I think it is fitting to talk about the importance of our shared work in the public interest here at Baruch College, in particular, which traces its history back to the establishment of the Free Academy in New York City in 1847. From its very beginning, this institution has had a public interest mission, and this was demonstrated in part by admitting students from families engaged in a wide variety of trades and professions: butchers, carpenters, laborers, blacksmiths, clergy.
The work of the SEC staff, as well as more broadly the work of the accounting profession, also has a broad set of beneficiaries. Our collective work benefits savers and workers, including teachers, factory workers, farmers, nurses, members of the military, veterans, as well as many others. Working in the public interest has been integral to our three-part mission to protect investors; to maintain fair, orderly, and efficient markets; and to facilitate capital formation.
Revenue Recognition and Credit Losses
I’d like to start the technical discussion with a few remarks regarding the implementation of the new revenue recognition standard. First, while we understand that some companies might be behind schedule in their implementation progress, I want to acknowledge the many companies that have been working very thoughtfully through their implementation and that have made significant progress. We understand that certain companies have substantially completed their technical accounting analyses and are in the process of analyzing and considering the required disclosures in the standard, and are also focused on developing sustainable processes and internal control over financial reporting. These companies should be commended for their efforts, and I believe the diligence that they have demonstrated in implementing the new standard will both benefit investors and serve as a good model for all companies, as the profession continues to implement other major GAAP standards over the next few years.
Second, I want to emphasize the importance of the disclosures in the new revenue recognition standard. There are a number of significant new disclosures, and for some companies, getting ready to prepare them might be one of the most challenging parts of the implementation process. I would continue to urge companies not to wait until the end of the year before trying to get the data, the systems, the process, and the controls in place to make the disclosures required by the standard. These disclosures are important for investors, and we urge companies to treat them as such and to allocate appropriate time and resources to them.
I’d like to also comment on implementation of the new credit losses standard. I think it’s important to a successful implementation that stakeholders continue to invest the time and the effort to identify any issues and submit them to the FASB staff for consideration for future TRG [Transition Resource Group] meetings. Implementation questions related to this standard need to be discussed in an open and transparent forum, so that all stakeholders can have confidence in the process and can learn from the discussions among a diverse group of interested parties.
I want to emphasize the value of our independent accounting standards setting process. Farsighted business leaders have supported the independence of the process, and they’ve accepted even those standards that worked against their short-term interests. At the same time, Congress and the SEC have taken steps to reinforce and ensure the independence of the accounting standards setter, because general acceptance of accounting standards used in our markets requires it. For investors to place full confidence in accounting standards, those standards must be perceived as being above political concerns, commercial interests, influence of special-interest groups, or bureaucratic convenience. In that context, I was concerned when I recently heard of some advocating for implementation of the new credit losses standard to be put on hold, pending an analysis of long-term macroeconomic effects.
FASB, as an independent standards setter for financial accounting and reporting standards, conducts an inclusive due process that invites all constituents to voice their concerns. If an individual or a group does not like the direction or the outcome of the process, they have appropriate forums to express their disagreement or doubt. At times, however, it can appear that the methods used to express such agreement, disagreement, or doubt could serve to undermine FASB’s independence as well as its due process, and could distort the objectives of general purpose financial reporting standards. The accounting profession has been proactive in defending the independence of FASB and its standards-setting process, and I hope that continues.
FASB developed the new credit losses standard in response to the needs of investors for more timely information about credit losses. Loan loss provisions under the new standard can provide investors with more timely information about the risks and economic conditions that affect providers of credit. It’s well established in academic research that more transparent financial reporting reduces investor uncertainty, leading to lower cost of capital.
We should all keep in mind that the new credit losses standard applies to all industries, and banks are both providers of credit loss information when they report their own GAAP financial information and users of that information when their underwriting process considers information in a potential borrower’s GAAP financial statements.
If there are questions about implementing the accounting requirements of the new standard, then FASB is the right body to address them. Banks can and should support the implementation process by identifying issues and submitting them to the TRG. They can listen to those meetings and certainly offer their resources to participate.
