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Business and the SEC: lessons in coexistence.

Representatives from the SEC, business, and the accounting profession conduct a dialogue on major issues of concern to the business community.

What is the latest SEC thinking on today's major accounting and reporting issues? Each year, Commission representatives offer an insider's view at FEI's Current Financial Reporting Issues conference.

Four issues, and their relevance to financial executives, were prime topics at the most recent CFRI meeting, along with comments by business and accounting panelists.

* What will be the impact of proposed federal legislation on accounting and reporting standards?

* How do accounting and reporting requirements affect the competitive position of U.S. companies?

* What are the pros and cons of current value accounting, and why does the SEC prefer it?

* Are consulting services still considered a threat to auditor independence?

Discussion of these issues was followed by news from the SEC staff and questions from the audience.

The panel members were: Donald Steine, vice president and controller at Exxon, who served as moderator; Lonnie A. Arnett, vice president and controller at Bethlehem Steel; Edmund Coulson, who has since left his position as chief accountant at the SEC; John O. Penhollow, director of the SEC's Office of EDGAR Management; Linda C. Quinn, director of the SEC's Division of Corporation Finance; and Norman N. Strauss, a partner at Ernst & Young.

The following is an edited and condensed version of their discussion. As usual, the opinions expressed by SEC staff members are their own opinions and not necessarily those of the SEC.


STEINE: Linda, we start with you.

What is the SECs view on proposed legislation covering accounting, reporting, and control standards?

QUINN: Two major legislative proposals were introduced last year that didn't make it through Congress. But I expect both will be reintroduced this year. The first of these proposals would repeal those provisions of the Securities Exchange Act of 1934 [Subsection (i) of Section 12 and Section 3(a)(2) and (3)(a)(5)] that exempt securities issued by banks and thrifts from registration with the SEC. It is our feeling that banks and thrifts should report to the SEC as do all other public companies, rather than to bank regulators as they do now.

The second is the proposed amendment to the Comprehensive Crime Control Act of 1990, entitled, "Accounting and Auditing Standards for the Detection and Disclosure of Financial Irregularities." The amendment passed the House in October but not the Senate, and was removed during conference. Representative John Dingell (D-Mich), chairman of the House Energy and Commerce Committee, and Representative Ron Wyden (D-Ore) have proposed a concept like this for several years, and this is the farthest it's gone. I understand they plan to reintroduce the legislation this year.

The legislation would require public companies to do the following: include in their annual report a description of management's responsibility to maintain an adequate system of internal controls; assess whether the internal control structure assures the preparation of financial statements that comply with GAAP; disclose material weaknesses previously identified that have not been corrected; and provide a report by the independent public accountant on management's assessment of the internal control standards.

Note that the SEC itself has a rule-making proposal that would require a similar assessment by management, but not the report by the independent accountant. The SEC received 189 letters of comment on the proposal, and the staff is considering it as well as legislative proposals.

The legislation also proposes that the audit include procedures to provide reasonable assurance of the detection of illegal acts that would have a material effect on financial statements. The proposal also would require an auditor who suspects an illegal act, whether or not its effect would be material, to do several things. First, assess if the illegal act is likely to have occurred. Second, consider its effect on the financial statement. Third, inform management, and assure that the audit committee or the board has the information. There are several other requirements, but they boil down to either the company going to the Commission with the information, or the auditor doing so.

STEINE: Was the SEC consulted by Congress about this legislation?

QUINN: Our general counsel testified before Congress in August 1990 and pointed out a number of drafting problems, but the Commission has not taken a position. That will depend on whether the legislation is reintroduced, and in what form. One of our major concerns, of course, is the cost/benefit analysis.

STEINE: Norm, the Big Six, as well as the AICPA, supported the legislation. Cynics suggest the Big Six has a financial incentive. Why did the Big Six support this legislation when the business community is so opposed?

STRAUSS: We felt that some legislation was going to be adopted by Congress, and we thought what was being proposed initially was completely unworkable. So we decided the better course of action would be to persuade Congress to change those provisions that we believed would cause tremendous practical problems. The initial proposal would have given auditors increased responsibility for detecting internal control weaknesses and illegal acts that were not even material to financial statements and for reporting illegal acts directly to the SEC. We felt lawyers, not accountants, should determine what is illegal.

