THE FUTURE OF ACCOUNTING AND FINANCIAL REPORTING

PART II: THE COLORIZED APPROACH

REMARKS OF COMMISSIONER STEVEN M.H. WALLMAN

BEFORE
THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
TWENTY-THIRD NATIONAL CONFERENCE ON CURRENT SEC
DEVELOPMENTS -[1]-

* The views expressed herein are those of Commissioner Wallman

and do not necessarily represent those of the Commission, other
Commissioners or the staff.

U.S. Securities and Exchange Commission

450 Fifth Street, N.W.
Washington, D.C. 20549

I. Introduction

A year ago I had the privilege of attending this same

AICPA National Conference on SEC Developments, and I thank you
now for the opportunity to appear before you again. At that
time, I shared with you a few thoughts relating to accounting and
financial reporting.

I expressed my belief that accountants are the primary

gatekeepers to the integrity of our financial markets. Without
accountants, and without a consistent and well thought through
set of auditing and accounting standards and principles to assure
the quality and integrity of financial information, the capital
markets would be much less efficient, the cost of capital would
be higher, and our standard of living would be lower. This is
particularly clear to me from my vantage point as an SEC
Commissioner. For the past 60 years, the Commission has relied
heavily on the accounting profession. The profession has been
critical in helping to satisfy the Commission s statutory
responsibility to craft accounting standards for public companies
that assure that our markets receive the highest quality
financial information.

Notwithstanding this effort over more than half a

century, I suggested last year that we are now at a cross-road in
terms of our system of accounting and, more generally, financial
and corporate reporting. Many, including others more
knowledgeable in this area than I, are concerned that such
reporting is not keeping pace with the accelerating changes in
the business world. In a real way, such reporting is at risk of
diminishing its utility -- and this to a serious degree. I

--------- FOOTNOTES ---------

-[1]- The following remarks represent the second ofa series of speeches
planned by Commissioner Wallman on
issues related to the future of accounting and
financial reporting. The first commentary in this series
was published in the September 1995 edition of Accounting
Horizons.
-------------------- BEGINNING OF PAGE #2 -------------------

encouraged those of us involved with accounting, standard

setting, and financial and corporate reporting to develop a
vision of what the future might hold in terms of challenges and
opportunities for accounting and financial and corporate
reporting -- and to reach for that vision.

During my remarks last year I also discussed certain

specific problems that affect the utility and relevance of
accounting and financial reporting. I would like to review those
problems briefly, while noting the various goals of financial
reporting, in other words, why we care about financial reporting.

I will also review some of the tensions among these goals that
make improving the system not as easy as one would hope. I would
then like to share with you my thoughts on a model for enhancing
the utility and relevance of financial accounting and reporting.

Before beginning, I would like to make two general

observations. First, I want to make it clear that I am not an
expert in accounting, and that the model that I will describe
represents my preliminary thinking. I also recognize that there
are many who are experts in this area and who may view the model
that I will discuss as evolutionary rather than revolutionary,
when, in fact, they believe a wholesale change in our accounting
and financial reporting is necessary to effect true change and
progress in these areas. I have some sympathy with this view.
However, my goal this morning is not to offer a perfect solution,
but to take advantage of the opportunity to receive your expert
views and encourage you to devote greater attention to the future
of accounting and financial reporting so that we do not lose the
advantages that our current system historically has bestowed upon
our markets. We must stimulate discussion and creative thinking
on these issues in order to avoid being overwhelmed by the
challenges that will face accounting and financial reporting in
the coming years.

Second, I believe that the recent enactment of the

Private Securities Litigation Reform Act of 1995 also presents us
with an opportunity to improve the quality of accounting and
financial reporting. -[2]- Historically, two of the primary
concerns with expanding the scope of financial disclosure have
been the need to maintain the involvement of auditors in the
disclosure process, and the potential liability associated with
new disclosures that may be less reliable or certain than
traditional disclosures, such as forward looking information.
The Litigation Reform Act touches on each of these concerns.

