Speech by SEC Staff:
Remarks before the Leventhal School of
Accounting: SEC and Financial Reporting Institute
by
James L. Kroeker
Deputy Chief Accountant, Office of the Chief Accountant
U.S.
Securities and Exchange Commission
Pasadena, California
May 31, 2007
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.
Good Morning. It is certainly an honor to participate in this
conference with its reputation as one of the premier financial accounting
and reporting events on the West Coast and I want to extend my thanks for
the invitation. While this is my first time attending or participating in
this prestigious event, interestingly enough, my last trip to the L.A.
area was also prompted by my desire to attend a world class event hosted
by the University of Southern California. I traveled to the West Coast
with great expectations for a successful day and on the date of the event
awaited anxiously for the activities to begin. However, shortly after the
beginning of the festivities I came to the realization that the event I
had chosen to attend was going to be a great disappointment for me (along
with thousands of other Nebraska fans who made the trip to the coliseum).
Indeed, as has been the case for many over the last few years the Trojans
went out to easily defeat my alma mater. However, after looking at the
line-up in today's schedule of events, I'm certain that, unlike that day
last fall, today's event will not be a disappointment.
As I'm sure many of you can attest, it is a challenging time to be a
member of the accounting profession, I personally believe it is also an
extremely exciting time. As a profession we face a host of exciting
opportunities, and through these opportunities we have the potential to
define the direction and the future of financial accounting and reporting
for years to come. I'm confident that during the course of today we will
hear about and discuss a number of projects, ideas and initiatives focused
on ways to improve upon our existing financial reporting framework. I'll
spend just a few minutes highlighting some of the initiatives that we have
been focused in the Office of the Chief Accountant; you'll hear more
detail in the next panel addressing current developments at the SEC. With
the balance of my time I will focus on a few areas where I think we can
make immediate and meaningful progress in addressing the challenges we
face on a daily basis.
However, before I go any further I must say that one of the things I
have picked up on very quickly in my new role is that I need to remind you
that the views I express here today are my own and do not necessarily
reflect the views of the Commission, the Commissioners, or other members
of the Commission staff.
AS No. 5 and Management Guidance and International Activity
Let me begin by highlighting just a few projects that will have a
significant impact on financial accounting and reporting. I'll just
highlight the initiatives and Joe Ucuzoglu will discuss these projects in
more detail in the next panel.
First, let me highlight the guidance to be issued to assist management
in its requirement to assess internal controls. The Commission's proposed
interpretive guidance to management for Section 404 of the Sarbanes-Oxley
Act is founded on a couple of key principles. The first, management should
evaluate whether it has implemented controls to prevent a material
misstatement. Second, management's evaluation should be based on their
assessment of risk. These principles, the foundation of the Commission's
guidance to management, should provide a framework for companies (both
large and small) to make an assessment in an efficient and effective
manner. At a Commission meeting last week, the Commission unanimously
approved the new guidance. This guidance provides management with a clear
framework, outside of the auditing guidance, enabling them to focus on
what matters to investors in financial reporting.
Moving on to the PCAOB's proposed new auditing standard (AS No. 5).
This proposed auditing standard should, if approved by the Commission,
also result in meaningful improvement to the financial reporting process.
While AS No. 2 has unquestionably provided much needed and significant
improvements, it also did so by adding tremendous costs. As stated by SEC
Chairman Christopher Cox, "Congress never intended that the 404 process
should become inflexible, burdensome, and wasteful". By focusing the
direction of audits on areas of risk and by encouraging a more integrated
approach, this new standard has the potential to provide significant
benefits to investors. Focusing on risk will not only result in a more
efficient process but will, as a result of that greater focus on risk,
result in a more effective process as well (resulting in a greater focus
on those controls that really matter). Jointly, the new management
guidance and auditing standard have the potential to strike the right
balance, maintaining and building upon the benefits already realized under
Section 404 while eliminating unnecessary or inefficient uses of
resources.
