International Accounting Standards - Questions and Analysis

Historical Observations

Edited by: Prof. Mentz

Over the last two decades, the global financial landscape has undergone a significant transformation. These developments have been attributable, in part, to dramatic changes in the business and political climates, increasing global competition, the development of more market-based economies, and rapid technological improvements. At the same time, the world's financial centers have grown increasingly interconnected.

Corporations and borrowers look beyond their home country's borders for capital. An increasing number of foreign companies routinely raise or borrow capital in U.S. financial markets, and U.S. investors have shown great interest in investing in foreign enterprises. This globalization of the securities markets has challenged securities regulators around the world to adapt to meet the needs of market participants while maintaining the current high levels of investor protection and market integrity.

Our efforts to develop a global financial reporting framework have been guided by the cornerstone principle underlying our system of regulation -- pursuing our mandate of investor protection by promoting informed investment decisions through full and fair disclosure. Financial markets and investors, regardless of geographic location, depend on high quality information in order to function effectively. Markets allocate capital best and maintain the confidence of the providers of capital when the participants can make judgments about the merits of investments and comparable investments and have confidence in the reliability of the information provided.

Because of increasing cross-border capital flows, we and other securities regulators around the world have an interest in ensuring that high quality, comprehensive information is available to investors in all markets. We stated this view in 1988, when we issued a policy statement that noted that "all securities regulators should work together diligently to create sound international regulatory frameworks that will enhance the vitality of capital markets."1 We have applied this approach in a number of instances, including our recent adoption of the International Disclosure Standards developed by the International Organization of Securities Commissions (IOSCO) for non-financial statement information.2 Our decision to adopt the International Disclosure Standards was based on our conclusion that the standards were of high quality and that their adoption would provide information comparable to the amount and quality of information that U.S. investors receive today.

Currently, issuers wishing to access capital markets in different jurisdictions must comply with the requirements of each jurisdiction, which differ in many respects. We recognize that different listing and reporting requirements may increase the costs of accessing multiple capital markets and create inefficiencies in cross-border capital flows. Therefore, we are working with other securities regulators around the world to reduce these differences. To encourage the development of accounting standards to be considered for use in cross-border filings, we have been working primarily through IOSCO, and focusing on the work of the International Accounting Standards Committee (IASC). Throughout this effort, we have been steadfast in advocating that capital markets operate most efficiently when investors have access to high quality financial information.

However, ensuring that high quality financial information is provided to capital markets does not depend solely on the body of accounting standards used. An effective financial reporting structure begins with a reporting company's management, which is responsible for implementing and properly applying generally accepted accounting standards. Auditors then have the responsibility to test and opine on whether the financial statements are fairly presented in accordance with those accounting standards. If these responsibilities are not met, accounting standards, regardless of their quality, may not be properly applied, resulting in a lack of transparent, comparable, consistent financial information.

Accordingly, while the accounting standards used must be high quality, they also must be supported by an infrastructure that ensures that the standards are rigorously interpreted and applied, and that issues and problematic practices are identified and resolved in a timely fashion. Elements of this infrastructure include:

In this release, we discuss a number of issues related to the infrastructure for high quality financial reporting. We solicit views on the elements necessary for developing a high quality, global financial reporting framework for use in cross-border filings. We believe these issues should be considered in the development of any proposals to modify current requirements for enterprises that report using IASC standards because our decisions should be based on the way the standards actually are interpreted and applied in practice.

We recognize that each of the elements of the infrastructure may be at different stages of development and that decisions and progress on some of these infrastructure issues may be independent of the body of accounting standards used.

II. ELEMENTS OF A HIGH QUALITY GLOBAL FINANCIAL REPORTING STRUCTURE

A. High Quality Accounting Standards

High quality accounting standards are critical to the development of a high quality global financial reporting structure. Different accounting traditions have developed around the world in response to varying needs of users for whom the financial information is prepared. In some countries, for example, accounting standards have been shaped primarily by the needs of private creditors, while in other countries the needs of tax authorities or central planners have been the predominant influence. In the United States, accounting standards have been developed to meet the needs of participants in the capital markets.

U.S. accounting standards provide a framework for reporting that seeks to deliver transparent, consistent, comparable, relevant and reliable financial information. Establishing and maintaining high quality accounting standards are critical to the U.S. approach to regulation of capital markets, which depends on providing high quality information to facilitate informed investment decisions.

High quality accounting standards consist of a comprehensive set of neutral principles that require consistent, comparable, relevant and reliable information that is useful for investors, lenders and creditors, and others who make capital allocation decisions. High quality accounting standards are essential to the efficient functioning of a market economy because decisions about the allocation of capital rely heavily on credible and understandable financial information.