IFRS and Foreign Private Issuers
High-quality information benefits the capital markets for both domestic companies as well as foreign private issuers. Many U.S. investors and companies continue to have an ongoing interest in the quality of IFRS, as they produce and use financial information prepared in accordance with it on a regular basis. Consequently, knowledge and understanding of IFRS, including the similarities and the differences between it and U.S. GAAP, are highly relevant to U.S. stakeholders. Reduced differences between U.S. GAAP and IFRS make those processes considerably more effective and lead to higher-quality reporting for U.S. companies overall.
OCA regularly consults with U.S. registrants on matters involving U.S. GAAP and IFRS, including some recent consultations with U.S. multinationals on their accounting policies that they plan to adopt for the new revenue recognition standard. But we’ve not observed the same level of consultation activity originating from foreign private issuers that file with the SEC. There may be various reasons for this, but this is a useful occasion to remind all issuers that OCA’s consultation process is available to provide SEC staff views on technical accounting positions on a pre-filing basis.
Maintaining effective internal control over financial reporting is essential to the production of high-quality information for investors.
Internal Controls and Supplemental Reporting
Maintaining effective internal control over financial reporting is essential to the production of high-quality information for investors. While the SEC has not mandated the use of a particular framework, most companies have selected the COSO framework. Most registrants have made the transition to the 2013 COSO framework, and I encourage those remaining to adopt the 2013 COSO framework timeline. In addition, I encourage stakeholders, including COSO, to monitor the evolving business and operating environments to determine whether updates to the control frameworks might be needed.
Moving beyond the financial statements, in addition to reporting non-GAAP measures, many companies also, of course, disclose key operational metrics, forecasts, and other kinds of reporting, which may represent important sources of information for investors and supplement the information provided by GAAP. Similar to non-GAAP financial reporting, key operating metrics and forecasts may be subject to distortion through bias, painting a potentially misleading picture. They could also be distorted by error or fraud, all of which undermine the credibility of the reporting. Therefore, it is important that companies proactively and thoughtfully address risks within their reporting systems.
Companies should first understand the other information being reported, including how operating metrics have been defined. Companies then should have adequate disclosure controls and procedures in place. In some respects, those other reporting processes may require more steps than some GAAP processes, not fewer. When a company determines a supplemental reporting framework, it must look to its own policies, audit committee, and other stakeholders for input. Companies should consider whether it would be beneficial to obtain insight into their other reporting processes from those outside of the finance and investor relations functions. Sometimes a fresh perspective can provide new insight into the potential risks and ways to maintain the effective operation of essential controls and procedures.
Auditors play a vital role in our capital markets, in part because of their impartial and objective judgment about financial reporting, reinforced by their independence. Given the central role of independence in the auditor relationship, OCA closely monitors the application of SEC rules and guidance, including through our consultations process.
In this regard, there’s one particular area that my office has analyzed as part of these ongoing monitoring efforts. A provision of the SEC’s independence requirements, often called the “Loan Provision,” generally provides that an accountant is not independent when the accounting firm has any loan to or from an audit client, or an audit client’s officers, directors, or owners, of more than 10% of the audit client’s equity securities. Last year, the Division of Investment Management, in consultation with my office and the Division of Corporation Finance, issued a temporary no-action letter with respect to the Loan Provision regarding certain lending and ownership relationships. The OCA is considering recommending potential amendments to the Loan Provision to address the circumstances that gave rise to the need for the no-action letter, while continuing to ensure that auditors are independent of their audit clients. At the same time, and in order to provide additional time to consider the issues raised, my colleagues in the Division of Investment Management expect to extend the relief originally provided by the no-action letter.
On another issue, the Sarbanes-Oxley Act of 2002 mandates that audit committees be directly responsible for the oversight of the engagement of the company’s independent auditor, and the SEC rules are designed to ensure that auditors are independent of their audit clients. The OCA staff was recently consulted regarding whether an auditor could, prior to its dismissal, propose prohibited nonaudit services to be performed after the end of the audit and professional engagement period. It’s the staff’s view that, depending on facts and circumstances, this activity could potentially impair the auditor’s independence under the general standard in Rule 2-01(b) of Regulation S-X. Also, proposing the activity while the firm is still the auditor could adversely impact the auditor’s ability to maintain professional skepticism while conducting the audit.
Consistent with maintaining good oversight of auditor independence and performance, I encourage audit committees to engage with the auditor to understand the impact of any proposed activities for nonaudit services on the auditor’s independence and audit quality. This is particularly relevant in a period where an audit committee is considering auditor rotation. As always, the staff is available to consult on matters of this nature.
