UNIVERSITY OF SOUTHERN CALIFORNIA SCHOOL OF BUSINESS ADMINISTRATION 16th ANNUAL SEC AND FINANCIAL REPORTING INSTITUTE MAY 29, 1997 CURRENT FINANCIAL REPORTING ISSUES Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission ____________________________________ 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 Good morning. Thank you for inviting me to be here and to share a few thoughts about current financial reporting issues from the perspective of the Office of the Chief Accountant. Today, I am going to focus on recent developments relating to three issues -- auditor independence, accounting and disclosure for derivatives, and international accounting standards. Before I begin, as is customary, I am obliged to remind you that the views I express are my own and are not necessarily the views of the Commission or others on the staff. Auditor Independence I believe most everyone here is aware that, last week, the Commission and the AICPA announced the creation of the Independence Standards Board, a new, private-sector body that will be charged with responsibility for addressing auditor independence issues and establishing independence standards for auditors of public companies. That announcement capped a cooperative effort between the accounting profession and the Commission to find ways to preserve and strengthen public confidence in the independent audit. As accounting firms have expanded into new service areas and merged and restructured their operations, and as business and professional relationships have become more complex, the existing processes for addressing issues relating to the fact and appearance of auditor independence have been strained. Indeed, we have been through a time in which questions have been raised on a number of fronts -- questions about relationships that might involve auditors too directly in management functions, questions about whether auditors have been advocates for the views of their clients in financial reporting matters, and questions about whether management has too much control over the audit relationship and how the relationship with independent directors and the audit committee can be strengthened. As these issues have come into focus, it has become increasingly clear that many of today’s independence regulations -- some developed years ago -- don’t provide adequate guidance for today’s environment. I am very encouraged by the initiative and the commitment to the public interest that the accounting profession has shown by taking this important step. The substantial public participation in this new process is encouraging. It also is reassuring that the new Board will have at its helm a Chairman of the caliber of Chancellor William Allen. Here are a few key facts about the new Board: * The Board will have eight members -- four practicing CPAs and four public members -- prominent individuals of high integrity and reputation -- who understand the importance of investor protection and the important roles the accounting profession and the independent audit play in US capital markets. * Standard-setting meetings will be open to the public, and proposed standards will be exposed for public comment. * The Board will be assisted by a nine-member Independence Issues Committee, made up of CPAs from firms that audit public companies, that will help with the timely identification and discussion of independence issues for consideration by the Board. * The Commission expects to recognize the Board as the private- sector body responsible for establishing independence standards for auditors of public companies and to consider its standards to have substantial authoritative support. * The Commission and its staff will oversee the work of the Board, and the SEC’s existing statutory authority over auditor independence matters, including the ability to bring enforcement actions, will continue. This is a tremendously important development for the public, for the profession and for self regulation. It offers an opportunity to take a fresh look at -- and find solutions for -- knotty issues that have become more and more challenging over the years. The model for this public/ private sector partnership was the FASB, and my hope is that this process will be equally successful. I look forward to working with the new Board as it undertakes its challenging assignment. Derivatives Accounting and Disclosure When I came to the Commission about two years ago, the financial reporting issue commanding the most attention and highest priority was accounting and disclosure for derivatives. It was a time when a series of highly-publicized derivatives losses had caught investors by surprise, and public awareness of the dramatic growth of derivatives activities was increasing. That growth has continued, and I am told that by the end of 1995, the notional amount of derivatives outstanding in the US had surpassed $20 trillion. What became apparent then, and continues as a priority issue today, is the realization that our accounting and disclosure system has not kept pace with the expanding role these instruments play as risk management tools for American business. As you know, the Commission and the FASB have been pressing ahead with important initiatives to address this financial reporting gap. Derivatives Accounting The FASB has pursued the accounting issues through an exposure draft that sets forth a proposed new model, and since January, the Board has been re-deliberating its proposals. It is encouraging to hear that the Board expects to complete its study in the next few months. I think it is important to recognize that, during its deliberations, the FASB has decided on a number of changes in response to issues raised in comment letters and during its public hearings. It seems to me that the Board has worked hard to try to address the legitimate concerns of its constituents without undermining the integrity of its proposal. Despite these changes, however, some of the most vocal critics continue to argue that more needs to be done. Some continue to say, for example, that the changes will result in artificial volatility in earnings and equity, or that the new model will favor inefficient -- rather than efficient -- risk management tools. I will offer a few thoughts about those arguments. First, we must acknowledge that when a derivative used as a hedging instrument is not an effective hedge, the new model will report earnings volatility. It seems to me, however, that, in fact, earnings are more volatile when a derivative is not effective at offsetting the risk that the derivative is supposed to hedge. Thus, reporting the real, rather than expected, outcome of hedging activities may, at times, result in earnings volatility. Reporting that volatility, however, is not the same as reporting artificial volatility. Rather, it is capturing, in the financial statements, real economic events that often are not reported today. With respect to the impact on equity of hedges of forecasted transactions, the Board has a bit of an accounting dilemma to deal with -- the same dilemma that we have today in our mixed attribute accounting model. Because we have different accounting for different types of financial instruments and transactions, including derivatives, changes in the values of economically hedged positions sometimes are recognized in different periods than changes in the values of the hedge instruments. In this financial reporting environment, improving the relevance of derivatives accounting requires tolerating some equity volatility. This is not a new issue -- the Board has faced this trade-off in a number of its past projects. I believe that improving the relevance of financial reporting by recording all derivatives on the balance sheet, at fair value, is a reasonable and necessary decision. In essence, this