The Act has implications for the future of accounting

and financial reporting in two respects. First, by enhancing the
duties of accountants to monitor for and report illegal
practices, the Act recognizes and reinforces the role of
accountants in financial reporting, over and above the
attestation function traditionally performed by the profession.
Second, the Act recognizes that some information that is useful
to investors is inherently subject to less certainty or
reliability than other information. By providing the safe harbor
for forward looking statements, Congress has sought to facilitate
access to such information by investors.

Finally, one last caveat -- as is always the case, the

views that I express this morning are my own and do not represent
the views of the Commission or its staff.

--------- FOOTNOTES ---------

-[2]- Public Law No. 104-67 (1995).

-------------------- BEGINNING OF PAGE #3 -------------------

II. The Importance of Accounting and Financial Reporting

From the most generalized perspective, the purpose of

accounting and financial reporting is to provide information that
is useful to investors, creditors, monitors, and others --
increasingly including employees and major suppliers and
customers -- in making investment, credit, monitoring, and other
decisions. This general goal may be further defined and analyzed
by describing three specific and distinct purposes and functions
of financial reporting: (1) asset, capital and investment
allocation; (2) "contracting" and ex post settling-up ; and (3)
corporate stewardship and monitoring.

A. Facilitating the Efficient Allocation of Capital,

Assets and Other Investments

Financial accounting and reporting should facilitate

the appropriate allocation of capital, assets and other
investments, including human capital. Clearly, suppliers of
capital -- of all types -- want reliable and relevant information
about their investment and investment opportunities. In the
absence of certain externalities that I will discuss in a moment,
entities seeking capital will disclose such information to reduce
the information risk premium ultimately sought by capital
suppliers. While neither the existence nor mandatory use of a
standardized system of accounting and financial reporting is a
prerequisite to the acquisition of capital -- for example,
suppliers and users of capital, including human capital, might
effectively contract for such information in the absence of a
standardized system -- a standardized system reduces the
transaction and investigation costs that otherwise would be
incurred under a contractual agreement, much in the same way that
the use of a common language facilitates everyday communication.
Thus, financial disclosures in accordance with a well-defined and
well-understood set of standards help bring users and suppliers
of capital together in a cost-effective manner, thereby reducing
the cost of obtaining capital.

B. Providing for Contractual and Ex-Post Settling-Up

Mechanisms
 Financial reports also are used in connection with
contractual and ex-post settling-up arrangements. For example,
lenders often require borrowers to maintain certain financial
ratios and to conform to other covenants based on accounting
measures. By providing uniformity in measurement and reporting,
as well as attestation where relevant, accounting and financial
reports facilitate "ex-post settling-up among contractual
parties, thereby encouraging cost-efficient contractual
arrangements.

C. The Stewardship" Function

Accounting and financial reporting also help outsiders

monitor the performance of company management, and company
management to assess its own performance and that of the
company s other employees. For example, the segment reporting
required by GAAP and Commission rules provides shareholders and
analysts with insight on the relative distribution of company
product area profitability and trends. Similarly, some believe
that management reporting systems based on financial accounting
models and GAAP provide invaluable information to senior
management regarding the operation of divisions, subsidiaries and

-------------------- BEGINNING OF PAGE #4 -------------------

other business units. However, the utility of this information

has been criticized by others precisely because it is based on
financial reporting which, in the view of these critics, is
designed to meet different needs.

D. Summary: Purposes and Functions of Financial

Reporting

The contractual functions of accounting seem reasonably

well-served by the current model. In the event a user does not
believe the current model adequately addresses its needs, that
user can -- quite literally -- contract around any deficiency and
customize the model as necessary, albeit some cost. It is in the
other two areas -- the capital and asset allocation, and the
monitoring/stewardship areas -- that accounting and financial
reporting do not appear to be meeting the needs of users as well
as they might.