We thought the whole proposal was too costly and unworkable. So we, the Big Six and the AICPA, conferred with Congress, and we think the final bill that the House passed was much improved and workable. The internal control report, for example, was changed to relate to material matters only, and auditors would need to report their suspicions of illegal acts to management first. Our approach was dictated by strategy, based on the assumption that legislation would be passed anyway, and that it would be far better to work with Congress to develop legislation that we could all live with at a reasonable cost.


STEINE: Let's turn to whether U.S. accounting and reporting requirements may be too complicated and too costly. Some think they adversely affect the competitive position of U.S. companies. Ed, what can we expect to bear regarding there concerns?

COULSON: SEC Chairman Breeden has asked Commissioner Lochner to review these concerns from three perspectives: their validity, their cause, and the SEC response. in addition to Commissioner Lochner's review, the SEC has been talking to the FASB and with the FAF oversight committee about these concerns. We are also working with major accounting firms to analyze seven or eight key accounting requirements, such as pensions, in seven or eight countries, and are working with them on a cost/benefit analysis. Other organizations are also looking into the issue. Financial Executives Research Foundation, for example, is conducting research into the relative complexity of U.S. requirements vis a vis the rest of the world, and the AICPA has run symposiums to bring together business people, auditors, and analysts to discuss the issue.

The goal of all of these efforts is to identify any parts of the financial disclosure package in this country that do not produce relevant information. But the bottom line is that we need strong standards consistent with full and fair disclosure and that offer the right protection to investors.

STEINE: Some have suggested that the rigorous U.S. reporting requirements for registrants go too far, that they put U.S. companies at a disadvantage versus their foreign competition. Linda, do such requirements really go beyond GAAP, beyond the FASB requirements?

QUINN: I've spent the last four years dealing with cross-border financing, not only for foreign issuers coming into the U.S. but to simplify the process for U.S. companies raising capital abroad. One of the biggest concerns these companies have is the need to reconcile with U.S. accounting standards and to comply with U.S. auditing and independence standards.

Reconciliation has been required for three basic reasons. Most important, U.S. investors need to get enough information to make an informed investment decision. Second, particularly in the case of equity investments, comparability of financial information is important in evaluating competing investment opportunities. And finally, U.S. issuers should not be disadvantaged in their home market compared with foreign issuers, who may have significantly different and less costly accounting, disclosure, and auditing obligations.

As Ed said, accounting and auditing are key to our financial disclosure system, and whatever we do in the name of competitiveness must not undermine the integrity and efficacy of those two components. We expect standards will converge, so we can accept financials from certain other jurisdictions without compromising the investor protections mandated by the Federal securities laws.

We have proposed a reciprocal agreement with Canada, so a U.S. company can finance in Canada using U.S. documents and U.S. oversight and vice versa. As proposed, reconciliation is necessary only in the case of certain equity financings.

Another concern foreign issuers frequently express is liability under the law and what they perceive as a litigious environment. I don't anticipate a fundamental change in the liability provisions of the Federal securities laws, so foreign investors will just have to decide, on a cost/benefit basis, whether listing or offering securities in the U.S is worth the risk. At this point, more than 400 do think so.

STEINE: Lonnie, do U.S. accounting standards and the SEC hurt you in international markets?

ARNETT: Yes, there are two areas where standards affect our international competitiveness. First, U.S. standards-such as for pensions, income taxes, and now OPEB-are more detailed and more complex. implementation imposes a higher cost, and we question whether the benefit of these standards justifies the cost. Do the readers of the financial statements-in which I include not only the average investor but the chartered financial analyst and even the top executives of our companies-really understand them? They are so complex that we don't follow all of them in our own internal reporting. Second, the different methods of accounting that we use for such items as good will and income taxes make it more difficult to compete with foreign companies in the financial markets. That's why we want the SEC and the FASB to balance the practical business impact, along with costs, against theoretical purity when they consider new standards.


STEINE: The SEC bas been advocating current value accounting instead of historical cost accounting for financial assets held by financial institutions. Some observers say that if financial assets are subjected to current value accounting, other assets-inventories, plant, and equipment-will be next. Lonnie, bow do you react to this?

