-------------------- BEGINNING OF PAGE #1 ------------------- THE FUTURE OF ACCOUNTING AND FINANCIAL REPORTING PART II: THE COLORIZED APPROACH REMARKS OF COMMISSIONER STEVEN M.H. WALLMAN BEFORE THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS TWENTY-THIRD NATIONAL CONFERENCE ON CURRENT SEC DEVELOPMENTS -[1]- * The views expressed herein are those of Commissioner Wallman and do not necessarily represent those of the Commission, other Commissioners or the staff. U.S. Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 I. Introduction A year ago I had the privilege of attending this same AICPA National Conference on SEC Developments, and I thank you now for the opportunity to appear before you again. At that time, I shared with you a few thoughts relating to accounting and financial reporting. I expressed my belief that accountants are the primary gatekeepers to the integrity of our financial markets. Without accountants, and without a consistent and well thought through set of auditing and accounting standards and principles to assure the quality and integrity of financial information, the capital markets would be much less efficient, the cost of capital would be higher, and our standard of living would be lower. This is particularly clear to me from my vantage point as an SEC Commissioner. For the past 60 years, the Commission has relied heavily on the accounting profession. The profession has been critical in helping to satisfy the Commission s statutory responsibility to craft accounting standards for public companies that assure that our markets receive the highest quality financial information. Notwithstanding this effort over more than half a century, I suggested last year that we are now at a cross-road in terms of our system of accounting and, more generally, financial and corporate reporting. Many, including others more knowledgeable in this area than I, are concerned that such reporting is not keeping pace with the accelerating changes in the business world. In a real way, such reporting is at risk of diminishing its utility -- and this to a serious degree. I --------- FOOTNOTES --------- -[1]- The following remarks represent the second ofa series of speeches planned by Commissioner Wallman on issues related to the future of accounting and financial reporting. The first commentary in this series was published in the September 1995 edition of Accounting Horizons. -------------------- BEGINNING OF PAGE #2 ------------------- encouraged those of us involved with accounting, standard setting, and financial and corporate reporting to develop a vision of what the future might hold in terms of challenges and opportunities for accounting and financial and corporate reporting -- and to reach for that vision. During my remarks last year I also discussed certain specific problems that affect the utility and relevance of accounting and financial reporting. I would like to review those problems briefly, while noting the various goals of financial reporting, in other words, why we care about financial reporting. I will also review some of the tensions among these goals that make improving the system not as easy as one would hope. I would then like to share with you my thoughts on a model for enhancing the utility and relevance of financial accounting and reporting. Before beginning, I would like to make two general observations. First, I want to make it clear that I am not an expert in accounting, and that the model that I will describe represents my preliminary thinking. I also recognize that there are many who are experts in this area and who may view the model that I will discuss as evolutionary rather than revolutionary, when, in fact, they believe a wholesale change in our accounting and financial reporting is necessary to effect true change and progress in these areas. I have some sympathy with this view. However, my goal this morning is not to offer a perfect solution, but to take advantage of the opportunity to receive your expert views and encourage you to devote greater attention to the future of accounting and financial reporting so that we do not lose the advantages that our current system historically has bestowed upon our markets. We must stimulate discussion and creative thinking on these issues in order to avoid being overwhelmed by the challenges that will face accounting and financial reporting in the coming years. Second, I believe that the recent enactment of the Private Securities Litigation Reform Act of 1995 also presents us with an opportunity to improve the quality of accounting and financial reporting. -[2]- Historically, two of the primary concerns with expanding the scope of financial disclosure have been the need to maintain the involvement of auditors in the disclosure process, and the potential liability associated with new disclosures that may be less reliable or certain than traditional disclosures, such as forward looking information. The Litigation Reform Act touches on each of these concerns. The Act has implications for the future of accounting and financial reporting in two respects. First, by enhancing the duties of accountants to monitor for and report illegal practices, the Act recognizes and reinforces the role of accountants in financial reporting, over and above the attestation function traditionally performed by the profession. Second, the Act recognizes that some information that is useful to investors is inherently subject to less certainty or reliability than other information. By providing the safe harbor for forward looking statements, Congress has sought to facilitate access to such information by investors. Finally, one last caveat -- as is always the case, the views that I express this morning are my own and do not represent the views of the Commission or its staff. --------- FOOTNOTES --------- -[2]- Public Law No. 104-67 (1995). -------------------- BEGINNING OF PAGE #3 ------------------- II. The Importance of Accounting and Financial Reporting From the most generalized perspective, the purpose of accounting and financial