There also is an inherent tension between the capital

allocation and stewardship functions of accounting and financial
reporting, from the perspective of those who have to report. As
I mentioned, in a perfect world, one would expect that users of
capital -- senior managers -- would wish to reduce their firm s
cost of capital by disclosing information about their activities
to the point where the costs of such disclosure equals the
perceived benefits in terms of reducing information risk.
However, the more information that is disclosed to meet this
goal, the more likely that senior managers will be subjected to
higher levels of scrutiny and review by those who are in a
monitoring role, and the more likely that proprietary or
confidential information will be compromised. For example,
disclosure of sensitive information relating to management's
expectations about a development stage product might raise
competitive issues and hamper management in meeting its goals and
objectives for the product. It may also reduce management s
discretion to make disclosures that it might prefer to make at
other times.

III. The Decreasing Relevance of Accounting and Financial

Reporting

Given the historical importance of financial reports,

the issue is are they becoming increasingly less useful and, if
so, how do we make them increasingly more useful? As noted by
the AICPA s Special Committee on Financial Reporting (the
Jenkins Committee ), there is little evidence to suggest that
users are abandoning financial statements altogether. But I
believe it is clear that financial reporting is in danger of
becoming less useful at an accelerating pace.

There are several indications that this is the case.

For example, traditional financial statements are now
significantly less reflective of the assets that create wealth
than in times past. Intangible assets such as brand names,
intellectual capital, patents, copyrights, human resources, etc.
are generating an increasing amount of our overall wealth.
Moreover, new, sophisticated risk management instruments that can
change a firm s business or risk profile overnight are
proliferating, thereby calling into question the timeliness of

-------------------- BEGINNING OF PAGE #5 -------------------

disclosure. -[3]-

Last year, I explored what I believe are the primary

reasons underlying the diminishing utility of accounting and
financial reporting, so I will just reference them here to give
context to my remarks. They may be summarized by reference to
the age old questions of "who", "what", "when", "where", "how",
and "why".

A. "Who" is the Company? The Changing Concept of the

Firm

It is becoming harder to define the outer edges of

companies. The information revolution is moving us to a new
plateau where businesses can operate with greater agility than
ever before. I agree with the AICPA Breakthrough Task Force's
report that the size of the average legal entity will likely
decline by 2005, as firms, their suppliers, employees and
customers work together in relationship-based transaction
systems. These transaction systems will be focused around the
formation of closely linked "clusters" of entities -- or "virtual
firms" -- that, in the aggregate, may be much larger than the
consolidated entities of today. -[4]-

We already have virtual firms today depending on the

flexibility of your vision. For example, VISA International can
be viewed as a firm with vast resources in a "nontraditional"
business structure that makes for a virtual firm. Going forward,
we also will have virtual firms with thousands of individuals
networked together in combinations that form and dissolve as
tasks are required to be performed. The key assets of such a
virtual firm may well be only soft assets such as human
resources or intellectual capital, its outer edges will change
daily as needed and as is efficient. Certain service oriented
firms -- such as law and accounting firms -- currently meet this
description in that they rely primarily on human resources or
intellectual capital. However, it is the networking of various
entities and the continuous changing and adapting of the outer
edges of the firm -- including nonservice firms -- that have
never been available in a significant way in the past, but which
will increasingly become the norm, that will become the
foundation for the virtual firm.

--------- FOOTNOTES ---------

-[3]- Furthermore, since the late 1960's, empirical research

has indicated a material time lag between the
reflection of economic events in share values --
meaning that investors have already learned of
and absorbed the information -- and the disclosure of
those events through periodic accounting reports.
While this observation does not suggest that
financial reporting is without utility -- for
example, periodic reports clearly deter arbitrary
public disclosures bymanagement by ensuring that
such results ultimately will be reported in
accordance with GAAP -- it does suggest a
significant timing issue related to financial
reporting. See, Ball, R. and Brown, P., An
EmpiricalEvaluation of Accounting Income Numbers,
Journal of Accounting Research (Autumn)(1968); see
also, Warfield, T. and Wild, J., Accounting
Recognition and the Relevance of Earnings as an
Explanatory Variable for Returns, The Accounting
Review (October)(1992).

-[4]- See AICPA Special Committee, Report of the Breakthrough

Task Force at 7-8 (1994)(the AICPA Breakthrough Task
Force ).

