==========================================START OF PAGE 1====== Remarks Of Isaac C. Hunt, Jr. Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "The Impact of the SEC on Financial Reporting" Ohio Council-Institute of Management Accountants 22nd Annual Professional Development Conference Kent State University Akron, Ohio April 19, 1996 ______________ * The views expressed herein are those of Commissioner Hunt 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 ==========================================START OF PAGE 2====== "The Impact of the SEC on Financial Reporting" Good Afternoon, Ladies and Gentlemen. Thank you for inviting me to speak at this 22nd Annual Professional Development Conference of the Ohio Council of the Institute of Management Accountants. As some of you may know, I recently concluded 8 1/2 enjoyable and, I hope, productive years in Northeast Ohio in nearby Akron, and I am pleased to be back here. Introduction Today, I would like to discuss with you the Commission's impact on financial reporting. First, I will mention briefly the Commission's authority in this area and our own rulemaking and interpretive efforts. Second, I will indicate how we work with those in the private sector who supplement our rules with professional standards and guidelines. And third, I would like to take a look down the road at the growing importance of international standard setting organizations and what this trend means to the SEC's role in the financial reporting process. Overview of the Commission's Role and Responsibilities for Financial Reporting As you know, the Commission was established in 1934 in the wake of the greatest financial disaster this country ever has experienced. It was a time when investors and the public in general had lost confidence in impersonal securities markets; when the value of substantial investments was lost in the short span of a few hours. The Securities Act of 1933, the Securities Exchange Act of 1934 and the four other laws-[1]- administered by the SEC were enacted to ensure that the securities markets are fair and honest and to provide the SEC and the courts the means to enforce the securities laws, through sanctions where necessary. These laws were designed to facilitate informed investment analyses and decisions by the investing public, primarily by ensuring adequate disclosure of material information. Integral to the adequate disclosure of material information is a robust financial reporting system. High quality accounting and reporting standards facilitate comparability and transparency, so that an investor can make meaningful comparisons of investment opportunities. ---------FOOTNOTES---------- -[1]- The Public Utility Holding Company Act of 1935; the Trust Indenture Act of 1939; the Investment Company Act of 1940; and the Investment Advisers Act of 1940. ==========================================START OF PAGE 3====== Provisions in the federal securities laws prescribe certain disclosures that are to be made in registration statements and prospectuses related to securities offerings,-[2]- and in annual, quarterly, and other public reports filed with the Commission.-[3]- In addition, Congress gave the Commission significant rule making authority,-[4]- which the Commission has used to fashion disclosure tools applicable to certain transactions and issuers. For example, the Commission has adopted Regulation S-K, which is a central repository for disclosure items that registrants may use in filings under both the Securities Act of 1933 and the Securities Exchange Act of 1934; Regulation S-X, which provides guidance on the form and content of financial statements filed with the Commission; and Regulation S-B, which recognizes the special circumstances of small issuers and provides them with reduced and simplified disclosure requirements. When the Commission adopts a disclosure requirement, the adopting release typically explains the background and scope of the new regulation. In addition, the Commission may publish interpretive releases to provide added guidance on how registrants should comply with existing rules. An example of this type of guidance was the Commission s interpretive release regarding Management s Discussion and Analysis of Financial Condition and Results of Operation.-[5]- These adopting and interpretive releases are identified as Financial Reporting Releases. Many of the most notable discussions in these releases have been categorized by topic and placed in the Codification of Financial Reporting Policies, to make them easier to research and use. In addition, the Commission staff often provides its own guidance, which does not carry the weight of Commission pronouncements, in the form of Staff Accounting Bulletins ("SABs") or Industry Disclosure Guides. The Commission also has a major impact on financial reporting through its authority to promulgate accounting principles for SEC registrants. The Federal securities laws state that the Commission has the authority to prescribe the form in which the information in financial statements filed with the Commission ---------FOOTNOTES---------- -[2]- Sections 7, 10, and Schedule A, to the Securities Act of 1933 (the "1933 Act"). -[3]- Section 12 of the Securities Exchange Act of 1934 (the "Exchange Act"). -[4]- See, e.g., section 19(a) of the 1933 Act and sections 13(a) and 13(b)(1) of the Exchange Act. -[5]- Securities Act Release No. 6835; Financial Reporting Release No. 36 (May 18, 1989). ==========================================START OF PAGE 4====== shall be set forth, the items to be shown in the balance sheet and the earnings statement, and the methods to be followed in the preparation of financial statements.-[6]- The Commission also has the authority to define accounting terms.-[7]- Interaction of the SEC with Private-Sector Standard Setting Practically since its inception, however, the Commission has looked to the accounting profession for leadership in the establishment and improvement of accounting principles.