We all have an important and shared responsibility to work in the public interest, providing high-quality information to our capital markets, which leads ultimately to better decisions.
I want to talk to you about my perception of changes in the financial reporting environment over the last 15 years and how those changes have impacted FASB in terms of what we do and how we do it, and how I think that they should impact FASB.
When I started with FASB, there were multiple accounting standards setters. We had FASB, the AICPA through AcSEC issuing SOPs, the AICPA issuing accounting and audit guides that provided GAAP guidance, the EITF issuing consensuses without FASB approval, and an SEC observer that would speak up at EITF meetings and effectively create what we termed “turbo” GAAP. Since I’ve been at FASB, the SEC has not created much turbo GAAP. The consensuses of the EITF are now subject to the approval of the board. And we met with the AICPA and asked them to stop issuing GAAP through SOPs and Audit Guides. So we basically have one standards setter now.
Obviously the existence of the PCAOB is a big change. I joined FASB on August 1, 2002—two days after George Bush signed Sarbanes-Oxley into law. But I think the PCAOB has had a significant impact on how accounting standards are applied and how FASB has to think about creating accounting standards, particularly with the increasing emphasis over internal controls over financial reporting.
Since I joined, there has been a significant increase in consultation and the creation of subject matter experts at all the firms. These are people that know the standards backward and forward much better than board members ever will. There has been a dramatic increase in the focus on users of financial information and what users need. When I joined the board, no staff had a user background. Now we have two full-time staff with user backgrounds. There was one board member with user background; now we have two board members with user background. The PCAOB has an Investor Advisory Group and the SEC has an Investor Advisory Committee, so there’s much greater focus on what users of financial statements need.
The length of financial reports continues to grow. I recently read a report from an attorney who looks at SEC filings that the typical 10-K today is over 10 times the size of a 10-K back in the 1950s. The user focus on information distributed prior to the filing of a 10-Q and a 10-K is also a major change. And there’s much more emphasis on the earnings releases and the investor packages that are provided to users. The professionalization and specialization of investors is another major development over the last 15 years. There are fewer and fewer generalists. The increase in non-GAAP metrics or non-GAAP disclosures is something; you cannot go a day without seeing another article about non-GAAP measures.
The creation of the [Accounting Standards] Codification is a significant change. Years ago, you had to go through eight or nine books on EITF consensuses, the listing of SOPs, and the industry audit guides to find something related to the topic you were looking for. Today, you just go to the topic and the codification and you can find it.
How FASB Has Changed
What do these changes mean for FASB? And how have they impacted us and how should they impact us in the future? First, when I joined the board, the view of most people was that FASB set standards in this ivory tower and didn’t pay much attention to what people thought. Today, we’ve significantly increased our outreach to constituents. In fact, I recently heard that the chairman of our trustees, Chuck Noski, was doing his own outreach and had discussions with a former board member who’s been particularly critical. The problem is, in his mind, that we’ve listened to our constituents. (If that’s the worst criticism, I’d say we’ve done one hell of a job.) The bad news is that because of this significant outreach effort, it takes us a heck of a lot longer to get things done.
We ought to try to do what’s best for financial reporting, but we can’t do it in a vacuum. We need information in order to make a better informed assessment of the costs and the benefits.
A second impact is the increase in complexity for board members in terms of making decisions on particular accounting issues. We have a conceptual framework that we’re supposed to adhere to, to guide us. But at the same time, we have users that don’t always understand accounting and don’t even have a clue that we have a conceptual framework, and they give us some guidance to go in another direction. Personally, I think some of the basic decisions that we’ve made on credit losses, on leases, and on consolidation of VIEs [variable interest entities] are not necessarily in accordance with our conceptual framework. But those decisions were all made because users requested a certain type of information or in a certain way. So this is something that FASB needs to figure out how to address.
Thirdly, the focus on press releases has influenced our decisions on how things should be presented in financial statements. Some board members are obviously aware that users are digesting information that is made public way before financial statements are filed. And as a result, they said, “No, I don’t want this information in the notes because I don’t want users to have to wait until the notes to get it. I want it on the face of the financial statements.” Over my 10 years as a board member, I’ve seen specific decisions made time and time again because of that.