-------------------- BEGINNING OF PAGE #6 -------------------

B. Determining "What" to Value: Recognition and

Measurement Issues

We also should question exactly "what" it is we are

measuring and reporting. As mentioned earlier, historically, the
assets and liabilities used to produce wealth were recognized in
financial statements at cost and were "hard" or tangible -- like
plant and equipment. However, the shift to a knowledge-based
economy has created or focused increased attention on entirely
different categories of assets such as brand names and other
soft assets previously mentioned.
 With certain limited exceptions, such as the purchase
of a brand name, these "soft" assets are not recognized in the
financial statements. The primary obstacles relate to valuation
difficulties, the inherent uncertainty of any value ultimately
determined, and the resulting potential for fraud. As a result
of these concerns, we attribute no value in financial reports to
something as obviously significant as Disney's Mickey Mouse.
This cannot be the correct result for the long-term utility of
financial reporting, particularly given the increasing importance
of firms with "soft" assets.

Some suggest that the values of these assets are

ultimately reflected, implicitly, in the statement of cash flows
or in earnings, and therefore they need not be reflected
elsewhere. Unfortunately, however, because it might be nice for
simplicity s sake if such an answer were right, the same can be
said for all other assets in the balance sheet. Our task then is
either to improve the credibility and reliability of soft asset
valuations, or to find other creative solutions to the problem -
- not to ignore this fast growing segment of our economy.

C. "When" to Report? The Timeliness of Financial

Reporting

The rapid acceleration of events that may significantly

affect share values has started to make our system of annual
audits and quarterly reports obsolete. Today's annual and even
quarterly reports -- relying on recognized items as the core of
the reports -- do not capture and communicate material
developments in sufficient time to meet market informational
needs. Product cycles have shortened, risk management practices
have improved and are more prevalent, and products and whole
companies become obsolete much more quickly now than ever before.

It is hard to obtain a good picture of a quickly moving and

changing item when only snapshots are taken at relatively long
intervals. As I mentioned last year, I am not suggesting now a
system of monthly, weekly, or daily audits and report filings
with the Commission. I am suggesting, though, that over time we
will need to develop a system that fills the need for timely --
and ultimately real-time -- financial information.

D. "Where" and "How" Should Financial Reporting be

Directed? Information Distribution Channels

We also should recognize that our current distribution

channels and our methods of dissemination and analysis have as
much to do with what is reported as do the underlying concepts
that dictate GAAP. Until recently, it has been impractical --
physically -- to provide much disaggregated information because
there has been no reasonable mechanism for distributing such a
huge amount of information and, more importantly, there has been
no reasonable mechanism for analyzing it. However, certain

-------------------- BEGINNING OF PAGE #7 -------------------

sophisticated end-users now have the means to perform high level

analysis on disaggregated information. Indeed, analysts
frequently spend substantial time and effort attempting to
disaggregate information aggregated by accountants and accounting
requirements. In the future, more end-users clearly will have
access to the analytics and electronic data bases that will make
disaggregated information highly useful and timely to them -- if
it is provided.

E. Summary: Declining Utility of Accounting and

Financial Reporting

I believe that some of the deficiencies I have noted

are caused by our overemphasis on the concept of recognition.
Recognition, of course, is a valid and time-honored concept that
is at the core of financial reporting. Furthermore, recognition,
in and of itself, is not problematic and, in fact, helps many to
separate some of the more useful information from the full set of
information relevant to investment, credit, monitoring,
managerial and other decisions. However, while financial
reporting is not explicitly tied to recognition, I believe that
we devote an inordinate amount of attention to assessing whether
a given item satisfies all of the recognition criteria, even to
the extent of losing sight of the overall goal of providing
information that is useful.

I believe that a different focus in financial reporting

is in order. The approach that I will describe in a moment,
however, would not address all of the issues I have discussed.
For example, it would not address the timeliness of disclosure or
the disaggregation issues. But it might help us provide more
useful information in financial reports. That at least is a
beginning -- albeit only a beginning -- of a longer journey that
we should embark upon.