When issuers prepare financial statements using more than one set of accounting standards, they may find it difficult to explain to investors the accuracy of both sets of financial statements if significantly different operating results, financial positions or cash flow classifications are reported under different standards for the same period. Questions about the credibility of an entity's financial reporting are likely where the differences highlight how one approach masks poor financial performance, lack of profitability, or deteriorating asset quality.

The efficiency of cross-border listings would be increased for issuers if preparation of multiple sets of financial information was not required. However, the efficiency of capital allocation by investors would be reduced without consistent, comparable, relevant and reliable information regarding the financial condition and operating performance of potential investments. Therefore, consistent with our investor protection mandate, we are trying to increase the efficiency of cross-border capital flows by seeking to have high quality, reliable information provided to capital market participants.

B. High Quality Auditing Standards

The audit is an important element of the financial reporting structure because it subjects information in the financial statements to independent and objective scrutiny, increasing the reliability of those financial statements. Trustworthy and effective audits are essential to the efficient allocation of resources in a capital market environment, where investors are dependent on reliable information.

Quality audits begin with high quality auditing standards. Recent events in the United States have highlighted the importance of high quality auditing standards and, at the same time, have raised questions about the effectiveness of today's audits and the audit process.3 We are concerned about whether the training, expertise and resources employed in today's audits are adequate.

Audit requirements may not be sufficiently developed in some countries to provide the level of enhanced reliability that investors in U.S. capital markets expect. Nonetheless, audit firms should have a responsibility to adhere to the highest quality auditing practices -- on a world-wide basis -- to ensure that they are performing effective audits of global companies participating in the international capital markets. To that end, we believe all member or affiliated firms performing audit work on a global audit client should follow the same body of high quality auditing practices even if adherence to these higher practices is not required by local laws.4 Others have expressed similar concerns.5

C. Audit Firms with Effective Quality Controls

Accounting and auditing standards, while necessary, cannot by themselves ensure high quality financial reporting. Audit firms with effective quality controls are a critical piece of the financial reporting infrastructure. Independent auditors must earn and maintain the confidence of the investing public by strict adherence to high quality standards of professional conduct that assure the public that auditors are truly independent and perform their responsibilities with integrity and objectivity. As the U.S. Supreme Court has stated: "It is not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional...."6 In addition, audit firms must ensure that their personnel comply with all relevant professional standards.

The quality control policies and procedures applicable to a firm's accounting and auditing practice should include elements such as:7

A firm's system of quality control should provide the firm and investors with reasonable assurance that the firm's partners and staff are complying with the applicable professional standards and the firm's standards of quality.

Historically, audit firms have developed internal quality control systems based on their domestic operations. However, as clients of audit firms have shifted their focus to global operations, audit firms have followed suit and now operate on a world-wide basis. Therefore, quality controls within audit firms that rely on separate national systems may not be effective in a global operating environment. We are concerned that audit firms may not have developed and maintained adequate internal quality control systems at a global level.8

D. Profession-Wide Quality Assurance

The accounting profession should have a system to ensure quality in the performance of auditing engagements by its members. Necessary elements of the system include:

In some jurisdictions the local accounting profession may have a system of quality assurance. However, structures focused on national organizations and geographic borders do not seem to be effective in an environment where firms are using a number of affiliates to audit enterprises in an increasingly integrated global environment.

E. Active Regulatory Oversight

The U.S. financial reporting structure has a number of separate but interdependent elements, including active regulatory oversight of many of these elements, such as registrants' financial reporting, private sector standard-setting processes and self-regulatory activities undertaken by the accounting profession. Each of these elements is essential to the success of a high quality financial reporting framework. This oversight reinforces the development of high quality accounting and auditing standards and focuses them on the needs of investors. It provides unbiased third party scrutiny of self-regulatory activities. Regulatory oversight also reinforces the application of accounting standards by registrants and their auditors in a rigorous and consistent manner and assists in ensuring a high quality audit function.

III. BACKGROUND ON EFFORTS TO REDUCE BARRIERS TO CROSS- BORDER CAPITAL FLOWS

A. Foreign Private Issuers -- The Current Requirements

The Securities Act of 19339 and the Securities Exchange Act of 193410 establish the disclosure requirements for public companies in the United States. The form and content requirements for financial statements filed with the Commission are set forth in Regulation S-X.11 This framework establishes the initial and continuing disclosures that companies must make if they wish to offer securities in the United States or have their securities traded publicly on an exchange or quoted on the Nasdaq stock market.12