ARNETT: A change to mark-to-market for the assets and liabilities of financial institutions could cause significant volatility in the reported capital of these institutions. Their attempts to minimize volatility could affect their decisions for making loans and investments as well as how to finance those investments. And the public might well misunderstand this information when it is published, Any such change in business practices that are driven by reported results but that do not affect cash flows could have a detrimental impact on the growth and stability of the U.S. economy. Apparently, in 1974, Arthur Burns, then the chairman of the Federal Reserve, was able to convince the SEC's chief accountant, Sandy Burton, to withdraw a mark-to-market proposal for banks for similar reasons, as reported in a September 27, 1990, article in The Wall Street Journal.

There is concern, too, that such a change might bring accounting advantages that would trigger foreign takeovers of U.S. companies. And it might also influence managers to make business decisions based on the perception of accounting results in the financial markets rather than on cash flows and other financial considerations.

Current value accounting can be applied reasonably to financial assets and liabilities traded on established markets. But when we turn to nonfinancial assets, there are problems, such as we experienced with FASB Statement 33-and I don't believe the Commission is considering a return to that. My concern is that current value accounting is more subjective than historical cost accounting, and such subjectivity could increase the risk that assets are overvalued, either by intentional abuse or by honest error. Since the reason for the change is to avoid problems like those in the thrift industry, where apparently assets were overvalued and liabilities undervalued, we need to be careful about introducing any such subjectivity.

COULSON: I don't see any near-term return to Statement 33 or replacement cost accounting, either, but I do want to stress that use of a principal historic cost basis for financial institutions is an area of major SEC concern. The chairman has said that market-value accounting is more relevant to financial institutions, and we should consider a change in that direction. However, it is important to recognize that any move to market-value accounting is a very complex undertaking-in terms of the cost/benefit ratio and in terms of reliable measuring techniques for assets with no liquid markets. These are all areas the FASB is considering in its financial instruments project.

There is a more immediate problem, however; the so-called "trading versus investment" issue. The AICPA's activity to establish accounting guidance for investment securities held by financial institutions by using the intent and ability concept appears to result in people automatically using historical cost for portfolio investments. So we have concluded that guidelines for capturing management's intent in an active economic environment are just not workable. We told the AICPA we'd be concerned about any codification of historical cost for investment securities.

As you know, the AICPA recently abandoned the pursuit of the intent notion and the use of historical cost unless the company intends to sell. It recommended that the FASB pursue a short-term project on investment securities, with a goal of having standards in place for 1991 financial statements. The Commission gives this a top priority. It's critically important that the FASB exercise leadership to undertake a timely, short-term, narrow-scope project to achieve a market-based solution. Obviously, the longer-term process of looking at other aspects of the balance sheet, such as liability valuation, and other assets, will be much more complex. [The FASB issued its exposure draft, "Disclosures About Market Value of Financial Instruments," on December 31, 1990. Comments must be submitted to the FASB by April 30.-ED]

STEINE: Then bow does one audit for current value accounting?

STRAUSS: Some information would be fairly objective, like Exxon's stock price. But some would be very subjective, such as a special-purpose plant you're not planning to sell. Appraisals of the property can be widely variable.

The auditing would cost more, of course, but it is doable. Mutual funds have been doing it for years. It would also take time to get the data and audit it, but ultimately the technology would be in place.

But I must say I kind of like the historical cost method. it shows what a company really did. I oppose current value accounting for commercial companies. And I'm not sure that in all instances current value reporting is useful even for a financial instrument. Take a government bond, for example. is it useful to show the ups and downs of the market on a balance sheet, if you plan to hold the bond to maturity?


STEINE: What does the trend toward consulting and other nonaudit revenue suggest about future audit independence? Norm, would more SEC guidance in this area be useful?

STRAUSS: Auditors have to be impartial and independent. Both the AICPA and the SEC have plenty of rules to keep us independent. More are not needed. From the beginning of the accounting profession, we've been rendering consulting services to clients. In my opinion, this does not adversely affect our independence. Actually, I believe it enhances our ability to perform audits. And both the Cohen Commission in the 1970s and the Treadway Commission in the 1980s failed to find evidence of any cases where non-audit services compromised our independence. in fact, in response to some public concern that there might be a problem, years ago, the SEC required proxy disclosure of nonaudit services-90 percent of registrants used their auditors for such services-and then after a couple of years concluded the disclosure wasn't of much interest and dropped it.