-[8]- As you know, the private sector body recognized today by the accounting profession to set the accounting standards used in financial reporting is the Financial Accounting Standards Board, or FASB. When the FASB was formed in 1973, the Commission endorsed it by indicating that financial statements prepared in accordance with the pronouncements of the FASB would be considered to have "substantial authoritative support," and those that did not follow FASB standards would be considered to have no such support and to be misleading.-[9]- The Commission's reliance on the FASB, however, always has been with the understanding that the Commission may exercise its authority and override, supplement, or otherwise amend the FASB's standards, or adopt standards in areas where the FASB's standards are silent. On rare occasions, the Commission has supplemented or amended FASB and other professional standards through the promulgation of rules in Regulation S-X, and through the issuance of interpretations in Financial Reporting Releases. Therefore, the typical standard-setting activity of the SEC is oversight, rather than the drafting of new accounting principles. For example, members of the Office of the Chief Accountant of the Commission monitor the FASB's progress with its projects, which includes attending selected FASB meetings, holding quarterly meetings with members of the FASB staff and reading comment ---------FOOTNOTES---------- -[6]- Sections 7, 19(a) and items (25), (26), and (27) of Schedule A of the Securities Act of 1933 ("1933 Act"), sections 12, 13(b)(1) and 17(e)(2) of the Securities Exchange Act of 1934 (the "Exchange Act"), sections 5(b), 14, and 20 of the Public Utility Holding Company Act of 1935 ("PUHCA"), and sections 8, 30(e), 31, and 38(a) of the Investment Company Act of 1940 ("ICA"). -[7]- Section 19(a) of the 1933 Act, section 3(b) of the Exchange Act, section 20(a) of PUHCA, and section 38(a) of the ICA. -[8]- Accounting Series Release ("ASR") No. 4 (April 4, 1938). -[9]- ASR No. 150 (December 20, 1973). See also, Rule 4- 01(a)(1) of Regulation S-X. ==========================================START OF PAGE 5====== letters received by the FASB on current projects. During this process, the Commission staff will inform the FASB staff if any significant concerns are noted with a particular FASB project. Occasionally, the Commission and the FASB will hold a public meeting to discuss items on the FASB's agenda and other items of mutual concern. The SEC staff also participates, usually as observers, in meetings of other standard-setting groups such as the FASB's Emerging Issues Task Force (the "EITF") and the Accounting Standards Subcommittee (AcSEC) of the AICPA. In addition to monitoring the standard-setting activity of the private sector organizations, the SEC staff influences the interpretation of existing financial reporting standards through its day-to-day involvement in the review and comment process. The staff's objective is to ensure that there is a consistent interpretation and application of existing standards, and that inconsistencies are identified and addressed on a timely basis. Often, when a potential problem is identified the SEC staff asks established standard-setting bodies such as the EITF to address the issue. Alternatively, the SEC or its staff may act directly by issuing a rule proposal or a Staff Accounting Bulletin, and sometimes there are complimentary SEC and private sector responses. Let me illustrate these different possibilities by reviewing two recent examples of the standard-setting process. One example of the SEC staff's impact on financial reporting is accounting for restructuring activities. In January of 1994 the Chief Accountant asked the FASB's Emerging Issues Task Force to provide guidance on accounting for restructuring charges since the staff had noted increasing diversity in practice in this area. Thereafter, the EITF devoted significant time at its next six meetings to develop guidance, and it discussed this issue for about a year. In between meetings, publication of the EITF's minutes and preliminary conclusions allowed the group to solicit input from the preparer and user communities. The final consensus improved financial reporting by narrowing the diversity in practice for the accounting for restructuring charges and improving disclosures about restructuring, thereby enhancing the comparability and transparency of registrants' financial statements. The history of the Commission's current rule proposals relating to derivatives-[10]- (the "derivatives release") illustrates another way that the SEC may impact financial reporting. During 1994, some registrants experienced significant, and sometimes unexpected, losses in market-risk sensitive instruments, due to, among other things, changes in interest rates and foreign currency exchange rates. The ---------FOOTNOTES---------- -[10]- Release Nos. 33-7250; 34-36643; IC-21625; File No. S7035-95. ==========================================START OF PAGE 6====== disclosure of significant losses often surprised investors who were not aware that some of these registrants held these instruments, either in an attempt to manage exposure to market risk or for trading purposes. During 1994 and 1995, to understand better this emerging issue and to assess current disclosure practice, the SEC staff initiated a special project to perform reviews of the annual reports filed with the Commission by approximately 500 registrants. During this time, the FASB issued Statement No. 119, "Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments" ("FAS 119"). The SEC staff observed that while disclosures reviewed in 1995 were more informative than those reviewed in 1994, in part because of improved guidance provided by the FASB in FAS 119, several