Remarks at the Third European FASB-SEC Financial Reporting Conference

by

Commissioner Isaac C. Hunt, Jr.

U.S. Securities & Exchange Commission

Frankfurt, Germany

April 5, 2001

Good afternoon, I apologize for not being able to be with you today, but other pressing Commission business has kept me in Washington. Thanks to recent advances in technology, however, I am delighted to still be able to address your conference. Before I begin my prepared remarks, I am obligated to give you the usual disclaimer that Commission members must make when speaking publicly; which is that the views I express here today are my own and do not necessarily reflect those of the Commission, other Commissioners, or the Commission's staff.

The U.S. Securities and Exchange Commission's mission is to protect investors and promote efficient capital formation. As many of you know, the Commission has been quite aggressive in its rulemaking in recent years. The Commission has addressed issues regarding market structure, decimalization, the Internet, and more recently, with Regulation FD, selective disclosure of material information. While I believe all these projects have provided benefits to investors, it has been in the area of accounting where I believe the Commission has made its most significant contributions to furthering the goal of investor protection and enhancing efficient capital formation.

Audited financial statements provide the foundation for our securities markets. Audited financial statements allow investors to make decisions on whether to buy, hold, or sell a particular security. If the numbers in the audited financial statements can't be trusted to provide relevant and reliable financial information about the company, investors might as well invest their money in lottery tickets. Because it will be by chance that their investments will be profitable. And based on some cases that I have seen, I have to believe that some shareholders would have received better odds in the lottery.

What I am telling you, however, is not new. After all, it was in 1933 that the U.S. first recognized that the integrity of a public company's financial statements was paramount to the health of our capital markets. As noted in the U.S. House of Representatives Report that accompanied the enactment of the Securities Act of 1933, Congress then sought, among other things, to provide for the disclosure of "distribution of profits, watered values and hidden interests." Congress sought to achieve such disclosure, in part, by requiring that an independent public accountant certify the financial statements of companies raising capital in our public markets.

During the adoption of the Securities Act, Congress considered whether the government should be in the business of auditing public companies. It determined, I believe correctly, that the accounting profession was best able to handle the task of auditing and certifying a company's financial statements. And thus, accountants became gatekeepers to our capital markets. It has been, in part, due to the significant efforts of the accounting profession, that the Commission has not only been able to protect investors but also watch over the creation of some of the most liquid and efficient capital markets the world has ever seen.

Now from time to time, the Commission has had to nudge the profession to become more effective, sometimes directly, as with our auditor independence rules, and sometimes indirectly, as with our audit committee disclosure rules. Sometimes the nudge is provided through staff guidance as with our three most recent Staff Accounting Bulletins, or "SABs": SAB 99 on materiality; SAB 100 on certain expenses commonly reported in connection with exit activities and business combinations; and SAB 101 on revenue recognition. Finally, in extreme cases, we have used our Enforcement capabilities, as in the numerous earnings management cases and 102(e) proceedings we have brought.

Some have argued that the Commission has been too aggressive in the accounting arena. I disagree. In recent years we have seen companies engage in the following practices, all with the approval of their accountants.

• "Big Bath" restructuring charges intended to encourage Wall Street to look beyond any one-time loss and focus only on future earnings;

• "Cookie Jar Reserves" created to protect the company in bad times by recognizing in good times extra accruals based upon unrealistic assumptions in estimating future liabilities;

• "Materiality" decisions that accept intentionally recorded errors on the basis of the supposed insignificance to one item of the financial statement; and

• the early recognition of revenue, such as before a sale is completed or at a time when the customer still has options to terminate, void, or delay the sale.

All of these practices move us away from a fair and accurate presentation of a company's financial situation. It creates a system where there is no transparency or comparability. Investors are unable to evaluate or compare companies when transactions, revenues, and earnings are manipulated in order to obtain some preconceived number. Companies must be expected to account for similar transactions and events in similar ways.

As gatekeepers, those who certify financial statements, you in the accounting profession must be aggressive in applying accounting standards objectively and uniformly. And as regulators and accounting standard setters, we must be aggressive in ensuring that accounting standards can be objectively and uniformly applied. If a standard is adopted that can be manipulated, the result will be a lack of confidence in the financial information provided to the securities and capital markets. Resources will not be efficiently allocated. There likely could be real world consequences. We could see our economies stop growing and/or our quality of life diminished. Let me provide an example for you: if accounting standards are applied less rigorously or differently to Internet companies to make them appear more successful than they are, we could see investors' funds being used to sell pet food over the Internet, instead of providing capital to companies searching for a cure for cancer.