reporting is to provide information that is useful to investors, creditors, monitors, and others -- increasingly including employees and major suppliers and customers -- in making investment, credit, monitoring, and other decisions. This general goal may be further defined and analyzed by describing three specific and distinct purposes and functions of financial reporting: (1) asset, capital and investment allocation; (2) "contracting" and ex post settling-up ; and (3) corporate stewardship and monitoring. A. Facilitating the Efficient Allocation of Capital, Assets and Other Investments Financial accounting and reporting should facilitate the appropriate allocation of capital, assets and other investments, including human capital. Clearly, suppliers of capital -- of all types -- want reliable and relevant information about their investment and investment opportunities. In the absence of certain externalities that I will discuss in a moment, entities seeking capital will disclose such information to reduce the information risk premium ultimately sought by capital suppliers. While neither the existence nor mandatory use of a standardized system of accounting and financial reporting is a prerequisite to the acquisition of capital -- for example, suppliers and users of capital, including human capital, might effectively contract for such information in the absence of a standardized system -- a standardized system reduces the transaction and investigation costs that otherwise would be incurred under a contractual agreement, much in the same way that the use of a common language facilitates everyday communication. Thus, financial disclosures in accordance with a well-defined and well-understood set of standards help bring users and suppliers of capital together in a cost-effective manner, thereby reducing the cost of obtaining capital. B. Providing for Contractual and Ex-Post Settling-Up Mechanisms Financial reports also are used in connection with contractual and ex-post settling-up arrangements. For example, lenders often require borrowers to maintain certain financial ratios and to conform to other covenants based on accounting measures. By providing uniformity in measurement and reporting, as well as attestation where relevant, accounting and financial reports facilitate "ex-post settling-up among contractual parties, thereby encouraging cost-efficient contractual arrangements. C. The Stewardship" Function Accounting and financial reporting also help outsiders monitor the performance of company management, and company management to assess its own performance and that of the company s other employees. For example, the segment reporting required by GAAP and Commission rules provides shareholders and analysts with insight on the relative distribution of company product area profitability and trends. Similarly, some believe that management reporting systems based on financial accounting models and GAAP provide invaluable information to senior management regarding the operation of divisions, subsidiaries and -------------------- BEGINNING OF PAGE #4 ------------------- other business units. However, the utility of this information has been criticized by others precisely because it is based on financial reporting which, in the view of these critics, is designed to meet different needs. D. Summary: Purposes and Functions of Financial Reporting The contractual functions of accounting seem reasonably well-served by the current model. In the event a user does not believe the current model adequately addresses its needs, that user can -- quite literally -- contract around any deficiency and customize the model as necessary, albeit some cost. It is in the other two areas -- the capital and asset allocation, and the monitoring/stewardship areas -- that accounting and financial reporting do not appear to be meeting the needs of users as well as they might. There also is an inherent tension between the capital allocation and stewardship functions of accounting and financial reporting, from the perspective of those who have to report. As I mentioned, in a perfect world, one would expect that users of capital -- senior managers -- would wish to reduce their firm s cost of capital by disclosing information about their activities to the point where the costs of such disclosure equals the perceived benefits in terms of reducing information risk. However, the more information that is disclosed to meet this goal, the more likely that senior managers will be subjected to higher levels of scrutiny and review by those who are in a monitoring role, and the more likely that proprietary or confidential information will be compromised. For example, disclosure of sensitive information relating to management's expectations about a development stage product might raise competitive issues and hamper management in meeting its goals and objectives for the product. It may also reduce management s discretion to make disclosures that it might prefer to make at other times. III. The Decreasing Relevance of Accounting and Financial Reporting Given the historical importance of financial reports, the issue is are they becoming increasingly less useful and, if so, how do we make them increasingly more useful? As noted by the AICPA s Special Committee on Financial Reporting (the Jenkins Committee ), there is little evidence to suggest that users are abandoning financial statements altogether. But I believe it is clear that financial reporting is in danger of becoming less useful at an accelerating pace. There are several indications that this is the case. For example, traditional financial statements are now significantly less reflective of the assets that create wealth than in times past. Intangible assets such as brand names, intellectual capital, patents, copyrights, human resources, etc. are generating an increasing amount of our overall wealth. Moreover, new, sophisticated risk management instruments that can change a firm s business or risk profile overnight are proliferating, thereby calling into question the timeliness of -------------------- BEGINNING OF PAGE #5 ------------------- disclosure. -[3]- Last year, I explored what I believe are the primary reasons underlying the diminishing utility of accounting and financial reporting, so I will just reference them here to give context to my remarks. They may be summarized by reference to the age old questions of "who", "what", "when", "where", "how", and "why". A. "Who" is the Company? The Changing Concept of the Firm It is becoming harder to define the outer edges of companies. The information revolution is moving us to a new plateau where businesses can operate with greater agility than ever before. I agree with the AICPA Breakthrough Task Force's report that the size of the average legal entity will likely decline by 2005, as firms, their suppliers, employees and customers work together in relationship-based transaction systems. These transaction systems will be focused around the formation of closely linked "clusters" of entities -- or "virtual firms" -- that, in the aggregate, may be much larger than the consolidated entities of today. -[4]- We already have virtual firms today depending on the flexibility of your vision. For example, VISA International can be viewed as a firm with vast resources in a "nontraditional" business structure that makes for a virtual firm. Going forward, we also will have virtual firms with thousands of individuals networked together in combinations that form and dissolve as tasks are required to be performed. The key assets of such a virtual firm may well be only soft assets such as human resources or intellectual capital, its outer edges will change daily as needed and as is efficient. Certain service oriented firms -- such as law and accounting firms -- currently meet this description in that they rely primarily on human resources or intellectual capital. However, it is the networking of various entities and the continuous changing and adapting of the outer edges of the firm -- including nonservice firms -- that have never been available in a significant way in the past, but which will increasingly become the norm, that will become the foundation for the virtual firm. --------- FOOTNOTES --------- -[3]- Furthermore, since the late 1960's, empirical research has indicated a material time lag between the reflection of economic events in share values -- meaning that investors have already learned of and absorbed the information -- and the disclosure of those events through periodic accounting reports. While this observation does not suggest that financial reporting is without utility -- for example, periodic reports clearly deter arbitrary public disclosures bymanagement by ensuring that such results ultimately will be reported in accordance with GAAP -- it does suggest a significant timing issue related to financial reporting. See, Ball, R. and Brown, P., An EmpiricalEvaluation of Accounting Income Numbers, Journal of Accounting Research (Autumn)(1968); see also, Warfield, T. and Wild, J., Accounting Recognition and the Relevance of Earnings as an Explanatory Variable for Returns, The Accounting Review (October)(1992). -[4]- See AICPA Special Committee, Report of the Breakthrough Task Force at 7-8 (1994)(the AICPA Breakthrough Task Force ). -------------------- BEGINNING OF PAGE #6 ------------------- B. Determining "What" to Value: Recognition and Measurement Issues We also should question exactly "what" it is we are measuring and reporting. As mentioned earlier, historically, the assets and liabilities used to produce wealth were recognized in financial statements at cost and were "hard" or tangible -- like plant and equipment. However, the shift to a knowledge-based economy has created or focused increased attention on entirely different categories of assets such as brand names and other soft assets previously mentioned. With certain limited exceptions, such as the purchase of a brand name, these "soft" assets are not recognized in the financial statements. The primary obstacles relate to valuation difficulties, the inherent uncertainty of any value ultimately determined, and the resulting potential for fraud. As a result of these concerns, we attribute no value in financial reports to something as obviously significant as Disney's Mickey Mouse. This cannot be the correct result for the long-term utility of financial reporting, particularly given the increasing importance of firms with "soft" assets. Some suggest that the values of these assets are ultimately reflected, implicitly, in the statement of cash flows or in earnings, and therefore they need not be reflected elsewhere. Unfortunately, however, because it might be nice for simplicity s sake if such an answer were right, the same can be said for all other assets in the balance sheet. Our task then is either to improve the credibility and reliability of soft asset valuations, or to find other creative solutions to the problem - - not to ignore this fast growing segment of our economy. C. "When" to Report? The Timeliness of Financial Reporting The rapid acceleration of events that may significantly affect share values has started to make our system of annual audits and quarterly reports obsolete. Today's annual and even quarterly reports -- relying on recognized items as the core of the reports -- do not capture and communicate material developments in sufficient time to meet market informational needs. Product cycles have shortened, risk management practices have improved and are more prevalent, and products and whole companies become obsolete much more quickly now than ever before. It is hard to obtain a good picture of a quickly moving and changing item when only snapshots are taken at relatively long intervals. As I mentioned last year, I am not suggesting now a system of monthly, weekly, or daily audits and report filings with the Commission. I am suggesting, though, that over time we will need to develop a system that fills the need for timely -- and ultimately real-time -- financial information. D. "Where" and "How" Should Financial Reporting be