significant disclosure issues remained, which the Commission has tried to address in the derivatives release. The disclosures proposed by the release would supplement, not override, the disclosure requirements established by the FASB. Meanwhile, the SEC staff also has encouraged the FASB to continue to work on its financial instrument project. Involvement of the U.S. in International Standard Setting I hope my remarks thus far have provided you with a good sense of the Commission's authority and responsibilities for standard- setting for financial reporting, and how our own rulemaking and interpretive efforts supplement private-sector professional standards and guidelines. With this information as a backdrop, I'd like to turn now to my last point, the growing importance of international standard setting organizations and what this means to the SEC's role in the financial reporting process. We all were reminded of the increasing interdependence of the world's capital markets by the collapse of Barings, when a Singapore-based trader, allegedly speculating on the Japanese market, triggered the demise of a UK company that ultimately was acquired by a Dutch concern. And it's not just financial traders whose reach spans the globe. Investors are, with increasing frequency, seeking investment opportunities abroad, while companies look to deeper international capital markets to obtain financing. The widespread privatization of national resources, particularly in Europe, Asia and South America, is fueling enormous capital requirements that are not being absorbed by any single country's capital markets. Established global companies also are reaching outside their home country capital markets as they seek to match off financing sources for their capital requirements with the markets in which they operate. Let me illustrate some of the current difficulties with cross- border offerings by looking back to 1993, when Daimler-Benz became the first German company to register securities in the ==========================================START OF PAGE 7====== U.S. Under US GAAP, Daimler reported a loss of almost a billion Deutchmarks for its 1993 fiscal year; under German GAAP, it reported a profit of 168 million DM for the same time period. Daimler was required, under the current U.S. requirements for foreign issuers, to reconcile net income and equity reported in its German GAAP financial statements to U.S. GAAP measures, and this huge difference was an illustration of how significant accounting differences could be between two major industrialized countries. Was this requirement imposed because Daimler's German GAAP financials were viewed by the SEC as wrong? No - it was required because US reporting requirements are driven by the needs of U.S. investors - and under the current system we presume that U.S. users speak U.S. GAAP. Currently, both U.S. investors and registrants enjoy many benefits provided by the strength of our capital markets. U.S. markets are perceived world-wide to be fair and efficient, reducing the cost of capital for those seeking financing. U.S. investors are protected by our markets' liquidity and efficiency, qualities that rely upon our strong financial reporting system. However, investors increasingly are drawn outside the protection offered by the U.S. capital markets as they pursue foreign investment opportunities involving companies unwilling or unable to comply with the rigorous U.S. listing requirements, particularly those that require restating years of financial information to measure and disclose information on a U.S. GAAP basis. The continued strength and premier position of the U.S. capital markets requires satisfying the foreign appetites of U.S. investors inside the U.S. markets, a goal that we hope to achieve through development of a common international financial reporting framework to facilitate cross-border financings. We must work to ensure that this framework be of equally high quality to the one that has served U.S. investors so well for 60 years. One key component of developing a common financial reporting framework is constructing a common body of uniformly accepted accounting standards. In July, 1995 the International Organization of Securities Commissioners ("IOSCO") agreed that the 1995 work plan developed by the International Accounting Standards Committee (the "IASC") will result, on successful completion, in a comprehensive core set of standards that IOSCO would recommend for acceptance in cross-border filings (the "core standards"). More recently, the IASC has undertaken a plan to accelerate this work program with a view toward completing the requisite core set of standards by March, 1998. The IASC faces a very difficult challenge: developing a single set of standards which can portray accurately the very different business environments and practices that have fostered the very different accounting frameworks currently in place around the world. A company operating principally in Eastern Europe has very different business risks than one operating in Australia - and both differ again from a U.S. based company, even if that US ==========================================START OF PAGE 8====== company is owned by a Hungarian or Australian company. The IASC's challenge is to develop a comprehensive core set of standards that can portray accurately the very different risks and rewards that each of these different companies deal with, and that measures consistently their different performances. From the Commission's perspective, there are three key elements to this program that form a prerequisite for the Commission's acceptance of the IASC results: 1. the standards must include a core set of accounting pronouncements that constitute a comprehensive, generally accepted basis of accounting; 2. the standards must be of high quality -- they must result in comparability and transparency, and they must provide for full disclosure; and 3. the standards must be rigorously interpreted and applied. The IASC is working to develop clearly articulated statements of principles that satisfy the objective of having similar transactions and events accounted for in similar ways whenever and wherever they are encountered.