NASD SYMPOSIUM ON GLOBAL ADOPTION OF INTERNATIONAL ACCOUNTING STANDARDS
HARVARD UNIVERSITY – 3 FEBRUARY 2003
Howard Davies
Chairman, Financial Services Authority.

As the financial and corporate worlds digest the implications of the Sarbanes-Oxley Act, and the SEC’s interpretations of its provisions – and the investment banks begin to plan their adjustment to a post-Spitzer world - the work of the International Accounting Standards Board has been less prominent in the public prints. Yet the move towards the adoption of international accounting standards is arguably the most important underlying development under way in international financial markets. Accounting standards do not set the pulse racing for non-accountants. But there is nothing more important for the health of our capital markets than ensuring that the raw material on which investors base their decisions is of a good and even quality around the globe.

My own involvement in accounting standards began when Arthur Levitt, then Chairman of the SEC, asked me to take part in an exercise to reconstruct the governance arrangements for the IASB. Arthur was, and indeed is a very persuasive man. He even once persuaded me to spend a week going down an Alaskan river in the rain. So when he asked me to join him in a Nominating Committee to establish a new group of trustees for the International Accounting Standards Board, only one answer was possible.

The establishment of new IASB governance was a very significant development. At the time, though much excellent work had been done by the old IASC under Bryan Carsberg, the process of developing a set of standards which would attract widespread international support was blocked. It had become a victim of one of those periodic transatlantic misunderstandings which plague an otherwise successful relationship. The US perceived the European Union as wanting an oversight structure for international accounting standards which was far too political in nature, and subject to too much influence by non-accountants. While, by contrast, the European Commission and others in Europe perceived the US as lacking commitment to the IAS process, and as harbouring secret designs to impose US GAAP on the rest of the world, and to enshrine the FASB as the global standard-setters. Indeed, at one point, the IASC itself proposed that the world should align itself to US GAAP, when it seemed impossible to achieve consensus around any other approach.

The securities regulators, with Arthur Levitt in the lead, took the initiative to break this impasse. I was persuaded that it made sense to make an attempt to devise a governance arrangement which would go some way towards responding to the concerns of both sides. But this was not simply an Anglo-American initiative. Had it been, I think it would not have succeeded. We were joined by- amongst others - Michel Prada, then the President of the French Stock Market Regulator, and by Andrew Sheng from Hong Kong, in a group which developed a broad international consensus.

The solution we came up with might look somewhat complicated to an outsider, and indeed in a sense it is. But it has proved an artful compromise, and one which indeed is already being seen as a possible model for other global standard setting bodies in related areas.

The Nominating Committee itself was deliberately designed to be a self-extinguishing body. While it lived, it was very active. We met several times to agree a slate of trustees who would oversee the process in future. That required a delicate balancing act to produce a team who would build confidence among the wide range of constituencies with an interest in accounting standards. This was not an easy task, but the presence of Jim Wolfensohn of the World Bank on the Nominating Committee undoubtedly helped us to provide a solution which generated support from the developing world. There is no "school solution" which tells you how to put together a body which can be large enough to attract broad international support, yet be small enough to work effectively in a collegiate way. The only test of success is in its operation. And under Paul Volcker’s inspired chairmanship, I believe the trustees have generated the needed support.

The trustees were then responsible for appointing a strong professional Board, including the most influential and skilled accounting standard-setters in the world, under the chairmanship of David Tweedie. David Tweedie is, without a shadow of doubt, the most amusing Scottish, Newcastle United supporting accountant in London today. He also has the personal authority to carry with him his professional colleagues with him, all around the world.

But the establishment of the Board would not have been of such significance had it not been accompanied by another development in which we at the FSA were also closely involved. Unless securities regulators, particularly the SEC, were prepared to envisage the adoption of international accounting standards for listed companies in their jurisdiction, the Board would be wasting its time. So the IOSCO agreement in April 2000 at its Sydney conference, was of the highest significance. Members of IOSCO committed themselves to working through the approval of a set of international accounting standards, with a view to their adoption for listed companies around the world.

A third key milestone was the European agreement in June 2000, to adopt IAS across the EU by 2005. These developments gave a new impetus for the process, which had been proceeding in a stately, but too slow a way before then. They created the basis for a new legitimacy for the IASB. They gave the Board itself the authority and intellectual horsepower it needed to overcome the significant obstacles which remained in its path. And they generated a broad constituency of support for the process which had been lacking before. The trustees quickly attracted a substantial degree of funding, which meant that the process could then begin in earnest, in a systematic and detailed way.

It would be fair to acknowledge, though, that even with this new and favourable environment, and with a strong wind behind it, it has not been all plain sailing. In my view that is largely because the Board have been grappling with some of the most difficult issues in accounting, issues which generate enormous controversy in the corporate world, and amongst professionals. They have been forced, for example, to address questions like the appropriate accounting treatment of stock options, the accounting approach to pension fund deficits and, perhaps most controversial of all, the accounting treatment of financial instruments. These three issues alone are enough to tax the ingenuity of the most ingenious standard-setter, whether national or international.