move will bring derivatives out of the footnotes and into plain view. The necessary price for that improvement will be some trade off -- until the Board considers the accounting for financial instruments more broadly. With respect to any alleged favorable treatment for some types of risk management tools, at the expense of others, I think that it is important to recognize -- again in the context of our current mixed attribute model -- that once the Board decided to permit hedge accounting, it effectively committed to a series of rules that would likely accommodate some, but not all, hedging activities. The same thing can be said for our accounting rules today, however. For example, currently we have hedge accounting rules for futures that are different than the rules for swaps and different rules for foreign currency forwards than for foreign currency options. I see nothing in the Board’s proposal that supports a conclusion that the new accounting model will create the kind of chaos in financial reporting -- and therefore in our capital markets -- that some fear. Nothing in the proposal would prohibit companies from engaging in the risk management activities they choose -- prudent or otherwise -- and explaining those strategies and their accounting impact in the financial statements. We all should keep in mind that, with every major change in accounting standards that the FASB has made, some have predicted dire consequences, and we should assess those claims objectively. Derivatives Disclosure As you know, in January 1997, the Commission adopted a Rule that calls for new forward looking disclosures about derivatives and other financial instruments. In recent weeks, there have been a number of press reports about various groups, including some Congressional committees, that have been critical of the Rule and have questioned whether its benefits justify its cost. Some of those reports have even suggested that the Rule has been overturned or otherwise delayed -- which is not true. Rather than attempting to articulate -- or respond to -- the specific criticisms here, I will only reiterate why the Rule was adopted. Very simply, the Rule was an effort to make the market risks inherent in derivatives and other financial instruments more transparent to investors. It is expected to provide investors with a reasonable amount of information at a reasonable cost. As a result, investors should be able, for example, to distinguish the risks of a portfolio of 30-year assets from the risks of a portfolio of 30-day assets. To recognize that the Rule breaks new ground in disclosure of market risks, the Commission built in a three-year review period, after which it will assess how well the Rule is working and whether changes are needed. In response to concerns raised by some members of Congress, the Commission also has undertaken to review the operation of the Rule about one year after implementation. As part of that review, the staff will analyze the disclosure and other data received from this first group of filings. The staff also will continue to discuss the impact and effectiveness of this Rule with registrants, investors, analysts, academics, and other interested participants. We expect to complete our review of these early filings around June 1998. International Accounting Standards The International Accounting Standards Committee, or IASC, currently is working to establish a core set of accounting standards to facilitate cross-border filings. Many groups around the world -- including the International Organization of Securities Commissions, or IOSCO -- have supported these efforts because we all are looking for ways to reduce unnecessary inefficiencies in cross-border capital flows. As a result, today there is significantly increased coordination among standard setters around the world -- not only through the IASC, but also through separate, important efforts like “G-4,” an informal group composed of national standard setters in the US, UK, Australia, and Canada. These groups share the objective of getting standard-setting bodies working on consistent objectives and from similar points of view. Standard setters around the world already are reaping benefits from this work as they share resources and focus on common problems. One complaint frequently heard in the process of developing international standards is that US standards too often are the benchmark. I believe that US standards tend to be emulated because they were developed to be responsive to the needs of investors and capital markets. US capital markets are characterized by widespread participation of individual investors, either directly or through mutual funds. These highly liquid, public markets have been a primary source of capital for American businesses and have created a public equity market culture. In other countries, banks and insurance companies often are the primary source of capital, and accounting standards that have evolved in those countries tend to reflect different primary audiences. I think we need to acknowledge that US standards, while demanding, have satisfied the needs of our capital markets very, very well. A frequent criticism of US standards has been that they are a “cookbook” -- that they preclude application of professional judgment. I think most realize that this an overstatement. No standard can eliminate the need for interpretation and judgment; the business environment changes too fast. The number of interpretive issues addressed each year by the EITF and the SEC staff is clear evidence. Undeniably, US standards are more prescriptive than those in other parts of the world -- in large part because our capital markets place a high premium on comparability. While no standard can assure complete comparability, it is critical that standards be developed that measure comparable transactions and events in comparable ways. To do this, the standards must provide clear and unambiguous guidance, and they must be consistently interpreted and applied. It is particularly important to keep this expectation in mind as the IASC’s core standards project addresses the most difficult issues on its agenda, including, for example, financial instruments, intangible assets, and impairments . While international standards are a desirable goal for US markets and companies, they are just that -- a goal and not a necessity. Our financial reporting system has served the US capital markets well, and it has been a widely accepted passport for US companies accessing markets in other countries. The acceptance achieved by US standards in other capital markets, I believe, attests to the high quality of our accounting and disclosure system. This does not mean that the development of international accounting standards is not important. We should not ignore the fact that markets are becoming more interconnected -- and we have to look for ways to improve the efficiency of capital flows between markets, while still protecting investors in the US markets. But it does bear repeating that acceptance of international standards in filings in the US is not a foregone conclusion. Certainly, it would be easier to connect separate markets if we all spoke the same language -- in the same way it is easier to network a group of computers if they all use the same software. But agreeing on a common language will not provide benefits if it becomes merely a search for the lowest common denominator, or an excuse to dilute demanding, but effective, national standards. Our participation in efforts to improve international accounting standards is a cooperative effort to build a framework for the 21st century -- a framework that should enhance -- not compromise -- the strength and stability of US capital markets. Conclusion Again, thank you for asking me to be here today. # # # # # # #