Directed? Information Distribution Channels We also should recognize that our current distribution channels and our methods of dissemination and analysis have as much to do with what is reported as do the underlying concepts that dictate GAAP. Until recently, it has been impractical -- physically -- to provide much disaggregated information because there has been no reasonable mechanism for distributing such a huge amount of information and, more importantly, there has been no reasonable mechanism for analyzing it. However, certain -------------------- BEGINNING OF PAGE #7 ------------------- sophisticated end-users now have the means to perform high level analysis on disaggregated information. Indeed, analysts frequently spend substantial time and effort attempting to disaggregate information aggregated by accountants and accounting requirements. In the future, more end-users clearly will have access to the analytics and electronic data bases that will make disaggregated information highly useful and timely to them -- if it is provided. E. Summary: Declining Utility of Accounting and Financial Reporting I believe that some of the deficiencies I have noted are caused by our overemphasis on the concept of recognition. Recognition, of course, is a valid and time-honored concept that is at the core of financial reporting. Furthermore, recognition, in and of itself, is not problematic and, in fact, helps many to separate some of the more useful information from the full set of information relevant to investment, credit, monitoring, managerial and other decisions. However, while financial reporting is not explicitly tied to recognition, I believe that we devote an inordinate amount of attention to assessing whether a given item satisfies all of the recognition criteria, even to the extent of losing sight of the overall goal of providing information that is useful. I believe that a different focus in financial reporting is in order. The approach that I will describe in a moment, however, would not address all of the issues I have discussed. For example, it would not address the timeliness of disclosure or the disaggregation issues. But it might help us provide more useful information in financial reports. That at least is a beginning -- albeit only a beginning -- of a longer journey that we should embark upon. IV. A Different Perspective: Color vs. Black and White A. Background Somewhat simplified, financial reporting can be divided into four broad segments. At the first level we have the financial statements themselves, which focus on recognized items that pertain to the resources (assets) of an entity, the claims to such resources (liabilities and equity), and the results of operations. Within this system, the recognition of items in the financial statements assumes primary standing. To be recognized in financial statements an item must meet each of four criteria: * First, the item must meet the definition of an element of those financial statements: It must be an asset, liability or component of equity; * Second, the item must be measurable: It must be susceptible to quantification in monetary units with sufficient reliability; * Third, the item must be relevant: It must make a difference to the investment or credit decision; and * Finally, the item must be reliable: It must have representational faithfulness, be verifiable and -------------------- BEGINNING OF PAGE #8 ------------------- neutral. -[5]- It is generally expected that the most useful information about assets, liabilities, revenues, expenses, and other items of financial statements would be recognized. -[6]- There is also an expectation that such information would have utility in making capital allocation decisions. That is, it can be used to help predict future cash flows and is comparable across entities. In addition, because such information is viewed as more reliable and is audited, it is viewed as having greater utility in contracting and monitoring. The second subset of financial reporting consists of the notes to the financial statements. The notes are designed to explain information in the financial statements. The final two categories are supplementary information (such as information related to changing prices) and other information supplied by a company (such as management's discussion and analysis). This information adds to the financial statements or the notes. It frequently includes information that may be relevant but that does not meet all criteria for recognition. It is frequently not subject to third party attestation. The current accounting and financial reporting model works reasonably well for many of the items that are recognized within financial statements. However, the model increasingly is subject to criticism. First, potentially relevant items are omitted because they do not meet recognition criteria (usually due to reliability concerns). Second, items are included that appear to be less and less useful due to valuation or other concerns. Finally, it is not always clear why some information is included and other information is excluded from financial reports. These concerns are exacerbated by the developments in the general business environment previously discussed. B. The Alternative Model In response to these concerns, I believe it is time to refine our perspective on financial reporting. We need, in particular, to move away from a model that primarily relies on black and white recognition in the financial statements. We need to move towards a model where financial statements and related disclosures are viewed more as different layers of information - - just as a finely textured color picture can provide more information than a black and white representation. The model that I am about to describe may be viewed as refining the current system by adding new sets or layers of information. It also refocuses our analysis to de-emphasize recognition and towards providing greater disclosure of useful information. --------- FOOTNOTES --------- -[5]- The criteria of measurability and reliability are often inextricably