These issues are not yet fully resolved. But my own view is that the IASB is on the right track in each case.

I strongly favour the expensing of options. There are clearly some complex issues surrounding the appropriate valuation methodology but, in principle, options are a cost to the business and that cost must be recognised in the accounts. It also seems to me to be clear that if a company has an obligation to make good a deficit in its pension scheme, the true cost of that obligation should also be recognised. Once again, there are technical issues to be resolved, but the general principle is not one I find problematic.

Perhaps the most difficult area concerns the treatment of financial instruments. Few people believe that IAS 39, which is based on the US model FAS 133, is a perfect standard. The fact that the IASB has published some 370 pages of explanatory guidance since it was issued tends to suggest that it is too complicated, and far too detailed.

To continue the numbers game, the IASB has now issued a 336-page exposure draft on potential improvements to the standard, and is now digesting the responses.

However, a less than perfect standard on accounting for financial instruments is in my view much better than no standard at all. As we in Europe move closer to a formal decision on the adoption of IASs for use in the EU from 2005, we need to recognise that we cannot pick and choose. The potential benefits that the adoption of internationally accepted standards can bring will not be realised if the EU - and indeed the SEC - do not adopt IASs in full.

I would not dare to attempt a detailed taxonomy of IAS 39. But, overall, I support a move to fair value accounting, which I believe will be the end point of this journey. Financial regulators have a particular interest in the subject. Without fair value accounting it will be difficult, if not impossible to produce an appropriate accounting regime for the insurance industry. And the existing accounting regime finds it difficult to cope with emerging developments in the banking sector. Banks’ balance sheets are becoming more tradeable, with the development of securitised loans in particular, and the existing accounting treatment does not fully reflect the economic reality. I recognise the complexities, and some of the concerns of the banks, particularly in Europe, about the methodology applied to achieve fair value accounting. Undoubtedly there is a need for an improved approach to setting exit prices, in particular. There are many other technical issues to address. There is certainly a need for more debate. But I am comfortable with the general direction taken by the Board.

And it is important to look beyond some of these short-term issues, and to keep in view the long-term objectives of the IASB process.

In our view there is a clear need for global accounting standards which provide that businesses undertaking similar activities should be subject to broadly the same accounting treatment wherever they are. But global standards will only work if they are principle-based. It is clearly not realistic or desirable to try to write detailed rules for universal application in more than 150 countries.

If one accepts the argument for principle-based standards, their success depends on three key corporate governance controls. There must be senior management in companies who want to get the right answer. There must be auditors who are independent of management, and aware of their broader public role in support of efficient capital markets and the interests of investors. And there must be an independent-minded audit committee, or the equivalent, to monitor the relationship between management and auditors.

In addition, there will need to be enforcement arrangements in each major jurisdiction, in which we can all have confidence, and which provide a sound basis for mutual recognition. Let me say a word or two about these three key points.

It has become something of a cliché to say that the UK accounting regime is based on principles, and the US on black-letter rules. Our accounting profession rather enjoyed saying that Enron would never have been allowed to treat its SPVs as off-balance items in the UK, though the force of this argument was somewhat diminished when it was pointed that UK GAAP lacked a standard on accounting for financial instruments in general.

There is, however, some truth in the point, as Bob Herdman when he was chief accountant at the SEC, recognised. In an important speech in Chicago in April of last year he said "rules-based accounting standards provide extremely detailed rules in an attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting but eliminates judgements". He went to say "a move away from a check-the-box approach to financial reporting means that all constituencies must make concerted efforts to report transactions consistent with the objectives of the standards". So in this area we have the clear emergence of a consensus view, which augurs well for the future.

The debate about the relationship between principles and rules is of course linked to the notion of the true and fair override, which is dear to the hearts of all British accountants, who tend to believe that such a thing is unknown in North America. Again, I am not so sure that the distinction between the two approaches is so sharp as some have suggested. The Judge Friendly opinion in the Continental Vending Machine Corporation case in 1970 has recently been revived. Harvey Pitt noted in a recent speech that "Judge Friendly took the view that if compliance with GAAP creates a fraudulent or materially misleading impression in the minds of shareholders, the accountants could and would, be held criminally liable".

This view has not been universally applauded by the accounting profession, but there is a rule – Article 203 of the Accountants Code of Professional Conduct – that says auditors may depart from GAAP to prevent financial statements from being misleading. This rule may need dusting off and reinvigorating. Clearly the way in which this potential override is applied in different jurisdictions remains materially different. But I can see the germ of a useful additional degree of convergence, which once again may buttress the move to international accounting standards.

Perhaps I am taking a somewhat Panglossian view. But I was reinforced in my opinion that, however difficult it may seem, the task of agreeing a set of global accounting standards is not beyond us, when the FSAB and the IASB published their Memorandum of Understanding – the Norwalk Agreement – last October.