Meanwhile, the profession has taken positive steps. Auditors have to review their non-audit services with the audit committee. And the peer review process monitors this further. But people still ask, I know, how we can decide against our client's interests if they are paying us consulting fees.

All auditors and accounting firms recognize the importance of being independent-it is the cornerstone of our profession-and recognize the risks of not maintaining our integrity, which includes damage to our reputation and possible litigation. Auditors strongly safeguard their independence.


STEINE: Will the SEC panelists update us on current developments?

COULSON: One of the hottest issues is revenue recognition. Specific industry guidance exists, but business practices have changed as poor economic conditions have hit some industries. For example, there's been an increase in what we call the delayed execution of contracts. Statement 48 on revenue recognition requires a valid sale first; only then can you estimate returns. But some companies are using Statement 48 in estimating whether the guy is going to sign the contract. That's a no-no.

We're also concerned about what may be a lack of consistency in auditors' "uncertainty modifications" to annual reports. We want to make sure that auditors use similar modifications in similar situations when they issue their "going concern" opinions. The report must make clear to investors the reasons for any modifications. This is, unfortunately, a situation we're likely to see more of in the current economy.

On issues coming up-like the OPEB standard and the proposed changes to Statement 96-I want to point out a misreading of the SEC's Staff Accounting Bulletin 74 on the need to disclose the impact of new accounting standards that have been issued but are not yet effective. This does not require a company to implement a standard early. it does not require a company to do calculations and disclose them. It says, disclose what you know, then discuss the potential impact. So, with OPEB particularly, no precise quantification would be expected at year end. But you should disclose, if you expect it to be material.

QUINN: At Corporation Finance, we're increasing to 90 the number of accountants we have on staff, which would be a little more than half our entire review staff. To leverage our review resources, we've introduced what we call a "financial review." This means an accountant looks at your full financial statements and related disclosures, then analyzes them, without a concurrent legal review.

We've also developed a task force of about 12 accountants for financial institutions, which has supplemented our regular reviews of banks and S&Ls. After reviewing 200 or 300 financial institutions, the task force has produced a number of enforcement referrals and amendments to annual reports. When the task force finishes with banks and S&Ls, we plan to move on to filings made by insurance companies.

We continue to look closely at the management discussion and analysis section of the annual report. We're going back to a number of issuers whose disclosure documents we looked at in the MD&A reviews that led to the interpretive release (No. 33-6835) to assess whether the release has had its intended effect of improving disclosure. I encourage you all to read the interpretive release, if you haven't already, before your next annual statement is prepared.

Environmental issues are also a key concern. Your MD&A is going to have to disclose the effect of clean-up contingency costs. We are working with the EPA to improve our information as to which issuers may have significant environmental exposure. We get their lists, and they get our disclosures. Those on a clean-up list who haven't disclosed anything will get a comment from us asking to share their analysis that no disclosure is necessary.

On a happier front, we're revisiting Rule 415, the shelf registration rule, which allows companies to register new issues on a delayed basis, to make it more efficient and perhaps to expand it for asset-backed financings.

Finally, Corporation Finance is reviewing proxy voting rules to see if there is a need to revise them. We have three questions: Do the rules have an unintended interference with shareholder communications? Can the costs of compliance be reduced? And are shareholders being adequately protected? I'm not certain when we'll be able to make our recommendations to the Commission.

PENHOLLOW: The EDGAR project is on track. The operational system that we contracted for in january 1989 is ready for testing by pilot participants as of February 1991. Currently, we have about 240 corporations in the pilot program that began in 1984. In addition, about 250 investment companies are filing most of their documents through the pilot system, and another 1,000 investment management companies are filing semiannual and initial reports.