linked. -[6]- See FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, paragraph 9. -------------------- BEGINNING OF PAGE #9 ------------------- In this model, the primary focus is on providing relevant information, with specification of both the items to be reported and the form and level of assurance of these items. The most relevant and reliably measured items would represent the core of the financial reports -- the clear black and white, with no shades of gray or color -- similar to the recognized content of the financial statement items in today's model. Successive outer layers of the financial reporting picture would consist of information that meet some -- but not all -- of the requirements of recognition, or that are not as susceptible to verification procedures. Under this approach, instead of starting with the question of whether an item must be recognized in the financial statements, the first question would be whether an item should be part of the firm s financial disclosure, with a progression then to a discussion of in which layer should the item be reported. Such a framework -- where the different layers of information could reflect, in essence, different levels of satisfaction of the traditional recognition criteria concepts (e.g., relevance, reliability, measurability), or could reflect entirely different concepts -- will be useful in progressing beyond the current recognition versus non-recognition debates. Application of this model to the current business environment requires: (i) specification of the additional layers, outside the core financial statements, including the criteria for inclusion of items in one layer versus another, and (ii) consideration of how different levels of attestation might attach to information in the various layers. Admittedly, establishing these components of this model is not an easy task. However, for discussion purposes, specification of the differing layers might be based, in part, on existing recognition criteria (as articulated in FASB Concepts Statement 5). The following examples illustrate this approach. 1. Specifying the Layers of the Model A. Layer 1: Items Satisfying Recognition Criteria The first layer would include those items satisfying recognition criteria. This layer is the easiest. Under at least one view of this model, it can just be assumed to be the current core financial statements. However, it might be useful to develop over time a better sense of what satisfies the core financials recognition criteria and how items are presented. -[7]- But I will leave that to another day. --------- FOOTNOTES --------- -[7]- For example, does it really make sense to recognize one parcel of real estate acquired a hundred years ago in 1896 dollars identically to another piece of real estate acquired yesterday? First, the value of the hundred year old acquisition most likely substantially changed during the past century, while the value of theparcel acquired yesterday is likely pretty current. Second, the reflection of that ancient value --even if it had not changed in real dollar terms -- in 1896 dollars with those dollars being added dollar for dollar to current dollars is not very enlightening. There are alternatives; other nations -- such as Australia -- permit revaluations of categories of assets with the goal of providing more useful information to the market. -------------------- BEGINNING OF PAGE #10 ------------------- B. Layer 2: Items Raising Reliability Concerns The second layer would include those items that would generally satisfy recognition criteria, except that there are reliability concerns that preclude their inclusion in the core financial statements. Let me provide a few examples: Research and Development, Advertising and Similar Expenditures. The current accounting for research and development and advertising requires these expenditures to be charged to earnings as incurred. Many would argue that these costs result in assets and therefore meet the first criterion for recognition in that they represent expected future benefits to the firm (otherwise companies would not make the original investments). Since companies must continually assess the outcomes associated with their research and development and advertising activities, an argument can be made that the value of the future benefits of these activities is measurable. Similarly, most statement users would not question the relevance of information related to these expenditures. However, the primary, and well known, difficulty with the recognition of these expenditures as assets concerns reliability. Because the expected future value of these expenditures is difficult to determine with certainty, and the utility of the expenditures often is intertwined with the use of other assets, questions arise about the verifiability and neutrality of valuation measurements. By establishing a second layer for the reporting of such information, outside the core layer of information, such amounts could be capitalized or revalued as appropriate. Brands, Deposit Intangibles, and Spending on Customer Satisfaction. Similar examples, with a similar conclusion, can be drawn from an analysis of other currently unrecognized elements in financial statements, such as the value of brands, deposit intangibles, and investments to improve customer satisfaction or loyalty (as opposed to measures of customer satisfaction or loyalty, which I will turn to in a moment). In these cases, unreliability of information prevents recognition of an item. However, waiting for complete reliability generally makes the information untimely so that it loses its relevance. Thus, establishing this additional layer of reporting outside the core, with the layer defined based on some but not all of the current recognition criteria, allows for the reporting of relevant, but perhaps less reliable information. To put it simply, assets like brand names that have been internally created are currently not recognized and, therefore, are implicitly carried on the balance sheet with a value of zero. It may be