1000 WORD ESSAY

© 1998 American Accounting Association Accounting Horizons Vol. 12 No. 1 March 1998 pp. 79-82

COMMENTARY

Arthur Levitt

Arthur Levitt is the chairman of the U.S. Securities and Exchange Commission.

The Importance of High Quality Accounting Standards

I want to tell you how excited I am about the hemisphere-wide investor education campaign that the Council of Securities Regulators ofthe Americas (COSRA) will launch March 1998. Each COSRA memher will run programs in its own country as part ofthe campaign. Initiatives will include town meetings and radio and TV announcements that raise awareness of important issues to consider when investing. I understand that "hot lines" also will be established for investor complaints.

As one who has led some 20 town meetings for individual investors across the U.S. over the last several years, I heartily endorse this project. The benefits of investor edu- cation are many. Not only do educated investors protect themselves better, but they also are willing to invest their money to provide capital to new and expanding compa- nies, thereby allowing businesses and jobs to grow, as well as contributing to regional economic stabihty. Informed investors are an important ingredient of liquid, stable capital markets. I wholeheartedly support this important COSRA initiative.

Let me now move on to the main subject I want to discuss with you: the need for high quality accounting standards. While this may seem miles removed from investor education, it really isn't. Educated investors need relevant, useful information to make their investment decisions—and that is what high quality accounting standards de- liver.

The SEC is concemed with accounting standards because of our mandate to protect investors. U.S. securities laws, as well as the SEC's own rules and regulations, all spring directly from this basic concept. We pursue this mandate not through merit regula- tion—allowing only "healthy" companies to trade their securities—but by market regulation.

Ever since the SEC was established in 1934, our approach has been to require com- panies that wanted to list or trade their securities to comply with initial and continuing disclosure obligations. The goals of this approach are to prevent misleading or incom- plete financial reporting and to facilitate informed decisions by investors.

Arthur Levitt presented this speech to the Inter-American Development Bank on September 29, 1997.

80 Accounting Horizons /March 1998

Robust financial reporting is essential to full disclosure—that's why the Commis- sion has the authority to set accounting standards. Practically since its inception, how- ever, the SEC has looked to the accounting profession to play a leading role, while the SEC staff monitors and oversees these standard-setting activities. This partnership with the private sector provides a way to build input into the standard-setting process from all stakeholders in our capital markets, including preparers, auditors and users, as well as regulators.

Establishing and maintaining high quality accounting standards are critical to our approach to market regulation. One way to look at this is to view accounting standards as the camera used to photograph a company. Good standards, like good cameras, pro- duce sharper, more accurate pictures. Weak stand£u-ds, like bad cameras, are unreli- able—with some, you never know if you v(dll get a good shot, while others produce fuzzy, out-of-focus images.

The U.S. approach to capital market regulation makes financial statements—the balance sheet snapshot and income statement video—the centerpiece of our financial reporting system. Therefore, although I am not an accountant, I care a great deal about the quality of accounting standards because I care about the quality of the financial picture that registrants show to market participants.

Let me give you a simple example of how accounting standards shape the pictures provided to investors. Good accounting standards produce financial statements that report events in the period in which they occur, not before, and not after. This means that there are no extra "rainy day" reserves, no deferral of loss recognition, and actual volatility is not "smoothed away" to create an artificial picture of steady and consistent growth.

Therefore, I'd expect that a company insuring beach-front homes would report losses when there are unusually severe hurricEuies and extra profits in unusually calm years. This is just one example ofthe representational faithfulness that investors need from disclosures, from financial statements—and therefore, from accounting standards.

In the U.S., our accounting and disclosure system supports—indeed, makes pos- sible—the willingness of both institutions and individual households to invest in our capital markets. This broad participation provides a much larger pool of investor funds than would otherwise be available. I firmly believe that the success of capital markets is directly dependent on the quality ofthe accounting and disclosure system. Disclosure systems that are founded on high quality standards give investors confidence in the credibility of financial reporting—and without investor confidence, markets cannot thrive.

INTERNATIONAL ACCOUNTING STANDARDS Turning to the global arena, I see investors broadening their horizons beyond na-

tional borders. At the same time, there are major new demands for capital that must be satisfied at an intemational level. The interplay of these forces, aided by improvements in communication technology, is working to connect national capital markets as part of a global economy. As a result, many companies are interested in the development of stauidards that would be accepted in all the world's major securities markets. As you may know, the SEC has participated actively in the current intemational project to develop such standards.