Our current financial statement requirements for foreign private issuers parallel those for U.S. domestic issuers, except that foreign private issuers may prepare financial statements in accordance with either U.S. generally accepted accounting principles (U.S. GAAP) or with another comprehensive body of accounting standards (including IASC standards). A foreign private issuer using accounting standards other than U.S. GAAP must provide an audited reconciliation to U.S. GAAP.13

There are some exceptions to this reconciliation requirement. For example, we have amended our requirements for financial statements of foreign private issuers to permit use of certain IASC standards without reconciliation to U.S. GAAP.14 These are:

By requiring a U.S. GAAP reconciliation, with the exceptions noted above, we do not seek to establish a higher or lower disclosure standard for foreign companies than for domestic companies. Rather, the objective of this approach is to protect the interests of U.S. investors by requiring that all companies accessing U.S. public markets provide high quality financial reporting that satisfies the informational needs of investors, without requiring use of U.S. standards in the presentation of that information.15

The U.S. GAAP reconciliation requirement requires foreign issuers to supplement their home country financial statements. The total number of foreign reporting companies increased from 434 in 1990 to approximately 1,200 currently.

B. Towards Convergence of Accounting Standards in a Global Environment

In the past, different views of the role of financial reporting made it difficult to encourage convergence of accounting standards. Now, however, there appears to be a growing international consensus that financial reporting should provide high quality financial information that is comparable, consistent and transparent, in order to serve the needs of investors. Over the last few years, we have witnessed an increasing convergence of accounting practices around the world. A number of factors have contributed to this convergence. First, large multinational corporations have begun to apply their home country standards, which may permit more than one approach to an accounting issue, in a manner consistent with other bodies of standards such as IASC standards or U.S. GAAP. Second, the IASC has been encouraged to develop standards that provide transparent reporting and can be applied in a consistent and comparable fashion worldwide. Finally, securities regulators and national accounting standard-setters are increasingly seeking approaches in their standard-setting processes that are consistent with those of other standard-setters.16 Some national standard-setters are participating in multinational projects, such as those on accounting for business combinations, in order to draw on a broader range of comment about an issue.

If convergence of disclosure and accounting standards contributes to an increase in the number of foreign companies that publicly offer or list securities in the U.S. capital markets, investors in the United States would benefit from increased investment opportunities and U.S. exchanges would benefit from attracting a greater number of foreign listings. Although the U.S. markets have benefited greatly from the high quality financial reporting that U.S. GAAP requires, current disparities in accounting practices may be a reason foreign companies do not list their securities on U.S. exchanges. As Congress has recognized,

[E]stablishment of a high quality comprehensive set of generally accepted international accounting standards would greatly facilitate international financing activities and, most importantly, would enhance the ability of foreign corporations to access and list in the United States markets. 17

These concerns are offset by significant benefits realized by companies reporting under U.S. GAAP, as a result of improvements in the quality of information available to both management and shareholders as a result of reporting under U.S. GAAP.18 It is important that convergence does not sacrifice key elements of high quality financial reporting that U.S. investors enjoy currently. Investors benefit when they have the ability to compare the performance of similar companies regardless of where those companies are domiciled or the country or region in which they operate.

Over the years, we have realized that foreign companies make their decisions about whether to offer or list securities in the United States for a variety of economic, financial, political, cultural and other reasons. Many of these reasons are unrelated to U.S. regulatory requirements.19 However, some foreign companies cite, among other reasons, a reluctance to adopt U.S. accounting practices as a reason for not listing in the United States. These companies have indicated that they have forgone listing in the United States rather than follow accounting standards that they have not helped formulate. Therefore, accepting financial statements prepared using IASC standards without requiring a reconciliation to U.S. GAAP could be an inducement to cross-border offerings and listings in the United States.

On the other hand, other factors could continue to deter foreign access to the U.S. markets. For example, some foreign companies have expressed concern with the litigation exposure and certain public disclosure requirements that may accompany entrance into the U.S. markets.20 Foreign companies also may be subject to domestic pressure to maintain primary listings on home country stock exchanges.

Footnotes

1 Regulation of International Securities Markets, Securities Act Release No. 6807 (November 14, 1988) [53 FR 46963].

2 International Disclosure Standards, Exchange Act Release No. 41936 (September 28, 1999) [64 FR 53 900].

3 We have asked the Public Oversight Board to study the effectiveness of audits. See "The Numbers Game"-- Remarks of Chairman Arthur Levitt at the N.Y.U. Center for Law and Business, New York, NY, September 28, 1998 and "Remarks to the Panel on Audit Effectiveness of the Public Oversight Board" by Chairman Arthur Levitt, New York, NY, October 7, 1999, both available on the SEC website at <www.sec.gov>.