The third major initiative that I want to briefly highlight is in the
area of international financial reporting standards. Just a few short
weeks ago the Commission issued a press release announcing the intention
to issue a Proposing Release requesting comments on rule changes that
would permit the use of IFRS (international accounting standards), as
issued by the IASB, in financial reports filed with the SEC by foreign
private issuers. In addition, the Commission expects to issue a Concept
Release addressing whether U.S. issuers should be provided the same option
as their foreign counterparts. That is, the Concept Release will address
the issue of whether U.S. issuers should be permitted the option of moving
away from U.S. GAAP and applying IFRS. While the idea of allowing the use
of international accounting standards is a new one, the impacts on
investors, preparers, auditors and others could be significant. The
opening up of the U.S. capital markets to IFRS has the potential to shape
the future of financial reporting and I encourage each of you to take the
opportunity to provide input to the releases. I look forward to reading
what I am certain will be many thought provoking and insightful
responses.
Immediate Steps to Improve Financial Reporting
As the SEC's Chief Accountant, Conrad Hewitt, has expressed on a number
of occasions, addressing complexity in financial reporting is one of the
top priorities of our office for the foreseeable future. Complexity in our
current financial reporting system has been the topic of significant
discussion and interest, at conferences such as these, in the media, and
certainly in Norwalk CT and in Washington D.C. Many rightly question
whether the U.S. financial reporting system (the premier system in the
world, in my opinion) could be improved by a concerted and aggressive
effort to address the issue of complexity and transparency in accounting.
Many also rightly question whether, if not addressed, the current level of
complexity in our system has the ability to undermine our competitive
advantage in financial reporting. As I stated before, the issue of
complexity in financial reporting will be a high priority for our office
over the next year (it's an area I am concerned deeply about and one of
the reasons that I took the job). Our office has been working closely with
the FASB and the PCAOB to address the issue, and one of the potential
ideas is to form a committee to study the causes of complexity, to
consider the transparency of current financial reporting and evaluate the
need for changes. The idea would be for the committee to study the issues
and make concrete recommendations as to how we can continue to improve
upon the best system of financial reporting in the world. It is an idea
that FASB Chairmen Bob Herz has been speaking about for a while now and I
think the time is right to get something going in this area. I am hopeful
that we will see some meaningful activity on this front in the near
future.
I think taking a step back to study ways to reduce complexity and
improve transparency is a much need effort. However, I do not believe that
we need to wait for the recommendations of some committee to make strides
to address complexity as we strive to improve upon our financial reporting
system. I believe that there are meaningful steps each of us can take,
almost on a daily basis, as we go about fulfilling our respective roles in
the financial reporting network. With the balance of my time here this
morning, I'll offer just a few suggestions or observations that I have in
this regard.
Focusing on the objective of existing standards
There appears to be a growing sense that U.S. accounting standards are
"rule-based" and that standards established internationally are more
"principles" based. In my opinion, there is too much guidance (maybe that
leads to the conclusion that there are too many rules) when it comes to
telling us how to apply U.S. standards. However, it is certainly not clear
to me that there is any common agreement on what exactly a
principles-based standard setting regime should look like. Further, it is
even less clear to me that U.S. standards are inherently less
principles-based than those established in London. In fact, I would
contend that the vast majority of U.S. standards were established with a
principle or objective in sight. Undoubtedly, exceptions, bright-lines,
application guidance and interpretations (what may be viewed by some to be
"rules") can have the effect (at least from time to time) of blurring our
vision on the principles. What is clear to me is that the volume of
guidance in the U.S. is certainly more expansive that the volume of
guidance related to other accounting standards systems.
Given that the vast majority of U.S. standards are written with an
objective(s) in mind, it is in this area that I believe we can all benefit
by focusing on the existing standards and their underlying objective. When
faced with a question related to how to account for a given activity, take
a step back, if there isn't an existing rule don't ask for one, rather see
if the question can be addressed within the existing framework of the
literature.
While I am not at all suggesting that we ignore the words in existing
authoritative accounting literature, I believe that we can make meaningful
improvements in our process by stepping back and focusing on the
objectives or principles (the P in GAAP) when considering how to account
for a transaction. I believe that in the long run we will find more
simplicity in looking to the objective of a standard rather than seeking
for a rule. Taking a broader step back and considering the underlying
economics of a transaction and how to most accurately portray a
transaction is a useful exercise, which leads me to my second point.
Exercising professional judgment
Exercising judgment is a necessary and valuable component of our
financial reporting framework. Many have made this point in the past, and
while I certainly do not want to sound like a broken record, I believe it
is an area where we can all afford to focus some additional attention
(regulators, standard setters, preparers, auditors and even users of
financial information). I believe that we can take important steps forward
by resisting the temptation to provide (as standard-setters and
regulators) and to ask for (as preparers, auditors and regulators)
guidance to address the myriad of potential financial accounting
difficulties we see on a daily basis. Rather than seeking detailed
guidance we should first seek to address the given difficulty by looking
to the objective(s) of a standard and applying professional judgment.
