Wesley R. Bricker, Interim Chief Accountant
Washington, D.C.
Sept. 21, 2016
The Securities and Exchange Commission (“SEC” or “Commission”), as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.
Introduction
Good morning and thank you Don [Walker] for the kind introduction and invitation to speak at today’s AICPA National Conference on Banks & Savings Institutions.
As has been the case at each of these prior events, today, you will hear from a number of accounting experts — among them staff from the Commission’s Office of the Chief Accountant (OCA) and Division of Corporation Finance. Michal Dusza, Rachel Mincin, and Ruth Uejio, from OCA, are here today and will address new accounting standards, recent developments on non-GAAP financial measures, and audit committee and other professional practice matters.
Within each of these areas, there are new and emerging issues to be identified, managed, and overseen by those with financial reporting preparation and oversight responsibilities. Investors are counting on each of you to fulfill your respective responsibilities for high-quality financial reporting.
Before I continue, let me remind you that for me and all of the SEC staff speaking at this conference, the views expressed are each speaker’s own and not necessarily those of the Commission, the individual Commissioners, or other colleagues on the Commission staff.
Financial Reporting Underpins Our Markets
The reliability and credibility of financial reporting are critical to the confidence of the investing public and the proper functioning of our capital markets.
As the agency empowered by the federal securities laws to be the investor’s advocate, maintain fair, orderly, and efficient markets, and facilitate capital formation, the Commission has the authority and responsibility to specify the form and content of financial statements filed with the Commission. Also, the federal securities laws mandate that these public company financial statements be audited by an independent public accounting firm that will provide an opinion as to the reliability and integrity of the information presented.
OCA is responsible for establishing and interpreting accounting policy to enhance the transparency and relevance of financial reporting for investors. OCA also works to improve the professional performance of public company auditors to ensure that financial statements used for investment decisions are presented fairly and have credibility. In this way, OCA furthers the Commission’s mission by working to enhance the foundation of our disclosure framework – the disclosure of reliable and informative financial information to investors.
OCA leads the Commission’s efforts to oversee two entities with key roles in the financial reporting process: the Financial Accounting Standards Board, or FASB, whose accounting and financial reporting standards the Commission has recognized as “generally accepted” for purposes of the federal securities laws; and the Public Company Accounting Oversight Board, or PCAOB, which is responsible for overseeing the audits and auditors of public companies and SEC-registered broker-dealers.
This morning I would like to talk about ways management, audit committees, auditors, and others can reinforce the reliability and credibility of financial reporting for investors. I will address:
- The FASB’s recent completion of its multi-year standard-setting process for credit losses, which requires earlier recognition of credit losses on many loans, securities, and other financial assets;
- The SEC’s rules and staff guidance for maintaining books and records for credit losses under current GAAP requirements, including a continued focus on internal control over financial reporting (ICFR); and
- The importance of coordination among all stakeholders in the transition and implementation activities relating to the new credit loss standard.
FASB’s New Standards for Reporting of Credit Losses
In June, the FASB issued its final standard for measurement of credit losses on financial instruments.[1] Along with the recently issued guidance on revenue,[2] leases,[3] and financial instruments recognition and measurement,[4] the FASB has now completed its significant work on the key priorities identified in the FASB and International Accounting Standards Board (IASB) 2008 Memorandum of Understanding.[5] Transition activities for each of these major, newly issued standards are underway for public companies.
To provide perspective on the magnitude of the transactions addressed by the FASB’s credit losses guidance, consider that public companies reported in their 2015 10-K filings aggregate amounts of approximately:
- $17 trillion in investment securities, designated as either available for sale ($14.5 trillion) or held to maturity ($2.5 trillion); and
- $10 trillion in loans and lease receivables.
While the focus of the conference today is on banks, the impacts of the new standard go beyond any particular industry group and apply to all reporting entities that hold financial assets not reported at fair value through earnings.
Appreciating the Historical Perspective
In considering the significance of the new credit loss standard, I believe it is relevant to consider how practices have evolved over time.