IV. A Different Perspective: Color vs. Black and White

A. Background

Somewhat simplified, financial reporting can be divided

into four broad segments. At the first level we have the
financial statements themselves, which focus on recognized items
that pertain to the resources (assets) of an entity, the claims
to such resources (liabilities and equity), and the results of
operations. Within this system, the recognition of items in the
financial statements assumes primary standing. To be recognized
in financial statements an item must meet each of four criteria:

* First, the item must meet the definition of an

element of those financial statements: It must be
an asset, liability or component of equity;

* Second, the item must be measurable: It must be

susceptible to quantification in monetary units
with sufficient reliability;

* Third, the item must be relevant: It must make a

difference to the investment or credit decision;
 and

* Finally, the item must be reliable: It must have

representational faithfulness, be verifiable and

-------------------- BEGINNING OF PAGE #8 -------------------

neutral. -[5]-

It is generally expected that the most useful

information about assets, liabilities, revenues, expenses, and
other items of financial statements would be recognized. -[6]-
There is also an expectation that such information would have
utility in making capital allocation decisions. That is, it can
be used to help predict future cash flows and is comparable
across entities. In addition, because such information is viewed
as more reliable and is audited, it is viewed as having greater
utility in contracting and monitoring.

The second subset of financial reporting consists of

the notes to the financial statements. The notes are designed to
explain information in the financial statements.

The final two categories are supplementary information

(such as information related to changing prices) and other
information supplied by a company (such as management's
discussion and analysis). This information adds to the financial
statements or the notes. It frequently includes information that
may be relevant but that does not meet all criteria for
recognition. It is frequently not subject to third party
attestation.

The current accounting and financial reporting model

works reasonably well for many of the items that are recognized
within financial statements. However, the model increasingly is
subject to criticism.

First, potentially relevant items are omitted because

they do not meet recognition criteria (usually due to reliability
concerns). Second, items are included that appear to be less and
less useful due to valuation or other concerns. Finally, it is
not always clear why some information is included and other
information is excluded from financial reports. These concerns
are exacerbated by the developments in the general business
environment previously discussed.

B. The Alternative Model

In response to these concerns, I believe it is time to

refine our perspective on financial reporting. We need, in
particular, to move away from a model that primarily relies on
black and white recognition in the financial statements. We need
to move towards a model where financial statements and related
disclosures are viewed more as different layers of information -
- just as a finely textured color picture can provide more
information than a black and white representation.
 The model that I am about to describe may be viewed as
refining the current system by adding new sets or layers of
information. It also refocuses our analysis to de-emphasize
recognition and towards providing greater disclosure of useful
information.

--------- FOOTNOTES ---------

-[5]- The criteria of measurability and reliability are often

inextricably linked.

-[6]- See FASB Concepts Statement No. 5, Recognition and

Measurement in Financial Statements of Business
Enterprises, paragraph 9.

-------------------- BEGINNING OF PAGE #9 -------------------

In this model, the primary focus is on providing

relevant information, with specification of both the items to be
reported and the form and level of assurance of these items. The
most relevant and reliably measured items would represent the
core of the financial reports -- the clear black and white, with
no shades of gray or color -- similar to the recognized content
of the financial statement items in today's model. Successive
outer layers of the financial reporting picture would consist of
information that meet some -- but not all -- of the requirements
of recognition, or that are not as susceptible to verification
procedures.

Under this approach, instead of starting with the

question of whether an item must be recognized in the financial
statements, the first question would be whether an item should be
part of the firm s financial disclosure, with a progression then
to a discussion of in which layer should the item be reported.
Such a framework -- where the different layers of information
could reflect, in essence, different levels of satisfaction of
the traditional recognition criteria concepts (e.g., relevance,
reliability, measurability), or could reflect entirely different
concepts -- will be useful in progressing beyond the current
recognition versus non-recognition debates.

Application of this model to the current business

environment requires: (i) specification of the additional layers,
outside the core financial statements, including the criteria for
inclusion of items in one layer versus another, and (ii)
consideration of how different levels of attestation might attach
to information in the various layers. Admittedly, establishing
these components of this model is not an easy task. However, for
discussion purposes, specification of the differing layers might
be based, in part, on existing recognition criteria (as
articulated in FASB Concepts Statement 5). The following
examples illustrate this approach.