Now as regulators and standard setters it is not our role to pick winners and losers, and if society values the convenience of buying pet food over the Internet more than a cure for cancer that is not our problem. But if we should provide favorable accounting treatment to Internet companies, or audit their financial statements any less rigorously than we audit traditional companies, then we are picking winners and losers; perhaps not directly but just as effectively. That is why accounting standards must generate financial statements that are accurate and comparable. Similar transactions and events must be treated the same.

I believe FASB is committed to ensuring that accounting standards are transparent and comparable. And I commend FASB on proposing the elimination of pooling accounting for acquisitions. Too often I have heard of companies searching for an acquisition near the end of a quarter for the sole purpose of meeting analysts' projections. These companies and their management teams did not produce these earnings -they bought them. Eventually, however, even these companies will have to grow earnings by actually running their businesses. In some cases, unfortunately, the damage to investors may already have been done. Purchase accounting treatment for such acquisitions should help to eliminate the practice of acquiring companies for short-term earnings growth.

Accounting treatment must accurately reflect transactions or events and it must be neutral. When accounting treatment of a transaction drives the business decision to conduct such a transaction, we often sacrifice long-term goals for short-term results.

I note that FASB also has proposed not to have goodwill automatically written down on some predetermined schedule but only when it is "impaired." While I agree with FASB on a theoretical basis, that goodwill of such transactions should only be adjusted downward when it is impaired, I am concerned that the test for determining whether goodwill has been impaired may be more art than science. Any test used to determine whether goodwill is impaired must be objective, so that all companies can be treated the same, and it must be practical, so that any impairment can be determined without great cost to a corporation. This is clearly a challenge that corporations, investors, and the SEC will be watching closely.

Now I would be remiss if I did not say a something about our International Accounting Standards concept release that the Commission issued a little over a year ago. To date we have received almost 100 letters from a wide variety of interested parties in the U.S. and other countries. While the views expressed are not uniform, they appear to be strongly held. For me, the big issue is the quality of the international standards and how they are applied. As you know, I believe any such standards must provide for transparency and comparability. But before I would eliminate the requirement for reconciliation with U.S. GAAP for foreign issuers selling securities in the United States, I would also need to know that these standards are rigorously enforced.

The importance of enforcement of international accounting standards cannot be overlooked. During my tenure at the SEC, I have learned at first hand the length that some companies will go to in order to meet revenue and earnings projections. From setting computer clocks back a few days, in an effort to fool their auditors and meet their quarterly revenue projections, to capitalizing marketing costs, in order to meet earnings projections, some companies will do whatever it takes to make Wall Street happy. Not only did executives of these companies risk SEC enforcement, and millions of dollars in private lawsuits, but also some executives risked their liberty, as in some cases prison terms were meted out.

If we are going to set high standards to ensure transparency and comparability but then not enforce them, we have not accomplished our goal. In fact, arguably, we have done more harm than good, because investors may mistakenly rely on financial statements without realizing, until it's too late, that those financial statements were not prepared in accordance with the proscribed accounting standards. Moreover, establishing such standards without enforcing them could be highly detrimental to the world economy as a whole. Companies that have abided by the proscribed accounting standards may experience higher costs of capital, since they will be competing for needed capital against companies that claimed to have abided by such standards but in reality have not.

Such standards without rigorous enforcement would establish an uneven playing field, favoring those that would provide lip service to high accounting standards, while simultaneously refusing to apply those same standards to their own financial statements. Non-enforced standards would only ensure that valuable resources would be allocated to inefficient enterprises. I believe U.S. investors don't need such an unfair system; nor, I suspect, do investors throughout the world.

Now I don't want people to think that I am raining on the international accounting standards parade. In fact, I can think of no greater gift to the investing public then establishing a set world wide accounting standards. You should also know that I do not hold the view that the American accounting standards are the best in all cases. There is plenty of room for improvement by all. In fact, I hope someday to vote in favor of a set of international accounting standards, where reconciliation with U.S. GAAP would not be needed.

In this regard I wish Sir David Tweedie and his colleagues all the success possible in bringing about a set of international accounting standards that would truly be a set of world wide accounting standards. Moreover, I encourage all accounting standard setters, regulators and auditing firms to support and contribute to the important work of the International Accounting Standards Board.

Well thank you for allowing me this opportunity to address you today.

http://www.sec.gov/news/speech/spch489.htm