Establishing reserves for bad loans is a concept with a long history. For example, the reserve for bad loans became a recognized tax accounting method with the Sixty-Seventh Congress’s Revenue Act of 1921, when banks were allowed to deduct the loan loss expenses on their tax returns. Following on the heels of the 1929 stock market crash and the creation of the Securities and Exchange Commission, the SEC appointed a chief accountant, Carman Blough, who promptly began to work closely with accounting experts, such as the American Institute of Accountants.
In 1940, for example, the American Institute of Accountants published a bulletin[6] that noted different reserving practices according to lien position, in noting: “It is common practice to create a reserve in full for all junior liens (such as second mortgages).”
By 1951, the guidance[7] of the American Institute of Accountants focused on including losses in the determination of net income in noting that “… under generally accepted accounting principles an allowance for losses … should be reflected … in arriving at net income.”
Still, later, in 1968, the American Institute of Certified Public Accountants, as successor to the American Institute of Accountants, published a description of practices for balance sheet presentation of the reserve,[8] noting:
“….some banks carried the reserve on the liability side as a reserve outside the capital accounts section, others carried it as a reserve among the capital accounts, and a small number of banks segregated the reserve, deducting from loans the portion of the reserve considered required to absorb loan losses in the current loan portfolio and carrying the remaining portion of the reserve on the liability side of the balance sheet, either within or outside the capital accounts section.”
Then, in 1975, shortly after its creation, the FASB issued Statement 5[9] addressing the accounting for loss contingencies, which practitioners have applied for 40 years – it dealt with the recognition and measurement threshold for accounting for contingencies. During the financial crisis that began in 2008, the recognition and measurement of credit losses was a point of focus for many, including Congress.[10] In response to the financial crisis, the FASB allocated significant resources to improve GAAP by gathering feedback from stakeholders, including the issuance of three documents for public comment[11] that generated more than 3,300 comment letters, and meetings with more than 200 financial statement users.[12]
The Commission and SEC staff have been active in this area over the years, as well, with methodology and documentation requirements in Financial Reporting Release No. 28 (“FRR 28”), coupled with the staff’s guidance in SEC Staff Accounting Bulletin 102 (“SAB 102”), and reinforced through Commissioner and SEC staff remarks, [13] “Dear CFO” letters to management,[14] interagency statements,[15] Congressional testimony,[16] and other guidance from the SEC staff.[17] As I will touch on again later, the Division of Enforcement has also acted to address violations of federal securities laws.
The New CECL Standard
The near century-long history of developments reflects the importance of the accounting estimate for loan losses, particularly to investors and other stakeholders.
Under the FASB’s new standard, a company will recognize an allowance for its estimate of current expected credit losses for financial assets measured at amortized cost, which the FASB believes will result in earlier recognition of credit losses, compared to the current standards. The guidance is also intended to reduce the complexity of accounting standards by decreasing the number of credit loss approaches that companies use to account for financial instruments.
Under the new standard, a company will recognize its estimate of expected credit losses for financial assets as of the end of the reporting period. Also, the standard does not specify a one-size-fits-all method for measuring expected credit losses. Rather, companies will need to use reasonable judgment to develop estimation methods that are well documented, applied consistently over time, and faithfully estimate the company’s estimate of expected credit losses.
In measuring the amount of loss, an entity must consider all available relevant information, including details about past events, current conditions, and reasonable and supportable forecasts and their implications.
Existing SEC Requirements and Guidance
Preparers are required to make and keep books, records, and accounts, that accurately and fairly reflect the transactions of the issuer. The SEC further requires preparers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurance that transactions are recorded in conformity with GAAP or any other criteria applicable to such statements.
