AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS 1997 National Conference on Current SEC Developments Washington, DC December 9, 1997 CURRENT DEVELOPMENTS IN FINANCIAL REPORTING: Perspectives from the SEC Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission Washington, DC __________________________________ 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.