4 See "Quality Information: The Lifeblood of Our Markets" remarks of Chairman Arthur Levitt at the Economics Club of New York, New York, NY, October 18, 1999, available on the SEC web site at <www.sec.gov>.

5 See "World Bank Warns Big Five Over Global Audit Standards," Financial Times, October 19, 1998, page 1.

6 United States v. Arthur Young & Co., 465 U.S. 805, 819 (1984).

7 See the discussion of the elements of quality control of an audit firm's practice in Statement of Quality Control standard section 20.07, published by the American Institute of Certified Public Accountants' (AICPA's) Auditing Standards Board.

8 See, for example, 34-40945, AAER-1098 (PricewaterhouseCoopers) and letters from the SEC Chief Accountant to the AICPA SEC Practice Section dated November 30 ,1998, and December 9, 1999 regarding the need for global quality internal controls over independence matters, available on the SEC website at <www.sec.gov>. We have asked the Public Oversight Board to sponsor reviews at other accounting firms and to oversee development of enhancements to quality controls and other professional standards to address this concern.

9 15 U.S.C. 77a et seq. (Securities Act)

10 15 U.S.C. 78a et seq. (Exchange Act)

11 17 CFR 210.1-01 et seq.

12 In addition to exchange and Nasdaq traded securities, which are required to be registered, the securities of many unregistered foreign issuers trade in the over-the-counter markets in the United States. Unregistered companies are not required to file periodic reports with the Commission or reconcile their financial statements to U.S. generally accepted accounting principles.

13 Items 17(c) and 18(c) of Form 20-F permit a foreign private issuer to provide financial statements prepared in accordance with another comprehensive basis of accounting, provided that the issuer also provides a reconciliation of net income and balance sheet items to U.S. GAAP. Domestic issuers are required to file financial statements prepared in accordance with U.S. GAAP. Rule 4-01(a)(2) of Regulation S-X, 17 CFR 210.4-01(a)(2). All financial statements must be audited in accordance with U.S. generally accepted auditing standards (Rule 2-02(b) of Regulation S-X, 17 CFR 210.2-02(b)) by an auditor satisfying the U.S. independence requirements (Rule 2-01 of Regulation S-X, 17 CFR 210.2-01).

We are not considering modifying the requirement that financial statements filed with the Commission be audited in accordance with U.S. generally accepted auditing standards. We note, however, that IOSCO currently is exploring further work on improving auditing requirements. Current auditing practices in the United States are under review by the Panel on Audit Effectiveness, sponsored by the AICPA Public Oversight Board. We also are not considering modifying the requirement that auditors comply with U.S. independence requirements.

14 See Items 17 and 18 of Form 20-F for a description of the relief from reconciliation provided to financial statements prepared using IASC standards or standards that are consistent with IASC standards. 17 CFR 249.220f.

15 See Grace Pownall and Katherine Schipper, "Implications of Accounting Research for the SEC's Consideration of International Accounting Standards for U.S. Securities Offerings" in Accounting Horizons, September 1999. Among other things, this paper describes selected academic research that addresses the usefulness to U.S. investors of non-U.S. GAAP reports and U.S. GAAP reconciliations. Pownall and Schipper point to research that suggest that higher net income often is reported under the current IASC standards than under U.S. GAAP. This paper also cites research that suggests that financial statements prepared using IASC standards are not seen as substitutes for U.S. GAAP performance measures by U.S. investors.

16 See, for example, the "FASB's Plan for International Activities," February 1997, that includes "Continu[ing] to consider foreign national and IASC standards in FASB project[s]" and "Cooperat[ing] directly with other standard-setting organizations to resolve specific issues and to work toward reducing differences in accounting standards between nations." Additionally, the FASB has undertaken joint projects with other standard setters, for example, on segments and earnings per share. Also, standard setters from the United States, Canada, Australia, New Zealand and the United Kingdom have worked with the IASC through the "G-4+1" group to debate current agenda items and coordinate standard setting efforts.

17 National Securities Market Improvements Act of 1996.

18 See Louis Lowenstein, "Financial Transparency and Corporate Governance: You Manage What You Measure," Columbia Law Review, Volume 98, No. 5 (June 1996).

"...Senior officers of Ciba Geigy Limited and The Holderbank Group report a long list of managerial gains from improved financial disclosure [footnote omitted]. Divisions now report on a consistent basis, there is a more rational allocation of costs, and expenses are no longer charged to surplus. In short, they have found it easier to manage the company...." (p. 1357)

19 James A. Fanto and Roberta S. Karmel, "A Report on the Attitudes of Foreign Companies Regarding a U.S. Listing," Stanford Journal of Law, Business and Finance, Summer 1997, Vol 3 No. 1 pg. 51-83.

20 See Fanto and Karmel, id.