SEC's new chief accountant: weighs the issues: In an interview, Donald Nicolaisen comments on subjects such as objectives-based standards, the importance of quality reporting and the changing role of the outside auditor.

The dramatic changes in the U.S. accounting and reporting environment over the past two years underscore the critical role that financial information plays in capital markets and in the economy as a whole. Against the backdrop of intense scrutiny of financial reports and those that prepare them, accounting standards-setters have been looking for ways to improve the transparency of the financial information.

Economic and accounting analysts at the Securities and Exchange Commission have proposed what they call "objectives-based standards" as the model of the future--one that provides some direction to filers, yet doesn't go as far as many of the complex financial accounting standards now in existence. At the same time, political concerns over the economic impact of new accounting standards has created another level of complexity for standard-setters, and promises to keep accounting standards reform in the spotlight for many months to come.

In this exclusive interview with Financial Executive, Donald Nicolaisen, the SEC's new chief accountant, reflects on these and other issues that will have important implications for both the issuers and users of financial information in the next year.

Nicolaisen was appointed to the post in August. He will oversee the commission's accountants and lead the SEC's efforts with national and international standard-setters on critical accounting and auditing issues, principles-based accounting, accounting for stock options and the formation of an international accounting model. Previously, Nicolaisen was a senior partner at PricewaterhouseCoopers, where he led the firm's national office for accounting and SEC services.

FE: The Financial Accounting Standards Board (FASB) is looking towards a more principles-based approach to standards-setting. The SEC has built on this concept, calling for "objectives-based standards," or standards that reflect both the accounting principle and its underlying economic objective. What are some of the benefits of moving towards an "objectives-based" standard?

NICOLAISEN: The real advantage would be clearer and more transparent financial statements. Investors would be better able to understand the accounting concepts and principles upon which the financial statements are based, without the need to be familiar with excessively detailed rules. In some respects, it's back to the future: Fewer rules and greater use of competent professional judgment.

The use of objectives-based standards would also result in less complexity and fewer exceptions. For example, it's hard to imagine that many users of financial statements are familiar with all the exceptions to FAS 133 (derivative instruments and hedging), or with the more than 800 pages of guidance that supports this rules-based approach to accounting, I believe the study prepared by the SEC staff provides compelling reasons for objectives-based standards. If followed, there would be increased comparability of financial reporting consistent with the underlying economic substance.

FE: One of the arguments in favor of objectives-based standards is that they hold management directly responsible for capturing the economic substance of transactions within the company's financial reporting. Can you comment on that?

NICOLAISEN: That certainly is a desirable objective. If we look at some of the shortcomings in financial reporting in recent years, there have been too many instances when companies expended great energy ill ensuring that their financial statements fully complied with all the detailed accounting rules. But, the results were not necessarily an accurate portrayal of the company's economic performance. And, in the worst cases, some engaged in financial engineering to present results totally at odds with actual performance. Objectives-based standards would require management and the auditor to focus on fairness of presentation and disclosure, not just compliance with the rules.

FE: What are the implications for CEOs/CFOs who now have to certify their financial statements? Do you see this concept as assisting them in that effort, or will it create new challenges in certification?

NICOLAISEN: I don't think it will make it easier for CEOs and CFOs. Their responsibility for clarity and transparency may actually increase. Applying principles inherently requires more judgment. If the objective is to comply with detailed rules, that responsibility can be disbursed more broadly throughout an organization. If the objective is fair presentation consistent with economic activity, that requires more input from senior management. The result, while challenging for management, will be more useful for investors.

FE: What does that say about the auditor's role?

NICOLAISEN: It, too, is likely to be more challenging. There would be no "bright line" tests, no rules-based security blanket. The auditor will have to exercise greater professional judgment and will have to upgrade training and auditing guidance in order to prepare professionals to meet the challenge. While challenging, I believe many professionals will welcome the opportunity to apply their judgment and experience, using objectives-based standards.

FE: How will U.S. GAAP change?

NICOLAISEN: In the U.S., the role of the FASB as the primary standard-setter is clear. Standards will continue to be established following due process, including public exposure. But the pace of change is likely to quicken. Perhaps more importantly, the FASB is working with others to reduce differences between U.S. GAAP and international accounting standards. Adopting principles-based standards is an enabler to global convergence. If successful, global GAAP will, over time, be recognized in the United States.

FE: So the SEC will accept filing under the IFRS (International Financial Reporting Standards)?

NICOLAISEN: Not at the moment. There are still significant differences. But moving in that direction is the right approach. Assuming good will persists, and international standard-setters and regulators continue to work together, believe it is an achievable goal.