difficult to determine for sure the value of the brand, but we know for certain that zero is almost always the wrong answer. C. Layer 3: Items Raising Reliability Concerns and Possibly Definitional Concerns The third layer could contain items that raise reliability concerns and possibly definitional concerns such as measures of customer satisfaction. These measures, are in some industries both highly relevant and easily and consistently measurable with a high degree of reliability; they also contribute to earnings capacity in a tangible manner. Customer satisfaction may sometimes meet the definition of an asset, such as when it is associated with a brand name (Nordstrom). In other instances, however, it is less clear that this is the case, such -------------------- BEGINNING OF PAGE #11 ------------------- as when customer satisfaction is expressed in the form of a rating in a survey (J.D. Power Surveys on Customer Satisfaction), or is not related to a particular brand but is tied to the employees associated with a service (such as the servicing department at an automobile dealership). D. Layer 4:Items Raising Definitional Concerns. A fourth layer in the color spectrum of reporting could be specified for items that satisfy measurement, reliability and relevance criteria, but clearly do not meet the definitions of statement elements. In many cases these are items that assist in the evaluation of recognized statement elements. Risk Measurement Practices. Risk sensitivity metrics, such as those recommended for disclosure in the Commission's recent derivatives disclosure release, provide a good example of information that might fall within this fourth layer of disclosure. Given the current focus on risk management, it is safe to say that risk sensitivity analysis is relevant to firms and users of financial statements. Similarly, although not completely free from doubt, risk metrics also meet the criteria of measurability and reliability based on the quantitative nature of these analyses. This will particularly be the case as firms gain more experience with risk measurement techniques However, leaving aside firms that develop and market risk metric programs, risk analyses generally fail to meet the definition of an asset, liability or component of equity. Rather, such measures are designed to convey information on the sensitivity of the values of recognized or unrecognized assets and liabilities to hypothetical changes (based on historical data) in market indices. Reporting such second order effects within an additional layer of the color framework might provide relevant information to the market while also conveying the characteristics of the information with respect to the item that does satisfy recognition criteria. E. Layer 5: Items Raising Definitional and Reliability and Measurement Concerns Finally, an additional layer of the color reporting spectrum can be specified for relevant items that do not meet the definitions of elements and which cannot yet be reliably measured. Going Concern Value and Intellectual Capital. For example, the going concern value of a firm, intellectual capital, or the value of a trained work force (even though the firm has invested substantial amounts in training), may not meet the definition of an asset because the employees to which these investments sometimes relate are, arguably, not controlled by the firm. In addition, estimates of the value of such assets are highly subjective, not easily auditable, and perhaps specific to a particular firm or industry. Therefore, such measures generally would not meet reliability criteria (e.g., they are not verifiable and /or neutral). However instead of not reporting these items at all, as is currently the case, under the colorized approach such items could be disclosed in the fifth layer, along with a description of the limitations associated with any particular valuation. -------------------- BEGINNING OF PAGE #12 ------------------- 2. Specifying Levels of Attestation One of the more challenging aspects of the proposed model involves providing an indication of the degree to which information in the various layers is subject to verification or attestation. The goal here would be to provide users of financial reports with a better indication of the quality or certainty of the information provided. We currently provide varying degrees of attestation to information in financial statements, ranging from full audits to reviews of such information. Admittedly, it would be more difficult to attest to much of the information that might be provided under the proposed model. For example, it may be difficult to arrive at a consensus among auditors regarding whether management s estimates of the value of a brand name are valid. However, although it may be difficult to attest to the value of such assets per se, it may be possible for auditors to attest to the procedures used by management to make such valuation estimates. Clearly, this area will need additional thought. To some extent, the accounting industry currently is moving in this direction. For example, the AICPA in Statement of Position 94-6 recognizes the inherent risks and uncertainties in certain amounts reported in financial statements and calls for additional reporting in the audited financial statements to reflect this. Its requirements make more apparent to statement readers the uncertainties associated with even recognized items, due to such matters as subjective estimates and the potential effects of significant concentrations in an entity s operations. -[8]- This SOP is important because it provides additional texture to amounts reported in financial statements. C. Distinctions from the Current Model Let me summarize the distinctions between the colorized model and the current accounting and financial reporting model. First, as I just alluded to, the colorized approach places the emphasis of financial reporting on providing information useful and having a high degree of utility to investment, credit or other decisions as opposed to deciding whether information