1. Specifying the Layers of the Model

 A. Layer 1: Items Satisfying Recognition
Criteria

The first layer would include those items satisfying

recognition criteria. This layer is the easiest. Under at least
one view of this model, it can just be assumed to be the current
core financial statements. However, it might be useful to
develop over time a better sense of what satisfies the core
financials recognition criteria and how items are presented.
-[7]- But I will leave that to another day.

--------- FOOTNOTES ---------

-[7]- For example, does it really make sense to recognize one

parcel of real estate acquired a hundred years ago in
1896 dollars identically to another piece of real
estate acquired yesterday? First, the value of the
hundred year old acquisition most likely substantially
changed during the past century, while the value of
theparcel acquired yesterday is likely pretty
current. Second, the reflection of that ancient value
--even if it had not changed in real dollar terms
-- in 1896 dollars with those dollars being added
dollar for dollar to current dollars is not very
enlightening. There are alternatives; other nations
-- such as Australia -- permit revaluations of
categories of assets with the goal of providing
more useful information to the market.

-------------------- BEGINNING OF PAGE #10 -------------------

B. Layer 2: Items Raising Reliability Concerns

The second layer would include those items that would

generally satisfy recognition criteria, except that there are
reliability concerns that preclude their inclusion in the core
financial statements. Let me provide a few examples:

Research and Development, Advertising and Similar

Expenditures. The current accounting for research and
development and advertising requires these expenditures to be
charged to earnings as incurred. Many would argue that these
costs result in assets and therefore meet the first criterion for
recognition in that they represent expected future benefits to
the firm (otherwise companies would not make the original
investments). Since companies must continually assess the
outcomes associated with their research and development and
advertising activities, an argument can be made that the value of
the future benefits of these activities is measurable.
Similarly, most statement users would not question the relevance
of information related to these expenditures.

However, the primary, and well known, difficulty with

the recognition of these expenditures as assets concerns
reliability. Because the expected future value of these
expenditures is difficult to determine with certainty, and the
utility of the expenditures often is intertwined with the use of
other assets, questions arise about the verifiability and
neutrality of valuation measurements. By establishing a second
layer for the reporting of such information, outside the core
layer of information, such amounts could be capitalized or
revalued as appropriate.

Brands, Deposit Intangibles, and Spending on Customer

Satisfaction. Similar examples, with a similar conclusion, can
be drawn from an analysis of other currently unrecognized
elements in financial statements, such as the value of brands,
deposit intangibles, and investments to improve customer
satisfaction or loyalty (as opposed to measures of customer
satisfaction or loyalty, which I will turn to in a moment). In
these cases, unreliability of information prevents recognition of
an item. However, waiting for complete reliability generally
makes the information untimely so that it loses its relevance.
Thus, establishing this additional layer of reporting outside the
core, with the layer defined based on some but not all of the
current recognition criteria, allows for the reporting of
relevant, but perhaps less reliable information. To put it
simply, assets like brand names that have been internally created
are currently not recognized and, therefore, are implicitly
carried on the balance sheet with a value of zero. It may be
difficult to determine for sure the value of the brand, but we
know for certain that zero is almost always the wrong answer.

C. Layer 3: Items Raising Reliability Concerns and

Possibly Definitional Concerns

The third layer could contain items that raise

reliability concerns and possibly definitional concerns such as
measures of customer satisfaction. These measures, are in some
industries both highly relevant and easily and consistently
measurable with a high degree of reliability; they also
contribute to earnings capacity in a tangible manner. Customer
satisfaction may sometimes meet the definition of an asset, such
as when it is associated with a brand name (Nordstrom). In other
instances, however, it is less clear that this is the case, such

-------------------- BEGINNING OF PAGE #11 -------------------

as when customer satisfaction is expressed in the form of a

rating in a survey (J.D. Power Surveys on Customer Satisfaction),
or is not related to a particular brand but is tied to the
employees associated with a service (such as the servicing
department at an automobile dealership).

