ours is a principles-based system". Presumably, that answer is meant to communicate either 1) that there is no answer to my question, because to answer the question would be to make a rule, or 2) that my question is one only an American, who doesn't understand principles-based systems, would ask.
In any event, let me say this — I do not believe for a minute that US GAAP is devoid of principles. Indeed, I think there are principles behind all of FASB's standards. That isn't to say that there aren't rules in US GAAP as well -- there are a lot of them. In theory, however, the rules are there to make sure the principles and objectives of the standards are understood and followed. And that, I think, is where problems often arise. Eventually, because business responds to new guidance quicker than standard-setters can put it out, we get to a point in which it is possible to achieve paper compliance with the rules, while ignoring the principles completely. We should all try to identify and eliminate these situations.
SEC Staff Report
As I'm sure most everybody is aware, the SEC staff released a study this past summer on principles-based accounting. During the course of the past year, both before and after we issued the report, I've asked many people whether they are in favor of principles-based standards — by and large, everybody says "yes". I then typically ask what "principles-based standards" means. As you might suspect, there was zero consistency in answers. Some said the Concepts statements are all we need, others referred to IAS as principles-based guidance, another referred to the Ten Commandments as a good example of principles-based guidance. These differing views as to what "principles-based" means caused us to spend a fair amount of time in the SEC staff study describing what we were evaluating. Essentially, we decided that what Congress was really interested in, as opposed to a study of some specific definition of a "principles-based accounting system", was a report that evaluates whether the current way accounting guidance is provided is the best one. That's why our report begins by defining the attributes of an optimal system, which we termed "objectives-oriented".
Of course, the report expresses support, in general, for "objectives-oriented" standards, which, compared to current accounting standards, would contain fewer bright-line tests, less checklist style detail, better defined scopes, and clearer descriptions of objectives. Our report also identifies a number of hurdles to successfully moving to this kind of system. And it is in discussing and examining these hurdles that I begin to worry whether there is sufficient support for changing our standards in this manner. If we are to truly move to a system that relies on principles and objectives with some implementation guidance but not bright lines and detailed rules, everybody will need to get comfortable with making accounting choices based not solely on what the rules say, but based on what provides the most transparent, useful information. Remember that the detailed guidance that exists in US GAAP today got there because it was asked for. So we need to learn how to work without asking for all the detail.
Hurdles to Overcome
Reflecting on things I've seen in my admittedly short career, it's easy for me to identify some of the things that must change. First, the one that auditors always bring up: Preparers will need to stop asking "Where does it say I can't do what I want?" when the auditor suggests that the company change its accounting for something. I heard that question numerous times when I was auditor, and I'm sure it is still asked. It isn't the right question — the right question is "Why does your suggestion, Mr. Auditor, provide better information then my suggestion?" That puts the discussion in the right mindset, with the right focus.
Auditors, too, will need to make changes. Along the lines of the situation I just discussed, auditors need to get more comfortable telling clients that certain accounting treatments are unacceptable, even in the absence of literature that specifically says so. Now I know that many auditors in the audience probably have a knee-jerk reaction to that last comment. Many of you are probably thinking that you do indeed say "no", a lot more often than you get credit for. I agree — auditors already prevent or correct a lot of financial reporting and accounting errors, and make financial reporting much better than it would otherwise be. That being said, I have, several times in the past 15 months, been involved in conversations with registrants and their auditors that had the following general pattern. Registrant believes a transaction should be accounted for under Method A. Auditor believes Method A is unacceptable, but agrees that if the registrant writes to the SEC staff and the SEC staff doesn't object to Method A, the auditor will then sign off on statements that use Method A. In addition to raising questions about the auditor's professionalism and commitment to quality financial reporting, this kind of situation clearly encourages a proliferation in specific guidance.
Its only fair, as I talk about hurdles to moving to an accounting system that relies less on detailed guidance and more on judgment, that I acknowledge the SEC's role in the process. A system with less detailed guidance will, obviously, result in more situations in which different companies make different judgments with the same set of facts. We understand that, and have no intention of punishing those who make good faith efforts and reasonable judgments — in fact, I don't think we do that today. But with less bright-line guidance, we will need to adapt to enforcing a different style of accounting standards — we will need to ask different questions, evaluate explanations in different ways, and accept and live with different interpretations of the principles, where multiple interpretations each make sense. We will do our part in the process if everybody else is able to do their part.
Commercial Substance
Let me switch gears now, and turn to a topic that, in the printed version of my speech, is titled "Commercial Substance". I think we all probably learned, in one of our very first accounting classes, that accounting is supposed to reflect substance over form. You'd be surprised how often that pithy little rule has come to my mind recently. Let me start with how "substance over form" fits into what I think is the purpose of the financial reporting function. To me, it's quite simple — the purpose of accounting and financial reporting is to tell the truth, the whole truth, and nothing but the truth. It is to explain what happened and why. In other words, it is to report the substance of what occurred. And, in my view, that's the way the effectiveness of financial reporting should be measured. Unfortunately, financial reporting has been viewed by some as a potential competitive advantage — as something that can help them succeed by making their financial position and results of operations look good, even when the economics do not warrant it. That isn't what financial reporting should be about.
Structured Transactions
One of the ways that some seek to use accounting to make things look better than they are is by the use of transactions structured to achieve an accounting result. You know, some have suggested that the complexity of accounting standards is largely to blame for the many restatements we've seen in recent years. But the major accounting scandals more often result from restatements that have nothing to do with lack of understanding of accounting standards — in fact, often the opposite is true. Scandals occur in situations in which the participants understand the accounting standards very well — so well in fact that they believe they can find their way around the literature if they structure a transaction "correctly". This is often the case with SPEs — at least the ones that we commonly think of as abusive. This is also the situation with a fair number of non-substantive "round-trip" transactions. And I'm sure just about everybody in the audience today, not to mention those of us on the stage, has seen many examples of transactions structured to meet an accounting goal.
So let me give you some advice that is equally applicable to preparers, auditors, lawyers, bankers, and other advisers. If you find yourself working on a transaction that has been initiated or deliberately restructured in order to obtain an accounting result that would not otherwise be obtained, think very critically about what you're doing. Often, this structuring is indicative of a goal using accounting that reflects more positively on the company than the substance of the transaction warrants. In other words, these transactions often are set up to frustrate the goal of telling the truth and providing transparent financial information.
Professionalism
I'm sure that advice — to refuse to be involved with transactions that seek an accounting edge, sounds overly harsh to some of you. What I'm asking for, though, is integrity and professionalism. Quite simply, engaging in or supporting the use of transactions designed to produce accounting results that are different from the economics is not professional behavior for anybody involved. Don Nicolaisen spoke a few minutes ago about the importance of professionalism. Refusing to be involved with these kinds of transactions, and working to eliminate them, is a tangible thing that we can all do to demonstrate professionalism. I'd encourage everybody to think about this as you move into the year-end process.
Conclusion
At this point, I will conclude my prepared remarks. I will be back later today on the Q&A panel to respond to any questions you may have. Thank you for your attention.
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