Clearly our agenda from 2002 to 2015 was significantly influenced by the Norwalk Agreement and the movement towards converging with the IASB. I doubt very much that we would have approached revenue recognition as comprehensively as we did had it not been for the IASB’s need for more complete guidance.
Finally, there’s been a significant increase in the length of time from issuing standard to its effective date. When I joined FASB, EITF consensuses were effective the next day. Now we give people four-plus years in order to adopt a standard.
What are the lessons for immediate consideration? First of all, we need to better evaluate the costs of implementing our standards, and we need to better evaluate them in terms of the increased emphasis on internal controls over financial reporting. Not a lot of people at FASB right now have audited or been preparers in a post–Sarbanes-Oxley world. I think it’s great that Marsha Hunt is joining the board to replace me, because she’s been a controller in the real world under Sarbanes-Oxley and has a better head for assessing what the costs of implementing a standard are.
I think revenue recognition is a perfect example. Under Topic 606, there are a significant number of transactions that will get recorded at the same amount and in the same timing as they were reported under Topic 605. But companies still had to first read and understand the new standard. They had to assess the impact of that standard on their systems and design and implement new systems of internal control in order to comply with financial reporting requirements. Then their auditors had to evaluate those changes. That’s a significant cost. And I can tell you that I probably underestimated what that cost was.
Some board members view this as “not their problem.” After all, FASB didn’t write Sarbanes-Oxley. We’re not the PCAOB. And they continue that thought process and say, “We ought to do what’s best for financial reporting, period.” I don’t disagree. We ought to try to do what’s best for financial reporting, but we can’t do it in a vacuum. We have to assess the costs of developing those systems of internal control, and we need information to do that in order to make a better informed assessment of the costs and the benefits. Another consideration is that FASB needs to figure out how to complete our projects on a timelier basis. It took us 10 years for leases, and what did we do? We took an existing standard and we effectively put operating leases on the balance sheet. It took us 12 years for revenue recognition, and the effective date for credit losses is 12 years after the financial crisis. We need to do a better job of more timely addressing the issues that are out there.
Third, as a result of the changes over the last 15 years, we need to come up with a better system of evaluating user input in relation to our conceptual framework.
Fourth, while I think the codification has been great in terms of the ability to access information and figure out where to go, we need to improve readability. And at this point I’m going to be a little bit critical of some of the firms. Any time we propose to rewrite something—even though our intention is not to change anything, but just make it more readable—the firms come back and say, “You can’t do that. You’re changing GAAP.” We changed the word “of” to “and,” and all of a sudden we’re accused of changing GAAP. I think we need a little bit more flexibility in terms of how firms address those types of changes, because I think it’s critical that the codification be presented in a more readable fashion.
We need to consider what information is being used, when that information is being used, and how it’s being used.
We tried that for certain topics and we’ve been criticized for those changes. I think people need to be more open-minded in terms of improvements to the codification. And, quite frankly, now is the time to do it. There is not a lot on the board’s agenda right now, and I think there would be a benefit to it.
I think there are some more fundamental considerations for the future. I think that we as standards setters—and I include FASB, the SEC, the PCAOB, and the AICPA—have to think more holistically. We need to consider what information is being used, when that information is being used, and how it’s being used in making investment decisions. What is the role of financial statements? What’s the role of press releases and related investor packages? What’s the role of non-GAAP measures, and should something be done to ensure their credibility?
The Center for Audit Quality in December 2016 put out an excellent brochure that raised certain questions that should be discussed among investors, auditors, preparers, the SEC, FASB, and the PCAOB relative to non-GAAP measures. I believe similar questions should be raised for information distributed through earnings releases and investor packages. Increasingly, information included in Form 10-Qs and Form 10-Ks is really just confirmatory in nature; investment decisions are being made earlier. A former chairman of Deloitte describes the role of financial statements in a great way. He describes the dissemination of financial information as a train and says that the financial statements are the caboose of that train.
What should be done in the future? Should someone mandate minimal information that must be presented when released prior to the financial statements? Should there be some kind of attestation report surrounding that information? Should standards ensure that non-GAAP measures that appear to be similar are in fact similar? These are some of the issues that I think the financial reporting community needs to address.