While again I am not suggesting that we ignore the existing accounting
guidance, I am suggesting that in places where bright-lines, exceptions
and rules do not exist we all need to resist the temptation to ask for
them. It seems fairly clear to me that if we keep asking for more and more
interpretative work, scope clarifications, and the like then it should
come as no surprise when we find that our standards become overly burdened
and detailed. On the other hand, if we are going to get to a place where
as a profession the volume of bright-lines and other interpretative
guidance is reduced, the temptation to structure accounting motivated
transactions that are not consistent with the objective of transparent
reporting needs to be resisted. It will be difficult to move to a less
complex world if, when faced with an accounting alternative that appears
to be in conflict with the objective of a given standard the response from
accounting professionals is to ask "show me where it says that I can not
do this?". This sounds like a call for a rule and in the past that has
often been the response.
Likewise we must understand that accepting judgment will mean accepting
some level of diversity in practice. This has to be the case as there will
certainly be times when reasonable people acting in good faith will not
reach identical conclusions in practice. Accounting, at least in my
opinion as practiced today, is not a series of immutable truths. There
certainly will occur, from time to time, situations where the reasonable
application of judgment will result in more than one acceptable accounting
or financial reporting conclusion. If you don't believe this just listen
to the discussion that goes on at a FASB board meeting when they are in
the process of debating an accounting issue. There are clearly issues
where even the top minds at the FASB find room for reasonable disagreement
and I can assure you that the same thing happens in our office from time
to time.
Some may believe that any significant application of judgment in
accounting and the potential for diversity in views will lead to
significant non-comparability from one company to the next. As already
discussed, it's important to keep in mind that it is likely impossible and
in my view certainly not desirable to eliminate professional judgment from
accounting, and I don't believe we should try to do so. Instead, if we are
to move forward with focusing more on objectives, we need to re-focus
accounting professionals to spend their time applying judgment in the
right areas -- the principles or objectives, rather than specific rules.
Of course this may require some training to refocus accounting
professionals. However, if professional judgment of preparers and auditors
is exercised in the interest of investors, principles-based standards have
the potential to increase the transparency and comparability of financial
reporting. In a regime that is overly proscriptive or "rules-based" where
the focus is on compliance with a set of rules or where the rules detract
from the objective the potential to create a smokescreen in which one
might try and hide inferior financial reporting is introduced. Such a
system also has the ability to foster an environment where structuring the
terms of transactions to achieve an accounting objective without
consideration of the true economics becomes acceptable. I believe that
investors are better served (through increased transparency) and
complexity is reduced when the role of accounting professionals is one of
focusing on faithful reporting of business. Professional judgment is
critical to this process.
In this regard, disclosure of transactions in which significant
judgment is required seems like an extremely useful tool for management to
describe the economics of a transaction, the business purpose and the
judgments involved in reaching an accounting conclusion which brings me to
my third and final point.
The role of transparent disclosure
As I just discussed, in applying judgment there will inevitably be
times when there are multiple reasonable conclusions. Rather than asking
for a rule to address each and every one of those situations, I would be
much more comfortable seeking to deal with the issue by asking companies
to explain in plain English the conclusion reached, how the accounting
principle(s) was applied and the significant judgment(s) made.
In fact, I believe that complexity in accounting can be reduced when
companies approach financial statement disclosure from the standpoint of
thinking about disclosures as an opportunity to communicate clearly with
investors, rather than approach disclosure from the view point of the
minimum requirement of a given standard. Approaching disclosure from this
perspective appears to me to be a step that entities can take that will go
a long way to helping users understand the significant judgments made by
management.
I believe it is important for the financial reporting community to
continue to embrace the opportunities that we face and I am excited about
the direction we appear to be moving toward. However, many of the
initiatives that we are talking about as a profession will not have an
impact overnight. I outlined just three small areas (I'm certain that
there are many others) that I believe can have an impact on each of us as
we strive to improve upon our financial reporting system. Thank you again
for the opportunity to participate in the program today.
http://www.sec.gov/news/speech/2007/spch053107jlk.htm
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Modified:
06/08/2007