FE: Under the principles-based standards, will CFOs have to go back and rethink the economic fundamentals of the business?

NICOLAISEN: I wouldn't think so. But it may cause some managements to focus more on the business itself, and less on transactions that produce a temporary accounting advantage. That has to be a positive development.

FE: How do we convince the market not to put so much pressure on earnings, so CFOs don't have to constantly focus on getting those numbers up, perhaps artificially?

NICOLAISEN: Ideally, there would be an expectation of volatility in earnings consistent with economic activity. That requires communication, education and understanding. We all know that segments of the U.S. investment community have focused unduly on short-term results. Perhaps that's cultural and may not change. But, for investors with a long-term view, the attraction will likely continue to be to enterprises with solid businesses, strong management and the potential for growth and improved profitability.

FE: How will Sarbanes-Oxley change the investment climate in the U.S.?

NICOLAISEN: The law is designed to better protect investors, and I believe it will. Thus, I would expect fewer restatements, reduced fraud and more tools to deal with those who fail to comply with the spirit of the law. The result should be an improvement in the quality of financial reporting and investor confidence. The recently enacted regulation, while not without cost, should improve the investment climate in the U.S.

FE: How do you see the reconstruction of the board of directors evolving over the next year? Is it possible to break down the "old boys' club," and how do shareholders get more representation on the board?

NICOLAISEN: I'm hopeful that boards will act with greater independence and be more vigorous in reviewing transactions--particularly those with related parties, including management--and that they will demand more transparent financial information and clearer disclosures. Board members, especially those who serve on audit communities, play a key role in ensuring that investors receive transparent financial information. Their allegiance should be closely aligned with the investor, more so than with management.

In the future, there may be more proxy initiatives involving directors, and undoubtedly we'll see situations where not all directors are re-elected. But, I wouldn't expect massive turnover, as there certainly have been many effective boards.

FE: Will it more difficult to get people to act as directors in this environment? Is it possible that, ultimately, boards will become worse instead of better?

NICOLAISEN: I don't think so. If anything, I suspect that those board members who don't feel up to the challenge will move on, and those who have the desire, ambition and intellectual curiosity to fulfill the responsibilities required of a director will be attracted to serve.

FE: As accounting standards evolve over the next year, what do you see as potentially having the most significant economic impact? I look to the example of expensing stock-based compensation and the argument recently made in Congress that that it could hurt innovation, particularly in the high-tech sector, which has typically relied on stock options to attract the best talent.

NICOLAISEN: Accounting for stock options would certainly be high on that list. Some believe that expensing of stock options shouldn't cause any major dislocation because the market already adjusts for them and will continue to do so in the future. From the perspective of investors, I favor accounting for options consistent with their economics, enabling better comparisons of one company to another. I support the FASB in its efforts to establish the appropriate accounting, not a desired economic outcome.

FE: I guess the broader question is: Where does economic policy stop and accounting standards-setting policy start? It seems that the lines are becoming increasingly blurred.

NICOLAISEN: I believe it best if the standard-setters develop accounting without economic bias. The FASB's role is to provide objective standards so that financial information is available to investors and others to enable informed decisions.

FE: Will we be seeing more conflict between legislators and the standards-setters over accounting principles or rules that are viewed as having significant economic impacts?

NICOLAISEN: That is possible, of course.

FE: There's been some concern about the U.S. current account deficit and the ongoing difficulties for U.S. capital markets abroad. Will efforts to improve the security of U.S. capital markets, through improving the accounting and regulatory regime, have a role to play in improving the current account deficit?

NICOLAISEN: Improving financial reporting adds to the strength of our capital markets and directs resources to the most attractive opportunities. Financial reporting is of little value if it doesn't objectively and fairly report financial results. As far as I'm concerned, there is no alternative to improved reporting and clearer disclosures.

I'm delighted that so many in the U.S. are committed to improving the country's investment environment. I'm excited about my new role as chief accountant at the SEC and the opportunity to improve financial reporting and to contribute to the effort to rebuild confidence in the U.S. capital markets.

FE: Can you comment on what the U.S. can teach other economies? What does the U.S. experience of the last two years have to show emerging capital markets, such as those in China?

NICOLAISEN: I believe the message is clear: accounting and financial reporting do matter. It is critical that any country that wishes to open its markets to investors adopt quality accounting standards, as well as audit and governance processes that provide investors with confidence in their application.

Ramona Dzinkowski, a frequent contributor to Financial Executive, is an economist and business writer working with FEI Canada. She can be reached at [e-mail].