We expect to invite pilot companies to file on the operational system in August 1991. By May, 1992, we will begin requiring all companies to do so, bringing in about 800 that month, 800 in August, and 900 in October. By November 1992, we hope to have, with the pilot filers, about 4,000 filers on the system. The law then requires us to operate the system for six months to assure that it meets the requirements of the filing community. If it does, then we plan by May 1993 to bring the remaining filers into the system at the rate of about 1,500 every three months. This would bring around 15,000 filers onto the new system by mid-1995.


STEINE: Would this count be better off if there were a five-year moratorium on issuing new accounting and financial reporting rules?

ARNETT: I think we do need a little time to absorb what has been thrown at us, such as accounting for income taxes and OPEB, but I don't think it practical to preclude any changes for the next five years. No, I'm not sure the country would be better off, since clearly there are things in the accounting area we need to improve.

STEINE: Next, don't legislative proposals only serve a cosmetic purpose for 95 percent of the companies that file? What is the real objective of these proposals? Linda?

QUINN: How can one say these proposals are already being met, when companies cite the additional costs they would face for meeting them? I agree that most companies are comfortable with their internal controls, and are now relying on them in doing their audits. But I think that this legislation would expand current requirements. Both the SEC and Congress need to understand clearly what all the incremental costs and benefits are and what existing alternatives would accomplish the same result.

STRAUSS: I would add that our clients engage us to give an opinion on their financial statements, not on their internal controls. Yes, for some, we do a lot of work on testing internal controls. But for others we don't see the need because it is more efficient to do extensive balance sheet auditing. So for us to give an opinion on internal controls for the latter would require more work, and higher fees, than is currently the case.

STEINE: Has the adoption of SEC Rule 144A last April had any impact on the number of foreign issues of debt and equity in the U.S.? And does this create any competitive advantage for foreign companies in the U.S.?

QUINN: Because 144A governs resales, not original issues, it's hard to say how many 144A placements there have been so far. We estimate there have been from 23 to 26, of which about 20 are foreign. Many are new to the U.S. market.

The rule does not distinguish between foreign and domestic issuers. U.S. issuers have equal access to the private market and simply have to decide whether it is more efficient for them to use the public or the private market. But I do think that for U.S. issuers, particularly the large ones, the registration process provides a more efficient way to tap the full range of the capital markets.

STEINE: Would the Commission be satisfied with some form of expanded disclosure in the foot-notes on the market value of assets, instead of letting market value changes create potentially large variations of reported results in the financial statements? Ed?

COULSON: We already get extensive disclosures, and it is becoming more complex. Corporation Finance, for example, will be looking even harder at the disclosures by financial institutions regarding their investment portfolios. No, if the most appropriate relevant accounting is the market value of readily traded investment securities, why should that be in a footnote? The Commission has concluded that it belongs in the financial statement.

STEINE: How do you view the handling of ongoing environmental expenditures?

QUINN: I'll speak to the disclosure, and let Ed address the Statement 5 issue. if there are going to be special expenditures for ongoing environmental costs, and those expenditures are going to be material and render historical financial statements materially different from what is likely to occur in the future, then you are going to have to address that in your MD&A. Because one of the purposes of the MD&A is to explain how historic results and financial condition affects the company's prospects, those items that are likely to have a material effect on financial condition or on results of operations have to be discussed. You need to reflect anything-a capital commitment, for example-that is going to make your financial condition different in the future.

COULSON: We've been getting a number of questions along this line. When you are going to be required to close up a mine site, for example, when do you accrue costs that are relatively fixed, how do you accrue them, and can you apply discounting techniques? Those points need to be talked out; but, in general, Statement 5 requires you to accrue known costs over the operational life.

STEINE: Ed, what kind of Statement 96 disclosure is needed for nonadopters, since 96 is currently under revision?

COULSON: I would see a sentence or two at the most, indicating that 96 is under review and you can't estimate the impact on your firm.

STEINE: Linda, a similar question. How can environmental issues be addressed adequately, when the compliance regulations are not yet written?

QUINN: You have to determine the disclosure on the basis of what is known. if the regulations are not yet proposed, look to the legislation and assess its potential effect. Of course, you would probably note that the actual size of the impact could or would be affected by the regulations.

STEINE: Thank you, panel, for your expert advice.
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Publication:Financial Executive
Article Type:panel discussion
Date:Mar 1, 1991
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