Management’s documentation of policies, procedures, methodologies, and decisions will continue to be necessary to support books and records. Given the role of and need to incorporate reasonable and supportable forecasts in applying the new standard, the Commission guidance in FRR 28 and SEC Staff guidance in SAB 102 will continue to be relevant in evaluating whether the key principles of the accounting standard have been achieved. The existing guidance directs registrants to ensure their loan loss allowance methodologies: [18]
- Include a detailed analysis of the loan portfolio, performed on a regular basis;
- Consider all known relevant internal and external factors that may affect loan collectibility;
- Be applied consistently but modified for new factors affecting collectibility, when appropriate; and
- Be well documented, in writing, with clear explanations of the supporting analyses and rationale.
In applying the accounting standard and meeting the existing guidance, management may need to identify and resolve as part of its application of internal control over financial reporting significant differences in views regarding collectibility advanced by various business units and other functions within the company, in determining that management’s best estimate is reflected in the financial statements.
The SEC staff’s efforts in the area of internal control over financial reporting remain ongoing, coordinated, and integrated. For example, frequently, OCA staff work with staff from the Divisions of Corporation Finance and Enforcement on issues involving internal control over financial reporting, including issues related to the adequacy of controls over recognition and measurement of loan losses. Enforcement cases have not been limited to violations by management only; cases have been brought against external auditors and consultants as well. Several recent enforcement cases have emphasized not only the importance of controls but also that all those involved in assessments of internal control over financial reporting must take their responsibilities seriously.[19]
Achieving Successful Implementation
As Chair White noted in a December speech, preparers, auditors, audit committee members, and their advisors must work together in order to fulfill the high expectations investors rightly set for financial reporting.[20]
In the spirit of Chair White’s remarks, there are several guiding concepts that I believe will promote an appropriate transition to the new standard.
Implementation discussions
Implementation of the new credit loss standard — or any principles-based standard for that matter — requires not only professional judgment rooted in values of good reasoning, practicality, and informational utility but also the engagement of and collaboration among all stakeholders as we better understand the application of the key principles of the standard to a variety of fact sets. OCA will continue to actively participate in implementation discussions and respect well-reasoned, practical judgments when those judgments are grounded in the principles of the standard, faithfully estimate expected credit losses and have considered the utility of the resulting information to investors. However, aggressive interpretations that appear to be taken to achieve a specific outcome will not be well received, particularly when that outcome is inconsistent with the principles of the new standard.
The FASB staff and members of the FASB Transition Resource Group (“TRG”)[21] have been instrumental in providing a collaborative forum to solicit, analyze, and discuss implementation issues as a mechanism to inform the FASB about those issues. This process has yielded useful enhancements reflected in the final standard which will improve the consistency of application, which is a hallmark of our financial reporting system. Moreover, the TRG has been a critical forum for stakeholders to share views about and understand how to make appropriate judgments. Future TRG deliberations and educational opportunities are limited unless preparers, industry groups, and others identify and refer challenging issues to the TRG for resolution.
The AICPA Depository Institutions Expert Panel, regulators, and other groups are working to help educate constituents on the application of the principles in the new standard. I appreciate the efforts of the AICPA and the volunteers who contribute their time and resources to the efforts. Collaboration and cooperation are important to this endeavor. The implementation processes operate best when all of the members bring their expertise and objective judgment to bear on the important issues under consideration, focus on faithful and practical applications of the standard, and produce information that serves the needs of investors. Ultimately, in order to arrive at a reasonable application of the new credit loss standard, and to be credible, views resolving implementation issues should be thoroughly vetted.
To the extent that a registrant has a material interpretative question that may not be appropriate for the TRG either because it is not likely to be wide-ranging or is specific to a particular set of facts, OCA is available for consultation. Registrants should follow our established consultation process.[22]
Implementation plans
It is a good time for companies, their audit committees, and their auditors to assess the quality and status of implementation plans so that the implementation of the standard achieves the financial reporting objectives intended by the standard setters. Without an appropriate allocation of time and resources, companies risk financial reporting failures that can lead to significant, adverse consequences for shareholders.
