Question

Describe how the changing world environment is leading to an increased focus on international financial reporting standards (IFRS)? What reasons do you think this is a good or bad proposition? Be detailed and provide references to support your assertions.

Answer 1

INTRODUCTION AND PURPOSE OF THIS RELEASE

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:

• effective, independent and high quality accounting and auditing standard setters;
• high quality auditing standards;
• audit firms with effective quality controls worldwide;
• profession-wide quality assurance; and
• active regulatory oversight.

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

• independence, integrity and objectivity;
• personnel management, including proper training and supervision;
• acceptance and continuance of clients and engagements;
• engagement performance; and
• monitoring.

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:

• providing continuing education and training on recent developments;
• providing an effective monitoring system to ensure that:
  • firms comply with applicable professional standards;
  • firms have reasonable systems of quality control;
  • there is an in-depth, substantive and timely study of firms' quality controls, including reviews of selected engagements;
  • deficiencies and/or opportunities for improvements in quality controls are identified; and
  • results of monitoring are communicated adequately to the appropriate parties.
• providing an effective and timely disciplinary process when individuals or firms have not complied with applicable firm or professional standards.

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:

• use of International Accounting Standard (IAS) 7, Cash Flow Statements (as amended in 1992) for the preparation of a statement of cash flows;
• acceptance of portions of IAS 22, Business Combinations (as amended in 1993), regarding the method of accounting for a business combination and the determination of the amortization period for goodwill and negative goodwill; and
• acceptance of portions of IAS 21, The Effects of Changes in Foreign Exchange Rates (as amended in 1993), regarding translation of amounts stated in a currency of an entity in a hyperinflationary economy.

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.

C. Development of the Core Standards Project

After studying issues relating to international equity flows, IOSCO noted that development of a single disclosure document for use in cross-border offerings and listings would be facilitated by the development of internationally accepted accounting standards. Rather than attempt to develop those standards itself, IOSCO focused on the efforts of the IASC. In 1993, IOSCO identified for the IASC what IOSCO believed to be the necessary components of a core set of standards that would comprise a comprehensive body of accounting principles for enterprises making cross-border securities offerings. IOSCO later identified a number of issues relating to the then-current IASC standards. The IASC then prepared a work plan designed to address the most significant issues identified by IOSCO -- the "core standards" work program. In 1995, IOSCO and the IASC announced agreement on this work program, and IOSCO stated that if the resulting core standards were acceptable to IOSCO's Technical Committee, that group would recommend endorsement of the IASC standards. The focus of IOSCO's involvement in the core standards project is on use of IASC standards by large, multinational companies for cross-border capital-raising and listing.²¹

IV. MAJOR ISSUES TO BE ADDRESSED IN OUR ASSESSMENT OF THE IASC STANDARDS

A. Criteria for Assessment of the IASC Standards

In an April 1996 statement regarding the IASC core standards project, we indicated that, once the IASC completed its project, we would consider allowing use of the resulting standards in cross-border filings by foreign issuers offering securities in the United States.²² The three criteria set forth in that statement remain the criteria that will guide our assessment of the IASC standards. We request your views on whether the IASC standards:

1. constitute a comprehensive, generally accepted basis of accounting;

2. are of high quality; and

3. can be rigorously interpreted and applied.

In responding to the requests for comment set forth below, please be specific in your response, explaining in detail your experience, if any, in applying IASC standards, and the factors you considered in forming your opinion. Please consider both our mandate for investor protection and the expected effect on market liquidity, competition, efficiency and capital formation.

IASC standards are published and copyrighted by the IASC, and we can not reproduce those standards as part of this release. However, copies of the standards have been placed in our public reference rooms. The IASC also has summaries of each standard available on its website at <www.iasc.org.uk>. A listing of the IASC standards and their effective dates is included as Appendix B. For your convenience, a listing of questions 1-26 is included as Appendix A.

1. Are the Core Standards Sufficiently Comprehensive?

The goal of the core standards project was to address the necessary components of a reasonably complete set of accounting standards that would comprise a comprehensive body of principles for enterprises undertaking cross-border offerings and listings. In developing the work program for the core standards project, IOSCO specified the minimum components of a set of "core standards" and identified issues to be addressed by the IASC.²³ For topics outside the core standards, such as industry-specific accounting standards, it was agreed that IOSCO members either would accept "home country" treatment or require specific "host country" treatment or equivalent disclosure.