We are very sensitive to the costs associated with non-uniform accounting stan- dards. But as we attempt to answer the call for more accounting harmony, we must focus, first and foremost, on the needs of capital markets and capital market participants.

The Importance of High Quality Accounting Standards 81

Harmonization would be easy to achieve if the mission were to develop standards that would accommodate every country's preferences—an approach that has been char- acterized as finding the lowest common denominator. Another simple approach would be to negotiate harmonization at a bargaining table, but that would result in a rule book vdthout clear concepts or objectives. Any set of accounting standards that seeks global acceptance must be shaped instead by looking to the needs of investors and the capital markets. This will not be the easiest road, but it is critical that we make sure that our global markets are built on firm foundations. I believe that harmonization of accounting standards will be successful only if those standards deliver what standards provide in U.S. markets—credible information grounded in transparent financial reporting.

For international standards to gain acceptance, they must meet three key objectives: • The standards should include a core set of accounting pronouncements that consti-

tute a comprehensive, generally accepted basis of accoxinting. • The standards must be of "high quality—they must result in comparability and

transparency, and they must provide for full disclosure. Investors must be able to meaningfully analyze performance across time periods and among companies.

• The standards must be rigorously interpreted and applied. If accounting standards are to satisfy the objective of having similar transactions and events accounted for in similar ways—^whenever and wherever they are encountered—auditors and regu- lators around the world must insist on rigorous interpretation and application of those standards. Othenvise, the comparability and transparency that is the objec- tive of common standards will be eroded.

In the final analysis, I believe that even those who view this approach—the approach followed in the U.S.—as too rigid or too demanding, or as imposing too many reporting obligations on management, will recognize that these are the characteristics of a sys- tem that has been shaped to meet the needs of investors and capital markets. This orientation—this equity market culture—has not been the historical frame of reference in many countries. But it is the quality that is most attractive to investors and regula- tors. It is vitally important that this quality be replicated in any harmonized intema- tional standards that seek to serve global capital markets.

High quality accounting standards are not created overnight; their development is part of a long-term process and commitment, the product of a continuous dialogue be- tween regulators and the private sector. That process can cost money and political re- sources. But it's worth it. It bears repeating; high quality accounting standards result in greater investor confidence, which improves liquidity, reduces capital costs, and makes fair market prices possible.

This is not a foreign concept to anyone. The Americas have clearly recognized the crucial role that full and fair disclosure plays in creating robust capital markets.

In 1994, COSRA, in its "Framework for Full and Fair Disclosure in the Americas," declared that the efficient allocation of capital in a free market requires full and fair disclosure to those providing the capital—and that this helps ensure investor protec- tion, thereby enhancing investor confidence and market liquidity and efficiency. And just this past June, COSRA issued a set of "Principles for Oversight of Independent Auditors," in which it restated its support for full and fair disclosure of information about public enterprises, including the presentation of financial information that is examined by independent auditors.

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CONCLUSION: WORKING TOGETHER In the United States, we have tried to build and maintain successful capital mar-

kets by instilling investor confidence through our system of full and fair disclosure. And if numbers are any indication, we are succeeding. U.S. markets are providing an unpar- alleled amount of capital to issuers, especially foreign issuers, including over 100 com- panies reporting to the SEC from 13 countries in Latin America and the Caribbean. Last year, more than $1.2 trillion of public securities offerings and private placements were made in the United States.

Our markets are the deepest, most liquid in the world, not because God made them so, but because no other nation has as broad a base of investors as we do. It is a chal- lenge for all of us to maintain and further develop this widespread participation through- out the Americas. Accounting standards are a cornerstone of that broad public involve- ment. People feel more comfortable about investing when thes^re confident that finan- cial statements aren't pulling any punches.

That's why we can't sacrifice quality. The truth is, high standards lower the cost of capital. And that's a goal we share.

So let's continue to work together to build investor confidence—to keep standards high and the cost of capital low— t̂o help fuel businesses and create jobs for all of our people—^building strong economies, and sharing prosperity throughout our hemisphere, from Alaska to Argentina.