-[11]- Establishing a core set of standards is not, and cannot become, a search for the lowest common denominator. Investors will rely upon, and derive benefit from, application of these standards only if the quality of the information produced is superior to that currently available. The IASC standards must be sufficiently complete so that they form, taken as a whole, a framework within which accounting issues can be resolved consistently - hence the notion of a "core" set of standards. However, it would be impractical to expect these standards to address every accounting decision that has to be made; the standards have to be statements of principles that will be resilient and responsive to ever-evolving business practices. Recognizing that achieving comparability and transparency is essential to allowing investors to make meaningful comparisons of investment alternatives, regulators around the world must insist on a consistent application and interpretation of these standards so that the comparability that is the objective of a single set of standards is not eroded. The Commission is committed to working with its securities regulatory colleagues, through IOSCO, and with the IASC to ---------FOOTNOTES---------- -[11]- Cherry, Paul G., "International Issues", speech at the AICPA Twenty-First National Conference on Current SEC Developments, Washington, D.C., January 12, 1994. ==========================================START OF PAGE 9====== provide the necessary input to achieve the goal of establishing a comprehensive set of international accounting standards. As soon as the IASC completes its project, accomplishing each of the noted key elements, it is the Commission's intention to consider allowing foreign issuers offering securities in the U.S. to utilize the resulting core standards in preparing their U.S. registration and other documents. As securities regulators participate in the development of a single set of core standards for cross-border offerings, we must interact constructively in the international standard-setting process to realize the goals of comparability and transparency. Achieving the IASC's goal involves a process of reconciling the interests of different business, professional, and regulatory cultures and systems. This will be a challenging task, but one that I believe is worth the effort. I support the objective of international harmonization, and the SEC's work as a member of the Technical Committee of IOSCO, and I am pleased that the Commission has published a statement clarifying its position on this matter.-[12]- From an international perspective, our challenge is, as I just discussed, active participation in the development, interpretation and application of a comprehensive set of core standards that provides comparability, transparency, and full disclosure. But there is also a challenge facing us here in the U.S.: a major educational effort that must occur, so that we all can be informed users of this new financial information when it becomes available to U.S. investors making capital allocation decisions. The development of financial reporting impacts not only financial statement preparers who must learn to speak a new language, but also financial statement users who must learn to read and understand that new language. Application of the core standards currently under development by the IASC, when completed, likely would produce yet a third measure of Daimler's 1993 profit or loss. The challenge that we face here in the U.S., as future users of financial statements prepared in accordance with the IASC standards, is to understand this new third measure of performance. Those of us currently involved in the capital markets will have to expand our knowledge to familiarize ourselves with the basic principles of the IASC framework. While many concepts will be familiar, appreciating the differences - and the reasons for those differences - will make us better investors who can use the new information that will be available to us as we make our capital allocation decisions. U.S. companies will have to be able to look at their foreign competitors and understand how to ---------FOOTNOTES---------- -[12]- SEC Statement Regarding International Accounting Standards (April 11, 1996). ==========================================START OF PAGE 10====== compare operating performance. The content of every accounting program's curriculum will have to be revisited, to prepare our students for the new world ahead. It also is likely that this process will lead many standard-setters around the world to rethink some current local accounting standards, ultimately furthering the goal of true harmonization of accounting principles around the world. There are many demands that will be made upon your time in the next three years, and IASC accounting standards will seem very remote when compared to the more pressing issues of quarterly or year-end reporting, analysts' meetings, brokers' reports, and the many other professional demands you try to satisfy on a day-to- day basis. But we should not turn away from the opportunity that lies ahead, even though it brings many challenges with it. If we are to have an international financial reporting system that produces the best information for investment decisions, we must all make significant investments now. I want to encourage you to become participants in this process. Conclusion Thank you very much for your invitation; I hope I have provided some useful information to you as well as some challenges for you. I look forward to working with you during my time at the Commission.