Implementation will involve in many cases a fresh look at estimation processes and related policies, procedures, systems, and internal controls. Investors expect companies to have internal controls in place to reasonably assure the reliability of the financial information reported by management. Therefore, transition plans for the new standard should include initiatives for identifying and implementing the necessary changes to controls.
The new credit loss standard will require significantly more judgments. This highlights the importance of another element of a company’s control environment — setting the right “tone at the top” and expectations for appropriate conduct throughout the organization. Appropriate tone at the top is the foundation for the consistent application of the sound judgments required by the new standard. Management should consider whether the existing control environment is adequate to support the formation and enforcement of sound judgments that will be necessary in executing control activities or whether changes are necessary.
These are just some areas of ICFR that may be impacted by the transition to the new credit loss standard. However, they highlight the importance of taking a holistic view of the potential effects that the new standard may have on internal controls.
Investor outreach and education
Registrants should also focus on investor outreach and education so that investors can sufficiently understand the effect of the new standards on companies’ financial reporting.[23] Disclosure regarding what is changing, why it is changing, and how, as well as the company’s adoption plan and potential impact on financial results and position, will be useful to investors and should be disclosed.[24]
Auditors
Auditors will have also a role in working through applications of the new credit loss standard. To effectively identify and assess the risk of material misstatement in the allowance for loan losses, auditors will need to obtain an understanding of changes made by management to processes, controls, and estimation methodologies. Auditors may also have to understand new accounting systems or re-designs made to existing systems with the new credit loss standard.
Auditors may have, or be asked to provide, input or feedback to management as changes are made or upon completion of management’s evaluation. It is worth reminding that investor confidence in financial reporting is highly dependent on auditors’ commitment to maintaining independence in both fact and appearance. Accordingly, the auditor should recognize there are boundaries to their involvement which should not extend to acting as management or being involved in decision making, such that the auditor later finds itself essentially auditing its own work.
I understand that as a result there are times when management may hesitate to ask auditors technical accounting, auditing, and financial reporting questions because of a heightened concern that providing management with advice might impair the auditor’s independence. However, auditors can still be helpful, as long as they are mindful of the independence rules. The Commission’s auditor independence requirements with respect to services provided by auditors are largely predicated on four basic principles.[25] In addition to these four basic principles, the Commission’s rules also specifically identify nine categories of prohibited services.[26]
The SEC staff[27] and the PCAOB[28] also previously addressed the permissibility of the auditor’s discussing and exchanging views with management under the independence rules. I support a strong audit profession where a hallmark of its professionalism is to exercise sound judgment in both the audit and in ongoing dialogue with management, consistent with the prior SEC staff guidance.
Investors benefit when auditors and management engage in dialogue, including regarding new accounting standards and the appropriate accounting treatment for complex implementations. Determining when it is appropriate for the auditor to provide accounting advice requires professional judgment and common sense. Auditors may not, of course, make accounting decisions for their clients, and management may not abandon its responsibility for reliable financial reporting and simply rely on auditors to perform their analysis, make decisions on their behalf, or catch errors.
Where management makes its own informed decisions regarding how applicable accounting principles apply to its company’s circumstances, the auditor may discuss freely with management the meaning and significance of those principles. As long as management, and not the auditor, makes the final determination based upon its own analysis as to the accounting used, including determination of estimates and assumptions, and the auditor does not design or implement accounting policies, such auditor involvement as an input to management’s process can be appropriate. Further, timely dialogue between management and the auditor may positively impact audit quality and the quality of financial reporting.
Closing
In summary, the issuance of the new credit loss standard represents a significant enhancement in the quality of financial reporting by providing financial statement users with more decision-useful information about the expected credit losses related to many financial assets. While the objective of the credit loss standard is not to prevent the next financial crisis – something no accounting standard could do – companies will be required to immediately recognize expected losses instead of deferring losses until incurred, which should result in more timely reporting of losses to investors. It’s worth stating again, investors are counting on each of you to fulfill your respective responsibilities for high-quality financial reporting.
I appreciate the opportunity to share my remarks with you today. Thank you for your attention.