D. Layer 4:Items Raising Definitional Concerns.

A fourth layer in the color spectrum of reporting could

be specified for items that satisfy measurement, reliability and
relevance criteria, but clearly do not meet the definitions of
statement elements. In many cases these are items that assist in
the evaluation of recognized statement elements.

Risk Measurement Practices. Risk sensitivity metrics,

such as those recommended for disclosure in the Commission's
recent derivatives disclosure release, provide a good example of
information that might fall within this fourth layer of
disclosure. Given the current focus on risk management, it is
safe to say that risk sensitivity analysis is relevant to firms
and users of financial statements. Similarly, although not
completely free from doubt, risk metrics also meet the criteria
of measurability and reliability based on the quantitative nature
of these analyses. This will particularly be the case as firms
gain more experience with risk measurement techniques

However, leaving aside firms that develop and market

risk metric programs, risk analyses generally fail to meet the
definition of an asset, liability or component of equity.
Rather, such measures are designed to convey information on the
sensitivity of the values of recognized or unrecognized assets
and liabilities to hypothetical changes (based on historical
data) in market indices. Reporting such second order effects
within an additional layer of the color framework might provide
relevant information to the market while also conveying the
characteristics of the information with respect to the item that
does satisfy recognition criteria.

E. Layer 5: Items Raising Definitional and

Reliability and Measurement Concerns

Finally, an additional layer of the color reporting

spectrum can be specified for relevant items that do not meet the
definitions of elements and which cannot yet be reliably
measured.

Going Concern Value and Intellectual Capital. For

example, the going concern value of a firm, intellectual capital,
or the value of a trained work force (even though the firm has
invested substantial amounts in training), may not meet the
definition of an asset because the employees to which these
investments sometimes relate are, arguably, not controlled by the
firm.

In addition, estimates of the value of such assets are

highly subjective, not easily auditable, and perhaps specific to
a particular firm or industry. Therefore, such measures
generally would not meet reliability criteria (e.g., they are not
verifiable and /or neutral). However instead of not reporting
these items at all, as is currently the case, under the colorized
approach such items could be disclosed in the fifth layer, along
with a description of the limitations associated with any
particular valuation.

-------------------- BEGINNING OF PAGE #12 -------------------

2. Specifying Levels of Attestation

One of the more challenging aspects of the proposed

model involves providing an indication of the degree to which
information in the various layers is subject to verification or
attestation. The goal here would be to provide users of
financial reports with a better indication of the quality or
certainty of the information provided.

We currently provide varying degrees of attestation to

information in financial statements, ranging from full audits to
reviews of such information. Admittedly, it would be more
difficult to attest to much of the information that might be
provided under the proposed model. For example, it may be
difficult to arrive at a consensus among auditors regarding
whether management s estimates of the value of a brand name are
valid. However, although it may be difficult to attest to the
value of such assets per se, it may be possible for auditors to
attest to the procedures used by management to make such
valuation estimates. Clearly, this area will need additional
thought.

To some extent, the accounting industry currently is

moving in this direction. For example, the AICPA in Statement of
Position 94-6 recognizes the inherent risks and uncertainties in
certain amounts reported in financial statements and calls for
additional reporting in the audited financial statements to
reflect this. Its requirements make more apparent to statement
readers the uncertainties associated with even recognized items,
due to such matters as subjective estimates and the potential
effects of significant concentrations in an entity s operations.
-[8]-

This SOP is important because it provides additional texture to

amounts reported in financial statements.

C. Distinctions from the Current Model

Let me summarize the distinctions between the colorized

model and the current accounting and financial reporting model.
First, as I just alluded to, the colorized approach places the
emphasis of financial reporting on providing information useful
and having a high degree of utility to investment, credit or
other decisions as opposed to deciding whether information should
be recognized in the financial statements. While recognition is
an important concept in this new model, it should be remembered
that recognized information is a subset of financial reporting
and the goal is to present information that users find useful.
With the colorized approach, the primary role of recognition
would be in connection with items for which there was general
agreement on the high degree of relevance, reliability and
measurement for the first or core level of presentation. As the
relevance, reliability and measurement of particular items became
more or less generally acceptable to financial standard setters
and users of information, the core would expand and contract as
necessary. But recognition would be de-emphasized in that it
would merely reflect the demarcation between the first layer and
the next layer of information. In other words: recognition
becomes one concept for one layer of presentation, not the

--------- FOOTNOTES ---------

-[8]- Indeed, almost all information reported in financial

 statements -- other than the date of the statements and
the number of shares outstanding -- would appear to
involve some element of prediction or uncertainty.

-------------------- BEGINNING OF PAGE #13 -------------------

paradigm for financial reporting.

Admittedly, the layers of the model just outlined can

not be specified with absolute bright lines or certainty -- there
will always be gray areas, even in this colorized approach.
Nevertheless, the colorized approach would promote disclosure of
information that is not disclosed under our current system of
financial reporting -- including information relating to
intangible assets and other difficult to value items. Although
such information arguably may be presented as supplementary
information, in practice this occurs all too infrequently.
Instead, supplementary disclosures today typically relate only to
items that are already recognized in the core financial
statements.

Finally, by conditioning the "colorization" of the

financial reporting system on (and with specific disclosure of)
the level of assurance associated with the information, we will
provide end-users with a far better sense of the quality of the
information upon which they are basing their decisions.

In sum, the colorized approach is more aligned with the

purposes of financial reporting, and more compatible with dealing
with the dynamic nature of information that is relevant to end-
users of financial reporting, than the current black and white
system. It allows us to make finer distinctions among various
types of information, thereby avoiding the daunting task of
determining whether items that are close to the recognition/non-
recognition line are in or out of the financial reporting
paradigm.

D. Issues for Consideration

There are, of course, important issues to be resolved

in changing our current system along the lines I have just
suggested. In addition to debate about the appropriate methods
for delimiting the layers of disclosure, these issues include (i)
determining the degree of comparability that will be required
under the model, (ii) assessing the costs to preparers of
financial reports, (iii) concerns about litigation exposure and
the need for a safe harbor, (iv) uncertainty about how such
traditional accounting measures as net income or earnings per
share will be calculated, and (v) whether the additional layers
of disclosure will result in greater confusion of users of
financial reports.

These are difficult issues and although you might

envision answers to some -- for example, net income or earnings
per share might continue to be calculated solely based on
recognized information, or varying net income and earnings per
share amounts could be reported for each of the various layers -
- it is unlikely that we will find answers for all of these
questions without more thought. We must confront these issues,
however, if we are to ensure the continued relevance of financial
reporting.

In addition to SOP 94-6, two other recent AICPA

initiatives indicate that the profession is beginning to move in
this direction. The Jenkins Committee identified various
additional types of information companies should provide to
investors and creditors, and considered the extent to which
auditors should be associated with that information. Finally,
the Elliott Committee (the Special Committee on Assurance
Services) is studying market needs for new services that are

-------------------- BEGINNING OF PAGE #14 -------------------

broader and more varied than audits of financial statements. It

is expected to recommend that CPAs be prepared to undertake a
much wider scope of assurance work.

These initiatives open the door to consideration of the

emerging issues that need to be addressed. They are consistent
with and in fact represent movements toward the alternative
perspective I have outlined.

Conclusion

The issues that I have raised this morning relating to

the utility of accounting and financial reporting are not new,
but are extremely important. As I alluded to at the outset, my
goal in proposing a model for your consideration is to stimulate
creative thinking to address the challenges facing accounting and
financial reporting in the next century, which is imminently
approaching. Clearly there are flaws to the current and the
proposed models; our goal, however, should be not only to
identify them but to consider whether and how they might be best
addressed -- or to develop an alternative approach -- to maintain
and enhance the utility of our current system.

As I mentioned, many efforts are underway to address

some of the issues I have been discussing. In addition to those
I mentioned earlier, the Commission -- with the participation of
a variety of interested parties, including the AICPA -- will be
sponsoring a series of symposia related to these issues. The
first event will involve issues related to the accounting and
reporting of intangible assets and is scheduled for April 11-12.

Thank you for your attention and I would appreciate any

thoughts or comments you may have.