should be recognized in the financial statements. While recognition is an important concept in this new model, it should be remembered that recognized information is a subset of financial reporting and the goal is to present information that users find useful. With the colorized approach, the primary role of recognition would be in connection with items for which there was general agreement on the high degree of relevance, reliability and measurement for the first or core level of presentation. As the relevance, reliability and measurement of particular items became more or less generally acceptable to financial standard setters and users of information, the core would expand and contract as necessary. But recognition would be de-emphasized in that it would merely reflect the demarcation between the first layer and the next layer of information. In other words: recognition becomes one concept for one layer of presentation, not the --------- FOOTNOTES --------- -[8]- Indeed, almost all information reported in financial statements -- other than the date of the statements and the number of shares outstanding -- would appear to involve some element of prediction or uncertainty. -------------------- BEGINNING OF PAGE #13 ------------------- paradigm for financial reporting. Admittedly, the layers of the model just outlined can not be specified with absolute bright lines or certainty -- there will always be gray areas, even in this colorized approach. Nevertheless, the colorized approach would promote disclosure of information that is not disclosed under our current system of financial reporting -- including information relating to intangible assets and other difficult to value items. Although such information arguably may be presented as supplementary information, in practice this occurs all too infrequently. Instead, supplementary disclosures today typically relate only to items that are already recognized in the core financial statements. Finally, by conditioning the "colorization" of the financial reporting system on (and with specific disclosure of) the level of assurance associated with the information, we will provide end-users with a far better sense of the quality of the information upon which they are basing their decisions. In sum, the colorized approach is more aligned with the purposes of financial reporting, and more compatible with dealing with the dynamic nature of information that is relevant to end- users of financial reporting, than the current black and white system. It allows us to make finer distinctions among various types of information, thereby avoiding the daunting task of determining whether items that are close to the recognition/non- recognition line are in or out of the financial reporting paradigm. D. Issues for Consideration There are, of course, important issues to be resolved in changing our current system along the lines I have just suggested. In addition to debate about the appropriate methods for delimiting the layers of disclosure, these issues include (i) determining the degree of comparability that will be required under the model, (ii) assessing the costs to preparers of financial reports, (iii) concerns about litigation exposure and the need for a safe harbor, (iv) uncertainty about how such traditional accounting measures as net income or earnings per share will be calculated, and (v) whether the additional layers of disclosure will result in greater confusion of users of financial reports. These are difficult issues and although you might envision answers to some -- for example, net income or earnings per share might continue to be calculated solely based on recognized information, or varying net income and earnings per share amounts could be reported for each of the various layers - - it is unlikely that we will find answers for all of these questions without more thought. We must confront these issues, however, if we are to ensure the continued relevance of financial reporting. In addition to SOP 94-6, two other recent AICPA initiatives indicate that the profession is beginning to move in this direction. The Jenkins Committee identified various additional types of information companies should provide to investors and creditors, and considered the extent to which auditors should be associated with that information. Finally, the Elliott Committee (the Special Committee on Assurance Services) is studying market needs for new services that are -------------------- BEGINNING OF PAGE #14 ------------------- broader and more varied than audits of financial statements. It is expected to recommend that CPAs be prepared to undertake a much wider scope of assurance work. These initiatives open the door to consideration of the emerging issues that need to be addressed. They are consistent with and in fact represent movements toward the alternative perspective I have outlined. Conclusion The issues that I have raised this morning relating to the utility of accounting and financial reporting are not new, but are extremely important. As I alluded to at the outset, my goal in proposing a model for your consideration is to stimulate creative thinking to address the challenges facing accounting and financial reporting in the next century, which is imminently approaching. Clearly there are flaws to the current and the proposed models; our goal, however, should be not only to identify them but to consider whether and how they might be best addressed -- or to develop an alternative approach -- to maintain and enhance the utility of our current system. As I mentioned, many efforts are underway to address some of the issues I have been discussing. In addition to those I mentioned earlier, the Commission -- with the participation of a variety of interested parties, including the AICPA -- will be sponsoring a series of symposia related to these issues. The first event will involve issues related to the accounting and reporting of intangible assets and is scheduled for April 11-12. Thank you for your attention and I would appreciate any thoughts or comments you may have.