In Norwalk the two Boards agreed to add a short-term convergence project to their active agendas. In that project they would use their best efforts to propose changes to US and international accounting standards, to reflect common solutions to specifically identified differences. Many of us in Europe were pleasantly surprised by this agreement, and look forward to seeing some tangible results from it in the next few months. Because if IASs are to attract broad international support, they should be seen to incorporate the best of the international standards available. It would be surprising were the best to amount to US GAAP in its entirety. And one perhaps unintended side effect – indeed certainly unintended side effect of the corporate and accounting scandals of the last 18 months in the US, is that the standard-setters and regulators in North America are more ready to look critically at their own regime, to identify possible improvements.

The second key area in which supportive action is required, to ensure that any set of accounting standards are effective, is corporate governance. It is not the time or the place today to review the causes and effects of the corporate scandals we have recently seen in the US and elsewhere. But it is evident that these episodes have thrown up deficiencies in corporate governance in many companies. In the US, the Sarbanes Oxley act has been the most outward and visible response by the authorities to these problems. The provisions of that Act will undoubtedly have a major impact on Boards of directors and, specifically, on audit committees in the US and perhaps elsewhere. The extra territoriality provisions of the act have generated a deal of controversy in Europe, albeit perhaps a little less in the UK than elsewhere. That is partly because our own corporate governance standards have evolved in recent years in a way in which brings many of our boards to a position of compliance or near compliance with the provision of Sarbanes Oxley already.

But of course we have not relied on legislation elsewhere to strengthen our regime. Indeed, as a general principle, I am resistant to extraterritorial legislation, from wherever it comes. And the British Government have, with participation from the FSA, been engaged in a number of reviews to assess, in the light of recent experience, whether our own corporate governance arrangements remain ‘state of the art’. In those reviews have taken into account the IOSCO principles on auditor independence and auditor oversight, and the role of the boards in maintaining that auditor independence.

Two weeks ago reports on the role of non-executive directors (by Derek Higgs), and of audit committees (by Robert Smith) were published. Each contains specific recommendations to strengthen the role of non-executive directors, to increase their number, to emphasise the need for a split of responsibilities at the top of corporations between the Chairman and the Chief Executive, and to clarify and strengthen the role of audit committees.

I will not go into the detail of those recommendations, here. But I believe they will, when implemented after consultation, create an even greater assurance that there is a strong independent element on British company boards which has a close interest in the integrity of accounts, and the independence of the audit. In the UK we promote compliance with those codes, developed in the private sector, under the listing rules, which are part of the FSA’s responsibilities. When the code revisions have been finalised, later this year, companies will be obliged under our listing rules to comply with them, or to explain to their shareholders why they do not. It will be our role to ensure that those explanations, and I suspect for a while at least there will be some companies who need to explain their non-compliance, are clearly set out. But it will be for shareholders to react if they think the explanations are inadequate.

In my view the UK approach to corporate governance, with Codes of Practice developed in the private sector, yet enforced through the Listing Rules, overseen by a statutory authority, is a good one. Corporate governance is an organic subject, and we learn more about how to optimise it as we go along. It makes sense to operate a system which allows rapid change to be made, yet permits appropriate flexibility, without needing to resort to legislation.

The third significant review in the UK has concerned the oversight of auditors and, crucially, the enforcement of accounting standards. Once again, the review has taken into account developments internationally and in the European Union.

In the US there has for some time been a proactive element in the enforcement of accounting standards, with reviews of a sample of companies carried out by the SEC. In the UK that has not been the case, though the Financial Reporting and Review Panel has been effective in securing rectification of accounts where shareholders or others have drawn their attention to possible problems. We have now agreed that there needs to be a proactive element to our regime. From now on the Financial Services Authority will help the Financial Reporting Review Panel on enforcement – particularly in identifying the high risk cases which most merit active investigation. And our enforcement mechanism will be actively co-operating with others in the European union through a subsidiary – so to speak – of the committee of European securities regulators, known rather clumsily as CESR Fin.

In the same report, published last Wednesday, the Government announced an overhaul of our regime of auditor oversight, to make it more independent of the accounting profession. The changes will also make our regime rather simpler. We have had perhaps a surfeit of different bodies involved in regulating the profession, which have been simplified now under the financial reporting council, on which the FSA sits.

The newly constituted body will need to grapple with the contentious issue of how far auditors may provide non-audit services, where our Government has not favoured a ‘black line’ approach. It will be interesting to see how that work develops.

I believe this new regime in the UK, if it is carefully implemented, should help to reassure our trading partners, and the overseas exchanges on which British companies are listed, that our system may be relied on. I believe we can now move towards developing a basis for mutual recognition of standards between the UK authorities and the US Public Companies Oversight Board, established under the Sarbanes Oxley act.

The last year has been a difficult period in Capital Markets, indeed the markets themselves remain turbulent. Regulators and others have learnt some important and painful lessons. I hope that company boards and audit firms have learnt lessons too. A number of countries have now overhauled the legislative and regulatory requirements surrounding company accounts, corporate governance and the regulation of the auditing profession. This new and more solid basis of regulation is a good platform for the launch of a comprehensive set of international accounting standards in a couple of years time.

More Speeches: