[Federal Register Volume 73, Number 100 (Thursday, May 22, 2008)]
[Notices]
[Pages 29808-29832]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-11276]
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SECURITIES AND EXCHANGE COMMISSION
[Release Nos. 33-8918; 34-57819; File No. 265-24]
Subcommittee Reports of the SEC Advisory Committee on
Improvements to Financial Reporting
AGENCY: Securities and Exchange Commission.
ACTION: Request for comments.
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SUMMARY: The Advisory Committee is publishing four subcommittee reports
that were presented to the Advisory Committee at its May 2, 2008 open
meeting and is soliciting public comment on those subcommittee reports.
The subcommittee reports contain the subcommittees' updates of their
work through the May 2, 2008 open meeting and contain preliminary
hypotheses and other material that will be considered by the full
Committee in developing recommendations for the Committee's final
report.
DATES: Comments should be received on or before June 23, 2008.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/other.shtml); or
Send an e-mail to [email protected]. Please include
File Number 265-24 on the subject line.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Federal Advisory Committee Management Officer, Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549-1090.
All submissions should refer to File No. 265-24. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comment more efficiently, please use only one
method. The Commission will post all comments on its Web site (http://www.sec.gov/about/offices/oca/acifr.shtml). Comments also will be
available for public inspection and copying in the Commission's Public
Reference Room, 100 F Street, NE., Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. All comments
received will be posted without change; we do not edit personal
identifying information from submissions. You should submit only
information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Questions about this release should be
referred to James L. Kroeker, Deputy Chief Accountant, or Shelly C.
Luisi, Senior Associate Chief Accountant, at (202) 551-5300, Office of
the Chief Accountant, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-6561.
SUPPLEMENTARY INFORMATION: At the request of the SEC Advisory Committee
on Improvements to Financial Reporting, the Commission is publishing
this release soliciting public comment on the subcommittees' reports.
The full text of these subcommittee reports are attached as Exhibits A-
D and also may be found on the Committee's Web page at http://www.sec.gov/about/offices/oca/acifr.shtml. The subcommittee reports
contain the subcommittees' updates of their work through the May 2,
2008 open meeting of the full Committee and contain preliminary
hypotheses and other material that may be deliberated by the full
Committee in considering recommendations for the Committee's final
report. As such, the Committee would like to request public input on
the material in these subcommittee reports. The subcommittee reports
have been prepared by the individual subcommittees and do not
necessarily reflect either the views of the Committee or other members
of the Committee, or the views or regulatory agenda of the Commission
or its staff.
All interested parties are invited to comment on the enclosed
subcommittee reports. Comments on the reports are most helpful if they
(1) Indicate the specific exhibit and paragraph to which the comments
relate, (2) contain a clear rationale, and (3) include any
alternative(s) the Committee should consider.
Authority: In accordance with Section 10(a) of the Federal
Advisory Committee Act, 5 U.S.C. App. 1, Sec. 10(a), James L.
Kroeker, Designated Federal Officer of the Committee, has approved
publication of this release at the request of the Committee. The
solicitation of comments is being made solely by the Committee and
not by the Commission. The Commission is merely providing its
facilities to assist the Committee in soliciting public comment from
the widest possible audience.
Dated: May 15, 2008.
Nancy M. Morris,
Committee Management Officer.
Note: These subcommittee reports have been prepared by the
individual subcommittees and do not necessarily reflect either the
views of the Committee or other members of the Committee, or the
views or regulatory agenda of the Commission or its staff.
Exhibit A
SEC Advisory Committee on Improvements to Financial Reporting
Substantive Complexity Subcommittee Update
May 2, 2008 Full Committee Meeting
I. Introduction
The SEC's Advisory Committee on Improvements to Financial Reporting
(Committee) issued a progress report (Progress Report) on February 14,
2008.\1\ In chapter 1 of the Progress Report, the Committee discussed
its work-to-date in the area of substantive complexity, namely, its
developed proposals related to industry-specific guidance and
alternative accounting policies; its conceptual approaches regarding
the use of bright lines and the mixed attribute model; and its future
considerations related to scope exceptions \2\ and competing models.
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\1\ Refer to Progress Report at http://www.sec.gov/rules/other/2008/33-8896.pdf.
\2\ Throughout this report, the term ``scope exceptions'' refers
to scope exceptions other than industry-specific guidance.
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Since the issuance of the Progress Report, the substantive
complexity subcommittee (Subcommittee I) has deliberated each of these
areas further, particularly its conceptual approaches and future
considerations, and refined them accordingly. This report represents
Subcommittee I's latest thinking. The Subcommittee's consideration of
comment letters received thus far by the Committee is ongoing and may
result in additional changes. The purpose of this
[[Page 29809]]
report is to update the full Committee, and also to serve as a basis
for the substantive complexity panel discussions scheduled for May 2,
2008 in Chicago. Subject to further public comment, Subcommittee I
intends to deliberate whether to recommend these preliminary hypotheses
to the full Committee for its consideration in developing the final
report, which it expects to issue in July 2008.
II. Exceptions to General Principles
II.A. Industry-Specific Guidance
In the Progress Report, the Committee issued a developed proposal
related to industry-specific guidance (developed proposal 1.1). Refer
to the Progress Report for additional discussion of this developed
proposal. Subcommittee I will consider the panel discussions on May 2,
2008, as well as the public comment letters received, before submitting
a final recommendation to the Committee, but at this time, is not
intending to propose any significant revisions.
II.B. Alternative Accounting Policies
In the Progress Report, the Committee issued a developed proposal
related to alternative accounting policies (developed proposal 1.2).
Refer to the Progress Report for additional discussion of this
developed proposal. Subcommittee I will consider the panel discussions
on May 2, 2008, as well as the public comment letters received, before
submitting a final recommendation to the Committee, but at this time,
is not intending to propose any significant revisions.
II.C. Scope Exceptions
Preliminary Hypothesis 1: GAAP should be based on a presumption
that scope exceptions should not exist. As such, the SEC should
recommend that any new projects undertaken jointly or separately by the
FASB should not provide additional scope exceptions, except in rare
circumstances. Any new projects should also include the elimination of
existing scope exceptions in relevant areas as a specific objective of
these projects, except in rare circumstances.
Background
Scope exceptions represent departures from the application of a
principle to certain transactions. For example: \3\
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\3\ Refer to appendix A for additional examples.
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SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, excludes certain financial guarantee contracts,
employee share-based payments, and contingent consideration from a
business combination, among others.
SFAS No. 157, Fair Value Measurements, excludes employee
share-based payments and lease classification and measurement, among
others.
FIN 46R, Consolidation of Variable Interest Entities,
excludes employee benefit plans, qualifying special-purpose
entities,\4\ certain entities for which the company is unable to obtain
the information necessary to apply FIN 46R, and certain businesses,
among others.
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\4\ Subcommittee I notes that the FASB has tentatively decided
to remove the qualifying special-purpose entity concept from U.S.
GAAP and its exception from consolidation.
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Similar to other exceptions to general principles, scope exceptions
arise for a number of reasons. These reasons include: (1) Cost-benefit
considerations, (2) the need for temporary measures to quickly minimize
the effect of unacceptable practices, rather than waiting for a final
``perfect'' standard to be developed, (3) avoidance of conflicts with
standards that would otherwise overlap, and (4) political pressure.
Scope exceptions contribute to avoidable complexity in several
ways. First, where accounting standards specify the treatment of
transactions that would otherwise be within scope, exceptions may
result in different accounting for similar activities (refer to
competing models section below for further discussion). Second, scope
exceptions contribute to avoidable complexity because of difficulty in
defining the bounds of the scope exception. As a result, scope
exceptions require detailed analyses to determine whether they apply in
particular situations, and consequently, increase the volume of
accounting literature. For example, the Derivatives Implementation
Group has issued guidance on twenty implementation issues related to
the scope exceptions in SFAS No. 133. Further, companies may try to
justify aggressive accounting by analogizing to scope exceptions,
rather than more generalized principles.
Nonetheless, scope exceptions may alleviate complexity in
situations where the costs of a standard outweigh the benefits. For
example, many constituents would contend that derivative accounting and
disclosures for ``normal purchases and normal sales'' contracts are not
meaningful, and thus, are appropriately excluded from the scope of SFAS
No. 133.
Discussion
Subcommittee I preliminarily believes that scope exceptions should
be minimized to the extent feasible. Possible justifications for
retaining scope exceptions include: (1) Cost-benefit considerations,
(2) the need for temporary measures to quickly minimize the effect of
unacceptable practices, rather than waiting for a final ``perfect''
standard to be developed, and (3) the need for temporary measures to
avoid conflicts in GAAP. However, in cases where scope exceptions are
provided as a temporary measure, they should be coupled with a long-
term plan by the FASB to eliminate the scope exception through the use
of sunset provisions.
Subcommittee I also notes that in certain areas, the SEC staff has
issued guidance to address transactions that are not within the scope
of FASB guidance, e.g., literature addressing the balance sheet
classification of redeemable preferred stock not covered by SFAS No.
150.\5\ Accordingly, as the FASB develops standards to address these
transactions, the SEC should eliminate its related guidance.
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\5\ Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity.
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From an international perspective, Subcommittee I notes that IFRS
currently has fewer scope exceptions than U.S. GAAP. Accordingly, the
Subcommittee will draft language for the full Committee's
consideration, which if adopted, would encourage the SEC to affirm the
IASB's efforts on this path. However, Subcommittee I also notes that,
in certain circumstances where IFRS includes scope exceptions, they are
sometimes more expansive than those under U.S. GAAP. For example, IFRS
3, Business Combinations, scopes out business combinations involving
entities under common control, which results in no on-point guidance
for such transactions. Accordingly, Subcommittee I also believes that
where IFRS provides scope exceptions, the IASB should ensure any
significant business activities that are excluded from one standard are
in fact addressed elsewhere. Said differently, the IASB should avoid
leaving large areas of business activities unaddressed in the
professional standards.
II.D. Competing Models
Preliminary Hypothesis 2: GAAP should be based on a presumption
that similar activities should be accounted for in a similar manner. As
such, the SEC should recommend that any new projects undertaken jointly
or separately by the FASB should not create
[[Page 29810]]
additional competing models, except in rare circumstances. Any new
projects should also include the elimination of competing models in
relevant areas as a specific objective of these projects, except in
rare circumstances.
Background
Competing models are distinguished here from alternative accounting
policies. Alternative accounting policies, as explained in the Progress
Report, refer to different accounting treatments that preparers are
allowed to choose under existing GAAP (e.g., whether to apply the
direct or indirect method of cash flows). By contrast, competing models
refer to requirements to apply different accounting models to account
for similar types of transactions or events, depending on the balance
sheet or income statement items involved.
Examples of competing models \6\ include different methods of
impairment testing for assets such as inventory, goodwill, and deferred
tax assets.\7\ Other examples include different methods of revenue
recognition in the absence of a general principle, as well as the
derecognition of most liabilities (i.e., removal from the balance
sheet) on the basis of legal extinguishment compared to the
derecognition of a pension or other post-retirement benefit obligation
via settlement, curtailment, or negative plan amendment.
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\6\ Refer to appendix A for additional examples.
\7\ For instance, inventory is assessed for recoverability
(i.e., potential loss of usefulness) and remeasured at the lower of
cost or market value on a periodic basis. To the extent the value of
inventory recorded on the balance sheet (i.e., its ``cost'') exceeds
a current market value, a loss is recorded. In contrast, goodwill is
tested for impairment annually, unless there are indications of loss
before the next annual test. To determine the amount of any loss,
the fair value of a ``reporting unit'' (as defined in GAAP) is
compared to its carrying value on the balance sheet. If fair value
is greater than carrying value, no impairment exists. If fair value
is less, then companies are required to allocate the fair value to
the assets and liabilities in the reporting unit, similar to a
purchase price allocation in a business combination. Any fair value
remaining after the allocation represents ``implied'' goodwill. The
excess of actual goodwill compared to implied goodwill, if any, is
recorded as a loss. Deferred tax assets are tested for realizability
on the basis of future expectations. The amount of tax assets is
reduced if, based on the weight of available evidence, it is more
likely than not (i.e., greater than 50% probability) that some
portion or all of the deferred tax asset will not be realized.
Future realization of a deferred tax asset ultimately depends on the
existence of sufficient taxable income of the appropriate character
(e.g., ordinary income or capital gain) within the carryback and
carryforward periods available under the tax law.
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Similar to other exceptions to general principles, competing models
arise for a number of reasons. These include: (1) Scope exceptions,
which, as discussed above, arise from cost-benefit considerations,
temporary measures, and political pressure, and (2) the lack of a
consistent and comprehensive conceptual framework, which results in
piecemeal standards-setting.
Competing models contribute to avoidable complexity in that they
lead to inconsistent accounting for similar activities, and they
contribute to the volume of accounting literature.
On the other hand, competing models alleviate avoidable complexity
to the extent that costs of a certain model exceed the benefits for a
subset of activities.
Discussion
Subcommittee I preliminarily believes that similar activities
should be accounted for in a similar manner. Specifically, Subcommittee
I acknowledges that competing models may be justified in circumstances
in which the costs of applying a certain model to a subset of
activities exceed the benefits. Further, Subcommittee I preliminarily
believes that competing models may be justified as temporary measures
(such as when they are temporarily needed to minimize the effect of
unacceptable practices quickly, rather than waiting for a final
``perfect'' standard to be developed), as long as they are coupled with
a sunset provision. To the extent a competing model meets one or more
of the justifications above, it would not seem objectionable to use
scope exceptions to clarify which accounting models cover various
transactions (e.g., standard A ought to refer preparers to standard B
for transactions excluded from the scope of A).
Subcommittee I recognizes that the FASB and IASB's joint project on
the conceptual framework will alleviate some of the competing models in
GAAP. However, Subcommittee I would encourage the implementation of
this preliminary hypothesis prior to the completion of conceptual
framework, where practical, as: (1) The conceptual framework is a long-
term project and (2) current practice issues encountered in the
standard-setting process will inform the deliberations on the
conceptual framework.
Further, as new accounting standards are issued, including that
which is issued through the convergence process, any competing models
in related SEC literature should be revised and/or eliminated, as
appropriate. Subcommittee I notes that, in certain cases, IFRS
currently has fewer competing models. For example, Subcommittee I notes
that, unlike U.S. GAAP, the IFRS impairment model is generally
consistent for tangible assets, intangible assets, and goodwill. As
such, Subcommittee I will draft language for the full Committee's
consideration, which if adopted, would encourage the SEC to affirm the
IASB's efforts on this path, particularly as it works with the FASB on
the joint conceptual framework.
III. Bright Lines
Preliminary Hypothesis 3.1: GAAP should be based on a presumption
that bright lines should not exist. As such, the SEC should recommend
that any new projects undertaken jointly or separately by the FASB
avoid the use of bright lines, in favor of proportionate recognition.
Where proportionate recognition is not feasible or applicable, the FASB
should provide qualitative factors for the selection of a single
accounting treatment. Finally, enhanced disclosure should be used as a
supplement or alternative to the two approaches above.
Any new projects should also include the elimination of existing
bright lines in relevant areas to the extent feasible as a specific
objective of those projects, in favor of the two approaches above.
Preliminary Hypothesis 3.2: Constituents should be better trained
to consider the economic substance and business purpose of transactions
in determining the appropriate accounting, rather than relying on
mechanical compliance with rules. As such, the SEC should undertake
efforts, and also encourage the FASB, academics and professional
organizations, to better educate students, investors, preparers,
auditors, and regulators in this respect.
Background
As noted in the Progress Report, bright lines refer to two main
areas related to financial statement recognition: quantified thresholds
and pass/fail tests.\8\
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\8\ Refer to appendix B of the Progress Report for additional
examples of bright lines.
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Lease accounting is often cited as an example of bright lines in
the form of quantified thresholds. Consider, for example, a lessee's
accounting for a piece of machinery. Under current requirements, the
lessee will account for the lease in one of two significantly different
ways: Either (1) reflect an asset and a liability on its balance sheet,
as if it owns the leased asset, or (2) reflect nothing on its balance
sheet. The accounting conclusion depends on the results of two
quantitative tests,\9\ where
[[Page 29811]]
a mere 1% difference in the results of the quantitative tests leads to
very different accounting.
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\9\ Specifically, SFAS No. 13, Accounting for Leases, requires
that leases be classified as capital leases and recognized on the
lessee's balance sheet where (1) the lease term is greater than or
equal to 75% of the estimated economic life of the leased property
or (2) the present value at the beginning of the lease term of the
minimum lease payments equals or exceeds 90% of the fair value of
the leased property, among other criteria.
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The other area of bright lines in this section includes pass/fail
tests, which are similar to quantitative thresholds because they result
in recognition on an all-or-nothing basis. However, these types of
pass/fail tests do not involve quantification. For example, a software
sales contract may require delivery of four elements. Revenue may, in
certain circumstances, be recognized as each element is delivered.
However, if appropriate evidence does not exist to support the
allocation of the sales price to, for example, the second element,
software revenue recognition guidance requires that the timing of
recognition of all revenue be deferred until such evidence exists or
all four elements are delivered.
Bright lines arise for a number of reasons. These include a drive
to enhance comparability across companies by making it more convenient
for preparers, auditors, and regulators to reduce the amount of effort
that would otherwise be required in applying judgment (i.e., debating
potential accounting treatments and documenting an analysis to support
the final judgment), and the belief that they reduce the chance of
being second-guessed. Bright lines are also created in response to
requests for additional guidance on exactly how to apply the underlying
principle. These requests often arise from concern on the part of
preparers and auditors of using judgment that may be second-guessed by
inspectors, regulators, and the trial bar. Finally, bright lines
reflect efforts to curb abuse by establishing precise rules to avoid
problems that have occurred in the past.
Bright lines can contribute to avoidable complexity by making
financial reports less comparable. This is evident in accounting that
is not faithful to a transaction's substance, particularly when
application of the all-or-nothing guidance described above is required.
Bright lines produce less comparability because two similar
transactions may be accounted for differently. For example, as
described above, a mere 1% difference in the quantitative tests
associated with lease accounting could result in very different
accounting consequences. Some bright lines also permit structuring
opportunities to achieve a specific financial reporting result (e.g.,
whole industries have been developed to create structures to work
around the lease accounting rules). Further, bright lines increase the
volume of accounting literature as standards-setters and regulators
attempt to curb abusively structured transactions. The extra literature
creates demand for additional expertise to account for certain
transactions. All of these factors add to the total cost of accounting
and the risk of restatement.
On the other hand, bright lines may, in some cases, alleviate
complexity by reducing judgment and limiting aggressive accounting
policies. They may also enhance perceived uniformity across companies,
provide convenience as discussed above, and limit the application of
new accounting guidance to a small group of companies, where no
underlying standard exists. In these situations, the issuance of
narrowly-scoped guidance may allow for issues to be addressed on a more
timely basis. In other words, narrowly-scoped guidance and the bright
lines that accompany them may function as a short-term fix on the road
to ideal accounting.
Discussion
Subcommittee I preliminarily believes that bright lines in GAAP
should be minimized in favor of proportionate recognition. As a
secondary approach, where proportionate recognition is not feasible or
applicable, the Subcommittee recommends that GAAP be based on
qualitative factors, supported by presumptions \10\ as necessary.
Subcommittee I also preliminarily believes that disclosure may be used
as a supplement or alternative to the approaches above.
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\10\ In order for the use of presumptions to be meaningful and
consistently applied, Subcommittee I preliminarily believes that the
FASB should adopt consistent use of terms describing likelihood
(e.g., rare, remote, reasonably possible, more likely than not,
probable), time frames (e.g., contemporaneous, immediate, imminent,
near term, reasonable period of time), and magnitude (e.g.,
insignificant, material, significant, severe).
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Subcommittee I uses the term ``proportionate recognition'' to
describe accounting for the rights and obligations in a contract. In
contrast to the current all-or-nothing recognition approach in GAAP,
Subcommittee I preliminarily believes that accounting for rights and
obligations would be appropriate in areas such as lease accounting--in
effect, an entity would fully recognize its rights to use an asset,
rather than the physical asset itself. In these cases, regardless of
whether the lease is considered to be operating or capital (based on
today's dichotomy), all entities would record amounts in the financial
statements to the extent of their involvement in the related business
activities. For example, consider a lease in which the lessee has the
right to use a machine, valued at $100, for four years. Also assume
that the machine has a 10-year useful life. Under proportionate
recognition, a lessee would recognize an asset for its right to use the
machine (rather than for a proportion of the asset) at approximately
$35 \11\ on its balance sheet. Under the current accounting literature,
the lessee would either recognize the machine at $100 or recognize
nothing on its balance sheet, depending on the results of certain
bright line tests. Similarly, this rights-and-obligations approach may
also be relevant in the context of revenue recognition, in particular,
in comparison to today's software revenue recognition model.
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\11\ For purposes of illustration, $35 represents a company's
net present value calculations. The example is only intended to be
illustrative and is not prescriptive. The basis of proportionate
recognition may be an asset's estimated useful life, its future cash
flows or some other approach depending on the facts and
circumstances.
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However, Subcommittee I recognizes that proportionate recognition
is not universally applicable. For example, proportionate recognition
is not applicable in situations where the economics of a transaction
legitimately represent an all-or-nothing scenario.\12\ In situations
like these, the FASB should consider providing qualitative factors,
supported by presumptions, to guide the selection of a single
appropriate accounting treatment by preparers. Subcommittee I
preliminarily believes qualitative factors, including presumptions,
would promote the application of principles over compliance with rules,
while still narrowing the range of interpretation in practice to
facilitate comparability across companies. Admittedly, presumptions may
result in all-or-nothing accounting, but differ from bright lines
because they are not arbitrary or determinative in their own right.
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\12\ Examples include determining (1) whether a contract should
be accounted for as a single unit of account or whether it should be
split into multiple components, and (2) whether a contract that has
characteristics of both liabilities and equity should be treated as
one instead of the other.
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Subcommittee I uses the term ``presumptions'' to describe a method
by which an accounting conclusion may be initially favored (i.e., not
stringently applied), subject to the consideration of additional
factors. This approach is used to some extent today. For instance, the
business combination literature contains an example of a presumption
[[Page 29812]]
coupled with additional considerations.\13\ There are situations in
which selling shareholders of a target company are hired as employees
by the purchaser because the purchaser may wish to retain the sellers'
business expertise. The payments to the selling shareholders may either
be treated as: (1) Part of the cost of the acquisition, which means the
payments are allocated to certain accounts on the purchaser's balance
sheet, such as goodwill, or (2) compensation to the newly-hired
employees, which are recorded as an expense in the purchaser's income
statement, reducing net income. Some of these payments may be
contingent on the selling shareholders' continued employment with the
purchaser, e.g., the individual must still be employed three years
after the acquisition in order to maximize the total sales price. GAAP
provides several factors to consider when deciding whether these
payments should be treated as an expense or not, but establishes a
presumption that any future payments linked to continued employment
should be treated as an expense. It is possible this presumption may be
overcome depending on the circumstances.
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\13\ Emerging Issues Task Force (EITF) 95-8, Accounting for
Contingent Consideration Paid to the Shareholders of an Acquired
Enterprise in a Purchase Business Combination. Subcommittee I notes
EITF 95-8 is nullified by a new FASB standard, SFAS No. 141 (revised
2007), Business Combinations. SFAS No. 141 (revised 2007) states ``A
contingent consideration arrangement in which the payments are
automatically forfeited if employment terminates is compensation * *
*'' However, the guidance in EITF 95-8 is still helpful in
describing our approach with respect to the use of presumptions
coupled with additional considerations in GAAP.
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Finally, Subcommittee I notes that disclosure is critical to
communicating with users, either by supplementing financial statement
recognition (proportionate or otherwise) or by discussing events and
uncertainties outside of the financial statements. Subcommittee I
preliminarily believes that in some cases, disclosure may be more
informative than recognition, as point estimates recognized in
financial statements may provide a misleading sense of precision.
Subcommittee I discusses examples of this situation in its
consideration of a disclosure framework (section V of this report).
In order for these preliminary hypotheses to be operational,
Subcommittee I recognizes the need for a cultural shift towards the
acceptance of more judgment. In this regard, Subcommittee I
preliminarily believes that professional judgment framework discussed
in developed proposal 3.4 is critical to the success of these
preliminary hypotheses. Subcommittee I further notes that even if the
FASB limits its use of bright lines, other parties may continue to
create similar non-authoritative guidance, which may proliferate the
use of bright lines. As such, Subcommittee I preliminarily believes
that developed proposal 2.4 regarding the reduction of parties that
formally or informally interpret GAAP is helpful.
From an international perspective, Subcommittee I notes that IFRS
currently has fewer bright lines than U.S. GAAP. Consequently,
Subcommittee I will draft language for the full Committee's
consideration, which if adopted, would encourage the SEC to affirm the
IASB's efforts on this path.
With respect to training and educational efforts, Subcommittee I
notes the U.S. Treasury Department's Advisory Committee on the Auditing
Profession has offered a number of preliminary recommendations on this
topic. The Subcommittee is generally supportive of their direction, and
will draft language for the full Committee's consideration, which if
adopted, would encourage the SEC to monitor these developments as it
takes steps, in coordination with the FASB, to promote the ongoing
education of all financial reporting constituents.
IV. Mixed Attribute Model
As previously noted in the Progress Report, the mixed attribute
model is one in which the carrying amounts of some assets and
liabilities are measured at historic cost, others at lower of cost or
market, and still others at fair value. There are several measurement
attributes that currently exist in GAAP, all of which result in
combinations and subtotals of amounts that are not intuitively useful.
This complexity is compounded by requirements to record some
adjustments in earnings, while others are recorded in equity (i.e.,
comprehensive income). For example, changes in the fair value of a
derivative may be charged directly to equity, while an asset's current
period depreciation expense reduces net income.
Optimally, the FASB should develop a consistent approach to
determine which measurement attribute should apply to different types
of business activities. While Subcommittee I is aware the FASB has a
long-term project to develop such an approach, known as the measurement
framework, it advocates three steps in the near term for the
Committee's consideration to improve the clarity of financial
statements for investors.
First, the Committee should advise caution about expanding the use
of fair value in financial reporting until a number of practice issues
are better understood and resolved, providing time for the FASB to
complete its measurement framework. Second, the Committee should
recommend a presentation of distinct measurement attributes on the face
of the primary financial statements, grouped by business activities.
This will make subtotals of individual line items in the statements
more meaningful. Third, the Committee should propose the development of
a disclosure framework, which would enable users to better understand
the key risks and uncertainties associated with different measurement
attributes (refer to section V below).
Preliminary Hypothesis 4: Avoidable complexity caused by the mixed
attribute model should be reduced in three respects:
Measurement framework--The SEC should recommend that the
FASB be judicious in issuing new standards and interpretations that
expand the use of fair value in areas where it is not already
required,\14\ until completion of a measurement framework. The SEC
should also recommend that, to the maximum extent feasible, the FASB
use a single measurement attribute for each type of business activity
presented in the financial statements.\15\
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\14\ For instance, improvements to certain existing,
particularly complex standards, such as SFAS No. 133, Accounting for
Derivatives and Hedging Activities and SFAS No. 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, may be warranted in the near term.
\15\ To make this approach operational, the FASB might establish
a rebuttable presumption in favor of a single measurement attribute
within each business activity (i.e., operating, investing and
financing). For example, the Board may determine amortized cost is
the presumptive measurement attribute within the operating section
of a company's financial statements. Nevertheless, the Board would
also have to consider whether fair value is appropriate for
financial assets and liabilities employed in those business
activities, such as certain derivative contracts used to hedge
commodity price risk for materials used in the production process.
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Financial statement presentation--The SEC should encourage
the FASB to:
[cir] Assign a single measurement attribute within each business
activity that is consistent across the financial statements.
[cir] Aggregate business activities into operating, investing and
financing sections.\16\
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\16\ Subcommittee I is aware of the FASB and IASB's joint
financial statement presentation project and is generally supportive
of its direction. Subcommittee I also notes that in addition to the
three business activities listed here, the FASB's project
contemplates two additional types of business activities--income
taxes and discontinued operations.
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[[Page 29813]]
[cir] Add a new primary financial statement to reconcile the
statements of income and cash flows by measurement attribute.\17\
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\17\ An example of this presentation is included below.
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Enhanced disclosure--refer to section V of this report.
Background
As the Committee noted in the Progress Report, examples of
accounting standards that result in mixed attribute measurement include
two FASB standards related to financial instruments. SFAS No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities,
permits the fair valuation of certain assets and liabilities. As a
result, some assets and liabilities are measured at fair value, while
others are measured at amortized cost or some other basis. SFAS No.
115, Accounting for Certain Investments in Debt and Equity Securities,
requires certain investments to be recognized at fair value and others
at amortized cost.
In practice, the costs associated with (potentially uncertain) fair
value estimates can be considerable. Some preparers' knowledge of
valuation methodology is limited, requiring the use of valuation
specialists. Auditors often require valuation specialists of their own
to support the audit. Some view the need for these valuation
specialists as a duplication of efforts, at the expense of the
preparer. In addition, there are recurring concerns about second-
guessing by auditors, regulators, and courts in light of the many
judgments and imprecision involved with fair value estimates.
Regardless of whether such estimates are prepared internally or by
valuation specialists, the effort and elapsed time required to
implement and maintain mark-to-model fair values is significant. For
these reasons, preparers and auditors will likely have to incur costs
to broaden their proficiency in basic valuation matters,\18\ and
additional education may be required for the larger financial reporting
community to become further accustomed to fair value information.
---------------------------------------------------------------------------
\18\ For instance, additional training for field auditors may be
necessary to lessen dependency on valuation experts.
---------------------------------------------------------------------------
Nevertheless, some have advocated mandatory and comprehensive use
of fair value as a solution to the complexities arising from the mixed
attribute model. However, opponents argue that this would only shift
the burden of complexity from investors to preparers and auditors,
among others. Specifically, certain investors may find uniform fair
value reporting simpler and more meaningful than the current mixed
attribute model. But under a full fair value approach, some objectivity
would be sacrificed because many amounts that would change to fair
value are currently reported on a more verifiable basis, such as
historic cost. These amounts would have to be estimated by preparers
and certified by auditors, as discussed above. Such estimates are made
even more subjective by the lack of a single set of generally accepted
valuation standards and the use of inputs to valuation models that vary
from one company to the next. Likewise, significant variance exists in
the quality, skill, and reports of valuation specialists, which
preparers have limited ability to assess. Finally, there is no
mechanism to ensure the ongoing quality, training, and oversight of
valuation specialists. As a result, some believe a wholesale transition
to fair value would reduce the reliability of financial reports to an
unacceptable degree.
Therefore, as the Committee noted in its Progress Report,
Subcommittee I assumes that a complete move to fair value is most
unlikely. Within this context, the partial use of fair value increases
the volume of accounting literature. Said differently, when more than
one measurement attribute is used, guidance is required for each one.
In addition, some entities may operate under the impression that
investors are averse to market-driven volatility. Consequently,
entities have demanded exceptions from the use of fair value in
financial reporting, resisted its use, and/or entered into transactions
that they otherwise would not have undertaken to artificially limit
earnings volatility. These actions have resulted in a build up in the
volume of accounting literature. More generally, some believe that
attempts by companies to smooth amounts that are not smooth in their
underlying economics reduce the efficiency and the effectiveness of
capital markets.
With respect to users, information delivery is made more difficult
by fair value. Investors may not understand the uncertainty associated
with fair value measurements (i.e., that they are merely estimates and,
in many instances, lack precision), including the quality of unrealized
gains and losses in earnings that arise from changes in fair value.
Some question whether the use of fair value may lead to
counterintuitive results. For example, an entity that opts to fair
value its debt may recognize a gain when its credit rating declines.
Others question whether the use of fair value for held to maturity
investments is meaningful. Finally, preparers may view disclosure of
some of the inputs to the assumptions as sensitive and competitively
harmful.
Despite these difficulties, the use of fair value may alleviate
some aspects of avoidable complexity. Such information may provide
investors with management's perspective, to the extent management makes
decisions based on fair value, and it may improve the relevance of
information in many cases, as historical cost is not meaningful for
certain items.
Fair value may also enhance consistency by reducing confusion
related to measurement mismatches. For example, an entity may enter
into a derivative instrument to hedge its exposure to changes in the
fair value of debt attributable to changes in the benchmark interest
rate. The derivative instrument is required to be recognized at fair
value, but, assuming no application of hedge accounting or the fair
value option, the debt would be measured at amortized cost, resulting
in measurement mismatches. In addition, fair value might mitigate the
need for detailed application guidance explaining which instruments
must be recorded at fair value and help prevent some transaction
structuring. Specifically, if fair value were consistently required for
all similar activities, entities would not be able to structure a
transaction to achieve a desired measurement attribute.
Fair value also eliminates issues surrounding management's intent.
For example, entities are required to evaluate whether investments are
impaired. Under certain impairment models, entities are currently
required to assess whether they have the intent and ability to hold the
investment for a period of time sufficient to allow for any anticipated
recovery in market value. As the Committee noted in the Progress Report
(see discussion supporting developed proposal 1.2 to minimize
alternative accounting policies) management intent is subjective and,
thus, less auditable. However, use of fair value would generally make
management intent irrelevant in assessing the value of an investment.
Discussion
Subcommittee I acknowledges the view that a complete transition to
fair value would alleviate avoidable complexity resulting from the
mixed attribute model. However, Subcommittee I also recognizes that
expanded use of fair value would increase avoidable complexity unless
numerous implementation questions related to relevance and reliability
are
[[Page 29814]]
addressed (as discussed above), which extend beyond the scope of our
work.
Therefore, consistent with current practice, Subcommittee I
preliminarily believes fair value should not be the only measurement
attribute in GAAP. At present, Subcommittee I believes the Committee
should advise caution about expanding the use of fair value until a
systematic measurement framework is developed, and in this regard, that
phase two of the FASB's fair value option project, which will consider
permitting fair value measurement for certain nonfinancial assets and
liabilities, should not be finalized prior to completion of a
measurement framework.\19\
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\19\ Similarly, Subcommittee I preliminarily believes the
Committee should recommend that the FASB consider deferring
provisions of new standards that are issued, but not yet effective,
which expand the use of fair value measurement where it has not been
previously required.
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At that point, the FASB should determine measurement attributes
based on considerations such as business activity, the relevance and
reliability of fair value inputs, and other considerations vetted
during the measurement phase of its conceptual framework project. While
Subcommittee I prefers an activity-based approach to assigning
measurement attributes, Subcommittee I is sympathetic to an approach
based on the type of asset or liability in question, such as financial
instruments vs. non-financial instruments. This is a natural tension
that the FASB should address as part of the measurement framework. For
example, in one scenario, the Board may determine amortized cost is the
presumptive measurement attribute within the operating section of a
company's financial statements. Nevertheless, the Board would also have
to consider whether fair value is appropriate for financial assets and
liabilities employed in those business activities such as certain
derivative contracts used to hedge commodity price risk for materials
used in the production process.
With respect to financial statement presentation, Subcommittee I
preliminarily believes the grouping of individual line items (and
related measurement attributes) by operating, investing and financing
activities would alleviate some of the concerns about fair value in
particular. It would also reduce confusion caused by the commingling of
all measurement attributes. Subcommittee I preliminarily believes this
presentation would be more understandable to investors, particularly
because it would delineate the nature of changes in income (e.g., fair
value volatility, changes in estimate) and allow users to assess the
degree to which management controls each one.
It may also facilitate earnings analyses by business activities
that correspond to the natural elements of most profit-driven entities,
for instance, operating income compared to investing or financing
results. Under this approach, companies should present earnings per-
share computations of the net activity in each section. Further, the
addition of a new primary financial statement--the reconciliation of
the statements of comprehensive income and cash flows--would
disaggregate changes in assets and liabilities based on cash, accruals,
and changes in fair value, among others. A visual example of this
statement might include the following: \20\
---------------------------------------------------------------------------
\20\ Subcommittee I has adapted and modified this table from a
similar schedule in the FASB's financial statement presentation
project.
Reconciliation of the Statements of Income and Cash Flows
--------------------------------------------------------------------------------------------------------------------------------------------------------
Non-cash items affecting income
----------------------------------------------------
Cash flow Cash flows Accruals Income
statement not and Recurring Other statement
affecting systematic valuation valuation (A+B+C+D+E)
income allocations changes changes
--------------------------------------------------------------------------------------------------------------------------------------------------------
A B C D E F
--------------------------------------------------------------------------------------------------------------------------------------------------------
Operating:
Cash received from sales...............
2,700,000 ........... 75,000 ........... ........... 2,775,000 Sales.
0 ........... (9,000) ........... ........... (9,000) Depreciation expense.
0 ........... ........... ........... (15,000) (15,000) Impairment expense.
0 ........... ........... (7,500) ........... (7,500) Forward contract adj.
Investing:
Capital expenditures................... (500,000) 500,000 ........... ........... ........... 0 .............................
Sale of available for sale securities.. 5,000 (4,900) ........... 350 ........... 450 Realized gain on sale.
Financing:
Interest paid.......................... (125,000) ........... (100,000) ........... ........... (225,000) Interest expense.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Subcommittee I preliminarily believes that the correlation of rows
and columns in this schedule will help users assess different elements
of financial performance, e.g., sales is comprised primarily of cash
receipts, but also end of period accruals. Recognizing companies will
use different titles for income statement line items, Subcommittee I
preliminarily believes the predominant value of this schedule is the
columnar depiction of measurement attributes and the context it
provides for earnings analysis. For example, users should be better
equipped to form opinions about a company's earnings quality and the
predictability of its future cash flows because they are generally
unable to prepare similar reconciliations based on today's financial
statements. While this revised presentation does not resolve all of the
challenges posed by the mixed attribute model, it represents an
improvement over the current approach for investors to understand a
company's financial condition and operating results.
From an international perspective Subcommittee I notes the mixed
attribute model also exists under IFRS. As such, Subcommittee I
preliminarily believes that this preliminary hypothesis applies equally
to IFRS, particularly as the IASB works with the
[[Page 29815]]
FASB on the joint financial statement presentation project.
V. Disclosure Framework
Disclosure provides important context for the estimates and
judgments reflected in the financial statements. It also highlights
uncertainties outside of the statements that could impact financial
performance in the future.
Subcommittee I preliminarily believes that any recommendations
regarding new disclosure guidance will be most effective and
informative for investors if the FASB and SEC update, or as necessary,
rescind outdated or duplicative disclosure requirements. Subcommittee
I's preliminary hypothesis advocates establishing a process to achieve
this goal.
Preliminary Hypothesis 5: The SEC should request the FASB to
develop a disclosure framework to:
Require disclosure of the principal assumptions, estimates
and sensitivity analyses that may impact a company's business, as well
as a qualitative discussion of the key risks and uncertainties that
could significantly change these amounts over time. This would
encompass transactions recognized and measured in the financial
statements, as well as events and uncertainties that are not recorded,
such as certain litigation and regulatory developments.
Integrate existing disclosure requirements into a cohesive
whole by eliminating redundant disclosures and providing a single
source of disclosure guidance across all accounting standards.
The SEC and FASB should also establish a process of coordination
for the Commission to regularly update and, as appropriate, remove
portions of its disclosure requirements as new FASB standards are
issued.\21\
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\21\ The Committee considers coordination between the SEC and
the FASB in chapter 2 of the Progress Report, particularly
conceptual approaches 2.A and 2.C.
---------------------------------------------------------------------------
Background
Historically, disclosure standards have developed in a piecemeal
manner (i.e., standard-by-standard). The lack of an underlying
framework has contributed to (1) Repetitive disclosures, (2)
excessively detailed disclosures that may confuse rather than inform,
and (3) disorganized presentations in financial reports. These factors
make fulsome and meaningful communication of all material information
challenging.
As noted above, disclosure provides important context for the
estimates and judgments reflected in the financial statements. However,
Subcommittee I acknowledges the perception that amounts recognized in
financial statements are generally subject to more refined calculations
by preparers and higher degrees of scrutiny by users compared to mere
disclosure. As a result, the effectiveness of disclosure standards--
whether existing or new--will be governed by the degree to which
constituents view them as another compliance exercise rather than an
avenue for meaningful dialogue.
Subcommittee I preliminarily believes that a disclosure framework
would facilitate this meaningful dialogue between preparers and users.
In order for such a disclosure framework to be useful over the long-
run, however, it should establish objectives, whose application will
vary. Otherwise, disclosure standards will degenerate into myriad rules
because it is not feasible for standards-setters to envision all of the
specific future disclosure requirements that would be necessary in
different settings.
For example, in the wake of the recent ``liquidity crisis,'' there
has been significant focus on disclosures related to off-balance-sheet
entities. Of particular interest is disclosure of structured investment
vehicles (SIVs).\22\ Recently, certain sponsoring banks have provided
liquidity support to SIVs that were unable to sustain financing in the
short-term commercial paper market. In some cases, this led the
sponsors to consolidate the SIVs under FASB Interpretation No. 46(R),
which added billions of dollars of assets and liabilities to the
sponsors' balance sheets. Consequently, some constituents have
criticized existing disclosure practices and called for standards-
setters to require additional ``early warning'' disclosure about off-
balance sheet activity (e.g., types of assets held by the SIVs,
circumstances that may result in consolidation or loss, and
methodologies used to determine fair value and related write-downs).
Others counter that: (1) Major SIV sponsors already disclosed the
magnitude of their investments in off-balance sheet entities prior to
the liquidity crisis and (2) further detail would have been
uninformative and potentially confusing to users because it would have
amounted to ``disclosure overload.'' For instance, at the time the
decision not to consolidate was reached, some sponsors may have
concluded it was quite unlikely that events which might lead to
consolidation would actually occur, and that discussion of these
scenarios was unnecessary. These two opposing points of view highlight
the tension noted above, namely, that some constituents prefer
detailed, prescriptive disclosure guidance, while others favor a more
principled approach.
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\22\ From a review of SEC filed documents, Subcommittee I has
identified seven SEC filers that sponsored SIVs around the time of
the liquidity crisis. Prior to the crisis, most of these filers did
not provide quantified disclosure of the unconsolidated SIVs' assets
and liabilities (in some cases, SIV assets and liabilities were
aggregated with the assets and liabilities of other off-balance
sheet arrangements--collectively, ``VIEs''). Subsequent to the
crisis, Subcommittee I notes that some sponsors have expanded their
disclosures to include additional quantitative information, as well
as qualitative disclosures such as the nature of SIV assets,
descriptions of SIV investment and operating strategies, risks
related to the current environment, and sponsors' obligations to the
SIVs.
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Discussion
Specifically, Subcommittee I preliminarily believes that at a
minimum, an effective disclosure framework is comprised of three basic
elements: (1) A description of the transactions reflected in financial
statement captions, (2) a discussion of the relevant accounting
provisions, and (3) an analysis of the key supporting judgments, risks
and uncertainties.\23\ In the following commentary, we focus largely on
the third element.
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\23\ Subcommittee I acknowledges the work of the FASB's
Investors Technical Advisory Committee on the topic of a disclosure
framework. Subcommittee I preliminarily agrees with the need to
establish a principles-based approach to future disclosure standards
and has adapted certain elements of ITAC's thinking in this
discussion.
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Within the financial statements, a disclosure framework should more
effectively signal to investors the level of imprecision associated
with significant estimates and assumptions, particularly some fair
value measurements. This can be achieved by disclosing the principal
assumptions, estimates and sensitivity analyses that impact a company's
business, as well as a qualitative discussion of the key risks and
uncertainties that could significantly change these amounts over time.
For example, Subcommittee I notes that in certain cases, there is no
``right'' number in a probability distribution of figures, some of
which may be more fairly representative of fair value than others.
While SFAS No. 157, Fair Value Measurements, established disclosure
requirements that provide insight into Level 2 and 3 fair value
estimates,\24\ it may not be sufficient in all cases. Many investors
might find information about the key assumptions in a valuation model,
key risks
[[Page 29816]]
associated with those assumptions,\25\ and related sensitivity analyses
helpful, as well as an understanding of how ``fat'' or ``thin'' the
tails of statistical modeling techniques are.\26\
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\24\ Statement 157 established a three level fair value
hierarchy. It assigns highest priority to quoted prices in active
markets (Level 1) and the lowest priority to unobservable inputs
that rely heavily on assumptions (Level 3).
\25\ For example, if a valuation model relies on historical
assumptions for a period of time that does not include economic
downturns, that fact and its implications may need to be disclosed.
\26\ In statistics, this notion is known as the ``goodness of
fit,'' which describes how well a statistical model fits a set of
observations. These are quantified measures that summarize the
discrepancy between observed values compared to values predicted by
the model. Large discrepancies can be described as ``fat,'' while
small discrepancies are ``thin.''
---------------------------------------------------------------------------
Outside of the financial statements, disclosure of environmental
factors may be more meaningful than attempting to ``force'' a wide
range of probabilities into a single point estimate on the balance
sheet or income statement. This would encompass events and
uncertainties such as relevant market conditions, off-balance sheet
activity, litigation and regulatory developments. Some constituents
argue that recording an estimate to reflect these events, instead of
disclosing them, may actually provide a misleading sense of precision.
Alternatively, they suggest companies could communicate to investors
more effectively by disclosing the factors that might trigger financial
statement recognition, the magnitude of possible and/or probable
transactions, and management's plans in those scenarios.
In any event, Subcommittee I acknowledges some disclosure guidance
establishes a ``floor'' for communication between companies and
investors, rather than a ``ceiling.'' \27\ Our preliminary hypothesis
offers a more cohesive structure for the narrative that supports and
explains the financial statements, but Subcommittee I believes
preparers should take the initiative in tailoring financial reports for
users.
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\27\ Subcommittee I notes companies are not precluded from
providing disclosure of the type proposed here. Indeed, certain
existing guidance is largely consistent with our views, such as APB
Opinion No. 22, Disclosure of Accounting Policies, SOP No. 94-6,
Disclosure of Certain Significant Risks and Uncertainties, Item
303(a) of Regulation S-K related to Management's Discussion and
Analysis, and FRR 60, Cautionary Advice Regarding Disclosure About
Critical Accounting Policies.
---------------------------------------------------------------------------
Subcommittee I also recognizes the proposed disclosure framework
incorporates factual information that, historically, is presented in
audited footnotes, as well as analytical and forward-looking
discussions that are typically part of MD&A narratives in SEC filings.
Subcommittee I acknowledges that there are important considerations
regarding assurance and legal issues when determining the placement of
disclosures in a filing (e.g., footnotes or MD&A). Therefore, an
optimally designed disclosure framework should be developed by the FASB
under close coordination with the SEC so that the Commission can amend
its guidance accordingly (e.g., Regulations S-K and S-X).
Beyond these concerns, the SEC or its staff should also update, and
as needed remove, portions of public company disclosure guidance that
are impacted by new FASB standards. Subcommittee I is aware of studies
in the past conducted to identify overlaps of this type.\28\ Unless the
SEC or its staff establishes a monitoring process to update its
disclosure requirements, similar studies may be necessary in the
future. Additionally, if developed proposal 1.1 to minimize industry-
specific accounting guidance is adopted, the SEC or its staff may need
to consider revising its Industry Guides in Items 801 and 802 of
Regulation S-K.
---------------------------------------------------------------------------
\28\ In particular, the 2001 FASB report on ``GAAP-SEC
Disclosure Requirements,'' which was a part of a larger Business
Reporting Research Project.
---------------------------------------------------------------------------
From an international perspective, Subcommittee I notes that IAS 1,
Presentation of Financial Statements, includes some of the elements
that Subcommittee I would expect of a disclosure framework, such as a
principle for: (1) What the notes to the financial statements should
disclose, (2) footnote structure. (3) disclosures of judgments, and (4)
disclosures of key sources of estimation or uncertainty, including
sensitivity analyses. Nonetheless, Subcommittee I preliminarily
believes that its preliminary hypothesis in this area would also result
in improvements to IFRS.
Appendix A
1. Scope Exceptions
Examples of scope exceptions include:
SFAS No. 109, Accounting for Income Taxes, scopes out
recognition of deferred taxes for undistributed earnings of certain
subsidiaries and for goodwill for which amortization is not deductible,
among others.
SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, scopes out certain financial guarantee contracts,
employee share-based payments, and contingent consideration from a
business combination, among others.
SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, scopes out goodwill, intangible assets not being
amortized that are to be held and used, financial instruments,
including cost and equity method investments, and deferred tax assets,
among others.
SFAS No. 157, Fair Value Measurements, scopes out its
definition of fair value for guidance related to employee share-based
payments and lease classification and measurement, among others. In
addition, they delay in the adoption of SFAS No. 157 for nonfinancial
assets and nonfinancial liabilities, except for items that are
recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually), effectively scoping out these
items for a period of time.
FIN 45, Guarantor's Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness to
Others, scopes out contracts that have the characteristics of
guarantees, but (1) are accounted for as contingent rent under SFAS No.
13 and (2) provide for payments that constitute vendor rebates (by the
guarantor) based on either the sales revenues of, or the number of
units sold by, the guaranteed party, among others.
FIN 46R, Consolidation of Variable Interest Entities,
scopes out employee benefit plans, qualifying special-purpose entities,
certain entities for which the company is unable to obtain the
information necessary to apply FIN 46R, and certain businesses, among
others.
SoP 81-1, Accounting for Performance of Construction/
Production Contracts, scopes out certain sales of manufactured goods,
even if produced to buyers' specifications, and service contracts of
consumer-oriented organizations that provide their services to their
clients over an extended period, among others.
2. Competing Models
Examples of competing models include:
Different models for when to recognize for impairment of
assets such as inventory, goodwill, long-lived assets, financial
instruments, and deferred taxes.
Different likelihood thresholds for recognizing contingent
liabilities, such as probable for legal uncertainties versus more-
likely-than-not for tax uncertainties.
Different models for revenue recognition such as
percentage of completion, completed contract, and pro-rata. Models also
vary based on the nature of the industry involved, as discussed in
other sections.
Derecognition of most liabilities such as on the basis of
legal extinguishment, as compared to the
[[Page 29817]]
derecognition of pension and other post-retirement benefit obligations
via settlement, curtailment, or negative plan amendment.
Different models for determining whether an arrangement is
a liability or equity.
Exhibit B
SEC Advisory Committee on Improvements to Financial Reporting
Standards-Setting Subcommittee Update
May 2, 2008 Full Committee Meeting
I. Introduction
The SEC's Advisory Committee on Improvements to Financial Reporting
(the Committee) issued a Progress Report (the Progress Report) on
February 14, 2008. In chapter 2 of the Progress Report, the Committee
discussed its work to date on the standards-setting process, namely
its:
Developed proposals related to increased investor
participation, FAF and FASB governance, standards-setting process
improvements and interpretive implementation guidance;
Conceptual approaches regarding clarifying the SEC's role
in standards-setting, design of standards and the FASB's priorities;
and
Future considerations related to international governance.
Since the issuance of the Progress Report, the standards-setting
subcommittee (Subcommittee II) has deliberated each of these areas
further, particularly its conceptual approaches and future
considerations and is in the process of refining them accordingly. This
report presents a summary of Subcommittee II's latest thinking and
serves as an update to the Committee. The Committee is also hosting
panel discussions on May 2, 2008, in Rosemont, IL. Subcommittee II will
re-deliberate each of these topics based on testimony received,
guidance to be provided by the Committee and comment letters received
thus far by the Committee. The Committee will deliberate any new
proposals and proposed revisions to existing developed proposals in
July 2008.
II. Current Status and Further Work
International Considerations
The Committee deferred deliberation of international considerations
until 2008. Subcommittee II acknowledges that the SEC has already
received significant input associated with its (1) removal of the U.S.
GAAP reconciliation for foreign private issuers reporting under IFRS as
promulgated by the IASB and (2) concept release on the possibility of
allowing domestic issuers to report under IFRS as promulgated by the
IASB. Subcommittee II also observes that debates regarding both the end
state of international convergence (that is, a single set of high
quality global accounting standards) and the best way to accomplish
that objective in the U.S. (that is, the transition) are underway among
standards-setters, their governance bodies, the international
regulatory community and others. After discussion with the SEC staff
and in light of these ongoing deliberations, which include SEC staff
consideration of comments received in response to the concept release,
input from roundtables, and the staff's work on developing a roadmap
for consideration by the Commission at the request of Chairman Cox,
Subcommittee II does not intend to advance detailed proposals at this
time.
Although an analysis of how the international standards-setting
processes could be improved was not in the Committee's mandate,
Subcommittee II believes that many of the Committee's developed
proposals and conceptual approaches may be equally applicable in
international standards-setting. Subcommittee II also noted that an
important U.S. convergence question has not been openly debated in the
public forum--how the SEC will fulfill its regulatory responsibility
without creating a U.S. jurisdictional variant of IFRS.
Although not intending to recommend detailed proposals,
Subcommittee II is deliberating whether the Committee should consider:
Expressing high-level support for moving to a single set
of high quality accounting standards in the U.S.,
supporting the SEC's efforts to develop an international
convergence roadmap, and
encouraging all participants in the financial reporting
community to increase coordination to foster consistency in global
interpretations and avoid jurisdictional variants of IFRS.
The final determination of whether Subcommittee II's deliberations
will result in a developed proposal will not be known until later in
2008.
FASB Dialogue
Since the Committee issued its Progress Report, Subcommittee II has
engaged representatives of the FASB in a dialogue regarding the
Committee's developed proposals and conceptual approaches. As a result
of this dialogue, as well as the public comments received on the
Progress Report, Subcommittee II is currently deliberating potential
modifications to the Committee's proposal for Committee deliberation as
its final recommendations.
A number of tentative modifications are being contemplated, which
are summarized as follows:
International--The Committee's proposals assume that U.S.
GAAP will continue to be in use for a number of years. However,
convergence matters significantly drive priorities in standards-
setting. Subcommittee II plans to propose clarifying the Committee's
proposals that will be impacted by the ultimate path chosen by the SEC
regarding international convergence.
Governance--Subcommittee II plans to propose updating the
Committee's proposals for recent changes made by the FAF, including
emphasizing which proposals have yet to be fully addressed.
Specifically, Subcommittee II is deliberating whether the FAF
resolutions regarding increased investor representation on the FAF and
FASB will meet the objective underlying the Committee's developed
proposal. Subcommittee II would also like to emphasize the importance
of the FAF establishing clear performance metrics related to the
efficiency and effectiveness of standards-setting and may propose
withdrawing the statement that academic representation should not be
mandated on the FASB.
Investors--Subcommittee II plans to propose integrating
the discussion of investor pre-reviews into developed proposal 2.1 and
propose clarifying that although investor involvement in standards-
setting has been improved recently, more formalized, structured
involvement utilizing existing advisory groups would be warranted,
particularly before a document is issued for exposure. In addition,
Subcommittee II plans to propose clarifying the Committee's view about
the ``significance'' of investor involvement to further promote
balanced standards-setting.
Agenda--Subcommittee II plans to propose clarifying that
the proposed Agenda Advisory Group was intended to be comprised of key
decision makers from the SEC, FASB, PCAOB and other constituent groups
that would meet on a real-time basis to address immediate needs in the
financial reporting system at large. Such a Financial Reporting Working
Group would not solely advise the FASB on its agenda. Involvement of
other constituents could be effectuated by leveraging members or
executive committees from existing FASB advisory groups. This may
require the FAF and FASB to reevaluate the composition and
responsibilities of other FASB advisory groups and agenda
[[Page 29818]]
committees, as well as what input is requested of them and when, to
improve the efficiency and effectiveness of standards-setting.
Field Work--Subcommittee II plans to propose clarifying
that the intent of the proposals on cost-benefit analyses and field
work were that these processes would benefit from additional
consistency across major projects and transparency of the process
followed and conclusions reached.
Periodic Reviews--Subcommittee II plans to propose
clarifying that the Committee's proposals regarding periodic reviews of
new and existing standards were intended to formalize existing
standards-setting processes for major projects. Subcommittee II may
also propose dispensing with a bright line time requirement, due to the
inconsistency of this approach with other Committee proposals and the
need for the standards-setter and its advisory groups to evaluate the
facts and circumstances surrounding each major project.
Clarifying SEC Role in Interpreting GAAP
Subcommittee II understands that the SEC staff is already in the
process of instituting internal processes that may address many, if not
all, of the points in the Committee's conceptual approach 2.A regarding
SEC interpretations of GAAP. Subcommittee II is in the process of
formulating a developed proposal that considers such improvements,
which will be presented to the Committee for consideration in July
2008.
Standards-Setting Priorities
Conceptual approach 3.C recommends revisiting standards-setting
priorities. However, Subcommittee II acknowledges that convergence
matters significantly drive priorities in standards-setting and that
the convergence paths being considered by the SEC will directly impact
certain of the Committee's proposals and U.S. standards-setting
priorities. As such, conceptual approach 2.C may not lead to a proposal
being presented to the Committee, as this reprioritization is likely
already being considered by those involved in the international
convergence dialogue and could be addressed with assistance from the
proposed Financial Reporting Working Group. However, Subcommittee II is
deliberating the feasibility of a phase II codification project,
subject to its path-dependency on international convergence matters,
within the Committee's discussion of the FASB's current codification
project and proposed periodic reviews of existing standards. The
Committee will deliberate this topic in July 2008.
Design of Standards
Subcommittee II has drafted a preliminary hypothesis related to the
design of accounting standards based on conceptual approach 2.B from
the Progress Report for the Committee's consideration, as follows:
Preliminary Hypothesis: The SEC should encourage the FASB to
continue to improve the way accounting standards are written by using
clearly-stated objectives, outcomes and principles that faithfully
represent the economics of transactions and are responsive to
investors' needs for clarity, transparency and comparability.
Design of Standards: As noted in the Progress Report, some
participants in the U.S. financial reporting community believe that
certain accounting standards do not clearly articulate the objectives,
outcomes and principles upon which they are based, because they are
sometimes obscured by dense language, detailed rules, examples and
illustrative guidance. This can create uncertainty in the application
of GAAP. Further, the proliferation of detailed rules fosters
accounting-motivated structured transactions, as rules cannot cover all
outcomes. As discussed in chapter 1 of the Progress Report, standards
that have scope exceptions, safe harbors, cliffs, thresholds and bright
lines are vulnerable to manipulation by those seeking to avoid
accounting for the substance of transactions using structured
transactions that are designed to achieve a particular accounting
result. This ultimately hurts investors, because it reduces
comparability and the usefulness of the resulting financial
information. Therefore, a move toward the use of more objectives,
outcomes and principles in accounting standards may ultimately improve
the quality of the financial reporting upon which investors rely.
The Committee recognized in the Progress Report that the question
of how to design accounting standards going forward is a critical
aspect of the standards-setting process and is at the center of a
decade-long principles-based versus rules-based accounting standards
debate. There has been much discussion in the marketplace on this topic
and there are differing views. The SEC has been a frequent participant
in the debate and has long been supportive of objectives-oriented
standards.\29\ Rather than engage in such a spurious debate, the
Committee preferred in the Progress Report to think of the design of
accounting standards in terms of the characteristics they should
possess. There are many publications on this topic written by well-
known theorists from the FASB, the IASB, the SEC, accounting firms,
academia and elsewhere. The most recent example is an omnibus of this
collective thinking published by the CEOs of the World's Six Largest
Audit Networks.\30\ Their paper attempts to outline what optimal
accounting standards should look like in the future and proposes a
framework the standards-setter should refer to over time to ensure that
these characteristics are consistently optimized.
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\29\ For example, the SEC issued Policy Statement: Reaffirming
the Status of the FASB as a Designated Private-Sector Standard
Setter (April 2003), which included numerous recommendations for the
FAF and FASB to consider, including greater use of principles-based
accounting standards whenever reasonable to do so. The SEC staff
also issued Study Pursuant to Section 108(d) of the Sarbanes-Oxley
Act of 2002 on the Adoption by the United States Financial Reporting
System of a Principles-Based Accounting System (July 2003), which
further lauded the benefits of objectives-oriented standards.
\30\ CEOs of the World's Six Largest Audit Networks, A Proposed
Framework for Establishing Principles-Based Accounting Standards,
Global Public Policy Symposium (January 2008).
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The FASB has made recent improvements in how it writes accounting
standards as part of its Understandability initiative and Codification
project. We support the increased use of clearly-stated objectives,
outcomes and principles in accounting standards that bring together
this thinking. We believe the highest goal for accounting standards in
the future is that they faithfully represent the economics of
transactions and are responsive to investors' needs for clarity,
transparency and comparability. Accounting standards that meet these
criteria, when applied in good faith in a standards-setting system that
employs the Committee's other proposals, will foster enhanced
comparability and help to restore trust and confidence in financial
reporting.
Although Subcommittee II supports increased use of objectives,
outcomes and principles, the goal would not be to remove all rules.
Rather, we agree with the notion that ideal accounting standards lay
somewhere on the spectrum between principles-based and rules-based and
that a framework may be helpful to consistently determine where on that
spectrum new accounting standards should be written over time. This
would assist the standards-setter in determining rules that might be
necessary in certain circumstances. For example, if the standards-
setter believes that there is only one way to reflect the
[[Page 29819]]
economics of a transaction while promoting clarity, transparency and
comparability for investors, it would be reasonable to provide
prescriptive guidance in addition to objectives or principles.
Exhibit C
SEC Advisory Committee on Improvements to Financial Reporting
Audit Process and Compliance Subcommittee Update
May 2, 2008 Full Committee Meeting
I. Introduction
The SEC's Advisory Committee on Improvements to Financial Reporting
(Committee) issued a progress report (Progress Report) on February 14,
2008.\31\ In chapter 3 of the Progress Report, the Committee discussed
its work-to-date in the area of audit process and compliance, namely,
its developed proposals related to providing guidance with respect to
the materiality and correction of errors; and judgments related to
accounting matters.
Since the issuance of the Progress Report, the audit process and
compliance subcommittee (Subcommittee III) has received a considerable
amount of public comment regarding the developed proposals included in
the Progress Report. This public input includes feedback obtained
during the panel discussions regarding the developed proposals in
Chapter 3 of the Progress Report held during the Committee's March 13
open meeting, feedback obtained when certain members of the
subcommittee met with the PCAOB Standing Advisory Group (SAG) on
February 27, 2008, feedback obtained when the subcommittee met with
market participants at our subcommittee meetings and the numerous
comment letters received by the Committee. Based on this considerable
public feedback, Subcommittee III believes that there are several areas
related to the Committee's original developed proposals that warrant
clarification by the Committee as well as some additional items that
need to be considered by the Committee. This report represents
Subcommittee III's latest thinking related to the developed proposals
in Chapter 3 of the Progress Report and reflects the subcommittee's
proposed clarifications for the Committee's consideration related to
the original developed proposals. Subject to further public comment and
Committee input, Subcommittee III will recommend these revised
developed proposals to the Committee for its consideration in
developing the final report, which is expected to be issued in July
2008.
II. Financial Restatements
In the Progress Report, the Committee issued three developed
proposals (developed proposals 3.1, 3.2 and 3.3) related to financial
restatements. These developed proposals have been the subject of public
debate and the subject of many comment letters received by the
Committee. Subcommittee III believes that one cause of the debate
surrounding these developed proposals relates to a lack of clarity
regarding the developed proposals.
First, the developed proposals were not intended to recommend
elimination of the guidance currently contained in SAB Topic 1M.
Instead, the developed proposals were intended to enhance the guidance
in SAB Topic 1M. As stated in the summary of SAB 99, which was codified
in SAB Topic 1M, ``This staff accounting bulletin expresses the views
of the staff that exclusive reliance on certain quantitative benchmarks
to assess materiality in preparing financial statements and performing
audits of those financial statements is inappropriate; misstatements
are not immaterial simply because they fall beneath a numerical
threshold.'' Subcommittee III believes that the guidance in SAB Topic
1M is appropriate and accomplishes what it was intended to do, which is
to address situations where errors were not being evaluated for
materiality simply due to the relatively small size of the error. As
the SEC staff noted in SAB 99, this concept was not consistent with the
total mix standard established by the Supreme Court. SAB Topic 1M was
not written to address all situations one must consider when
determining if an error is material, yet in practice, SAB Topic 1M is
often cited as the guidance to use in all materiality decisions.
Because SAB Topic 1M primarily addresses one issue, which was to
correct the misperception in practice at the time that small errors
need not be evaluated for materiality solely based on their size,
Subcommittee III believes that this has resulted in less consideration
to the total mix of information in the evaluation of whether an error
is material or not. Since this is not consistent with the standard
established by the Supreme Court or as we understand it the intent of
SAB Topic 1M, Subcommittee III believes that additional guidance is
needed to supplement the guidance contained in SAB Topic 1M.
Second, there have been some additional studies of restatements
that have been published since the issuance of the Progress Report. The
most significant study is the study commissioned by the U.S. Treasury
entitled ``The Changing Nature and Consequences of Public Company
Financial Restatements 1997-2006'', conducted by Professor Susan Scholz
of the University of Kansas. Subcommittee III believes that the results
of this study are not inconsistent with the developed proposals in the
Committee's Progress Report.
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\31\ Refer to Progress Report at http://www.sec.gov/rules/other/2008/33-8896.pdf.
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Third, Subcommittee III believes clarifications are needed related
to the use of the term ``current'' investor in the Progress Report.
Some have concluded that this term only refers to investors who
currently own securities of a company. Subcommittee III did not intend
the Committee's developed proposal to convey such a narrow definition
of current investor, so there are proposed edits to the developed
proposal to reflect that the correction of an error should be based on
the needs of all investors making current investment decisions.
Fourth, there were several public comments related to the use of
the term ``sliding scale'' in the developed proposals in the Progress
Report. Many of these comments were concerned that this term was
confusing and did not help explain the principles in the developed
proposal. Subcommittee III does not believe that the use of this term
is critical to the principles articulated in the developed proposals in
the Progress Report. Therefore Subcommittee III proposes to remove the
use of this term in the developed proposals.
Finally, because Subcommittee III believes that issues related to
the dark period, most notably the potential high cost to investors
during the dark period, are very important, a new developed proposal is
being recommended by the subcommittee to highlight the importance of
this issue. This new developed proposal contains substantially the same
wording that was included in the Progress Report, but has been moved to
give more prominence to this important issue.
III. Judgment
Similar to the reaction to the Committee's developed proposals
related to restatements in the Progress Report (Developed Proposals
3.1, 3.2 and 3.3), there has been much public comment related to the
Committee's developed proposal 3.4 in the Progress Report related to
professional judgment. Subcommittee III believes that the comments it
has received during this
[[Page 29820]]
process have been very helpful to its continuing deliberations on this
matter. Based on the comments received, Subcommittee III believes that
some changes are necessary to the developed proposal 3.4 in the
Progress Report to allow the developed proposal to meet the goals
established in that Progress Report without the risks that the
subcommittee has been concerned about from the beginning, such as the
risk that the developed proposal devolve into a checklist-based
approach to making judgments and the risk that the proposed framework
could be used as a shield to protect unreasonable judgments.
The primary change that Subcommittee III believes should be made is
to refocus the developed proposal away from a recommendation for a
framework. While Subcommittee III believes that there is great merit in
the idea of a framework, the term ``framework'' can imply a mechanistic
process. Making and evaluating judgments can involve a process, but the
notion of a process is dangerous because it implies that an outcome can
be achieved. Indeed, no matter how robust a process one uses to make
judgments, there can be no guarantee that the outcome will be
reasonable. Instead, Subcommittee III believes that a preferable way to
accomplish the goals set forth in the Progress Report would be to have
the SEC formally articulate in a statement of policy how the SEC
evaluates judgments, including the factors that it uses as part of its
evaluation. Therefore, Subcommittee III believes the developed proposal
should be changed to formally propose such a statement of policy to be
issued.
Some commenters have stated that developed proposal 3.4 in the
Progress Report advocates a safe harbor be established for the exercise
of professional judgment. Subcommittee III did not intend to advocate
any particular way for the implementation of developed proposal 3.4.
Instead, this decision was left to the SEC. With the change in focus
outlined above, Subcommittee III believes that a statement of policy
would be the preferred way to implement the revised proposal and
therefore, there should be no reference to a safe harbor in the revised
Chapter 3.
Subcommittee III also proposes to remove the use of the term
professional when referring to judgment. Subcommittee III believes that
there could be a misunderstanding that the term ``professional''
implies that one must have a professional certification in order to
make or evaluate a professional judgment. While Subcommittee III
believes that such professional certifications are important, it did
not intend to suggest such a requirement for the application or
evaluation of accounting judgments.
Appendix A
Subcommittee III has included as Appendix A to this update a
revised version of Chapter 3 from the Progress Report that reflects the
proposed edits for the Committee's consideration.
Chapter 3: Audit Process and Compliance
I. Introduction
We have concentrated our efforts to date regarding audit process
and compliance on the subjects of financial restatements, including the
potential benefits from providing guidance with respect to the
materiality\32\ and correction of errors; and judgments related to
accounting matters: Specifically, whether guidance on the evaluation of
judgments would enhance the quality of judgments and the willingness of
others to respect judgments made.
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\32\ A fact is material if there is a substantial likelihood
that a reasonable investor in making an investment decision would
consider it as having significantly altered the total mix of
information available. Basic, Inc. v. Levinson, 485 U.S. 224, 231-32
(1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449
(1976).
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II. Financial Restatements
II.A. Background
Likely Causes of Restatements
The number of financial restatements\33\ in the U.S. financial
markets has been increasing significantly over recent years, reaching
approximately 1,600 companies in 2006.\34\ Restatements generally occur
because errors that are determined to be material are found in a
financial statement previously provided to the public. Therefore, the
increase in restatements appears to be due to an increase in the
identification of errors that were determined to be material.
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\33\ For the purposes of this chapter, a restatement is the
process of revising previously issued financial statements to
reflect the correction of a material error in those financial
statements. An amendment is the process of filing a document with
revised financial statements with the SEC to replace a previously
filed document. A restatement could occur without an amendment, such
as when prior periods are revised in a current filing with the SEC.
\34\ U.S. Government Accountability Office (GAO) study,
Financial Restatements: Update of Public Company Trends, Market
Impacts, and Regulatory Enforcement Updates (March 2007), and Audit
Analytics study, 2006 Financial Restatements A Six Year Comparison
(February 2007).
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The increase in restatements has been attributed to various causes.
These include more rigorous interpretations of accounting and reporting
standards by preparers, outside auditors, the SEC, and the PCAOB; the
considerable amount of work done by companies to prepare for and
improve internal controls in applying the provisions of section 404 of
the Sarbanes-Oxley Act; and the existence of control weaknesses that
companies failed to identify or remediate. Some have also asserted that
the increase in restatements is the result of an overly broad
application of the concept of materiality and misinterpretations of the
existing guidance regarding materiality in SAB 99, Materiality (as
codified in SAB Topic 1M). SAB Topic 1M was written to primarily
address a specific issue, when seemingly small errors could be material
due to qualitative factors, however, the guidance in SAB Topic 1M is
often utilized in all materiality decisions. As a result of this overly
broad application of SAB Topic 1M, errors may have been deemed to be
material when an investor\35\ may not consider them to be important.
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\35\ We use the term investor to include all people using
financial statements to make investment decisions.
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It is essential that companies, auditors, and regulators strive to
reduce the frequency and magnitude of errors in financial reporting.
When material errors occur, however, companies should restate their
financial statements to correct errors that are important to current
investors. Investors need accurate and comparable data, and restatement
is the only means to achieve those goals when previously filed
financial statements contain material errors. Efforts to improve
company controls and audit quality in recent years should reduce
errors, and there is evidence this is currently occurring.\36\ We
believe that public companies should focus on reducing errors in
financial statements. At the same time, we believe that some of our
developed proposals in the areas of substantive complexity, as
discussed in chapter 1, and the standards-setting process, as discussed
in chapter 2, will also be helpful in reducing some of the frequency of
errors in financial statements.
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\36\ A Glass Lewis & Co. report, The Tide is Turning (January
15, 2008), shows that restatements in companies subject to section
404 of the Sarbanes-Oxley Act have declined for two consecutive
years.
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While reducing errors is the primary goal, it is also important to
reduce the number of restatements that do not provide important
information to investors making current investment decisions.
Restatements can be costly for companies and auditors, may reduce
confidence in reporting, and may create
[[Page 29821]]
confusion that reduces the efficiency of investor analysis. This
portion of this chapter describes our proposals regarding: (1)
Additional guidance on the concept and application regarding
materiality, and (2) the process for and disclosure of the correction
of errors.
Our Research
We have considered several publicly-available studies \37\ on
restatements. The restatement studies we have reviewed all indicate
that the total number of restatements has increased in recent years.
The studies also indicate that there are many different types of errors
that result in the need for restatements. Market reaction to
restatements may be one indicator as to whether restatements contain
information considered by investors to be material. Based on these
studies, it appears to us that there may be restatements that investors
may not consider important. We draw this conclusion in part based upon
the lack of a statistically significant market reaction, particularly
as it relates to certain types of restatements such as
reclassifications and restatements affecting non-core expenses.\38\
While there are limitations \39\ to using market reaction as a proxy
for materiality, other trends in these studies are not inconsistent
with our conclusion--the trend toward restatements involving correction
of smaller amounts, including amounts in the cash flow statement, and
the trend toward restatements in cases where there is no evidence of
fraud or intentional wrongdoing.\40\ Also, while there is recent
evidence \41\ that the number of restatements has declined in 2007, we
note that the total number of restatements is still significant. We,
therefore, believe supplementing existing guidance on determining
whether an error is material and providing additional guidance on when
a restatement is necessary for certain types of errors, would be
beneficial in reducing the frequency of restatements that do not
provide important information to investors making current investment
decisions.
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\37\ Studies considered include the study commissioned by the
Department of the Treasury, The Changing Nature and Consequences of
Public Company Financial Restatements 1997-2006, by Professor Susan
Scholz, An Analysis of the Underlying Causes of Restatements by
Professors Marlene Plumlee and Teri Yohn, GAO study, Financial
Restatements: Update of Public Company Trends, Market Impacts, and
Regulatory Enforcement Updates (March 2007); Glass Lewis & Co.
study, The Errors of Their Ways (February 2007); and two Audit
Analytics studies, 2006 Financial Restatements A Six Year Comparison
(February 2007) and Financial Restatements and Market Reactions
(October 2007). We have also considered findings from the PCAOB's
Office of Research and Analysis's (ORA) working paper, Changes in
Market Responses to Financial Statement Restatement Announcements in
the Sarbanes-Oxley Era (October 18, 2007), understanding that ORA's
findings are still preliminary in nature as the study is still going
through a peer review process.
\38\ Professor Scholz's study defines restatements related to
non-core expenses as ``Any restatement including correction of
expense (or income) items that arise from accounting for non-
operation or non-recurring activities''. This definition includes
restatements related to debt and equity instruments, derivatives,
gain or loss recognition, inter-company investments, contingency and
commitments, fixed and intangible asset valuation or impairment and
income taxes.
\39\ Examples of the limitations in using market reaction as a
proxy for materiality include (1) The difficultly of measuring
market reaction because of the length of time between when the
market becomes aware of a potential restatement and the ultimate
resolution of the matter, (2) the impact on the market price of
factors other than the restatement, and (3) the disclosure at the
time of the restatement of other information, such as an earnings
release, that may have an offsetting positive market reaction.
\40\ These trends are addressed in Professor Scholz's study.
\41\ Glass Lewis & Co. report, The Tide is Turning (January 15,
2008) indicates that approximately 1 out of every 11 public
companies had a restatement during 2007.
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We have also considered input from equity and credit analysts and
others about investors' views on materiality and how restatements are
viewed in the marketplace. Feedback we have received included:
Bright lines are not really useful in making materiality
judgments. Both qualitative and quantitative factors should be
considered in determining if an error is material.
Companies often provide the market with little financial
data during the time between a restatement announcement and the final
resolution of the restatement. Limited information seriously undermines
the quality of investor analysis, and sometimes triggers potential loan
default conditions or potential delisting of the company's stock.
The disclosure provided in connection with restatements is
not consistently adequate to allow an investor to evaluate the
likelihood of errors in the future. Notably, disclosures often do not
provide enough information about the nature and impact of the error,
and the resulting actions the company is taking.
Interim periods should be viewed as more than just a
component of an annual financial statement for purposes of making
materiality judgments.
II.B. Developed Proposals
Based on our work to date, we believe that, in addressing a
financial statement error, it is helpful to consider two sequential
questions: (1) Was the error in the financial statement material to
those financial statements when originally filed? and (2) How should a
material error in previously issued financial statements be corrected?
We believe that framing the principles necessary to evaluate these
questions would be helpful. We also believe that in many circumstances
investors could benefit from improvements in the nature and timeliness
of disclosure in the period between identifying an error and filing
restated financial statements.
With this context, we have developed the following proposals
regarding the assessment of the materiality of errors to financial
statements and the correction of financial statements for errors.\42\
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\42\ We have developed principles that we believe will be
helpful in addressing financial statement errors. In developing
these principles, we have not determined if the principles are
inconsistent with existing GAAP, such as SFAS No. 154, Accounting
Changes and Error Corrections, or APB Opinion No. 28, Interim
Financial Reporting. To the extent that the implementation of our
proposals would require a change to GAAP, the SEC should work with
the FASB to revise GAAP.
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Developed Proposal 3.1: The FASB or the SEC, as appropriate, should
supplement existing guidance to reinforce the following concepts:
Those who evaluate the materiality of an error should make
the decision based upon the perspective of a reasonable investor.
Materiality should be judged based on how an error affects
the total mix of information available to a reasonable investor.
Just as qualitative factors may lead to a conclusion that a small
error is material, qualitative factors also may lead to a conclusion
that a large error is not material.
The FASB or the SEC, as appropriate, should also conduct both
education sessions internally and outreach efforts to financial
statement preparers and auditors to raise awareness of these issues and
to promote more consistent application of the concept of materiality.
The Supreme Court has established that ``a fact is material if
there is a substantial likelihood that a reasonable investor in making
an investment decision would consider it as having significantly
altered the total mix of information available.'' We believe that those
who judge the materiality of a financial statement error should make
the decision based upon the interests, and the viewpoint, of a
reasonable investor and based upon how that error impacts the total mix
of information available to a reasonable investor. One must ``step into
the shoes'' of a reasonable investor when making these judgments. We
believe that too many
[[Page 29822]]
materiality judgments are being made in practice without full
consideration of how a reasonable investor would evaluate the error.
When looking at how an error impacts the total mix of information, one
must consider all of the qualitative factors that would impact the
evaluation of the error. This is why bright lines or purely
quantitative methods are not appropriate in determining the materiality
of an error to annual financial statements.
We believe that the current materiality guidance in SAB Topic 1M is
appropriate in making most materiality judgments. We believe that, in
current practice, however, this materiality guidance is being
interpreted generally as being one-directional, that is, as providing
that qualitative considerations can result in a small error being
considered material, but that a large error is material without regard
to qualitative factors. This one-directional interpretation is not
consistent with the standard established by the Supreme Court, which
requires an assessment of the total mix of information available to the
investor making an investment decision. We believe that, in general,
qualitative factors not only can increase, but also can decrease, the
importance of an error to the reasonable investor, although we
acknowledge that there will probably be more times when qualitative
considerations will result in a small error being considered material
than they will result in a large error being considered not to be
material.\43\ Therefore, we recommend that the existing materiality
guidance be enhanced to clarify that the total mix of information
available to investors should be the main focus of a materiality
judgment and that qualitative factors are relevant in analyzing the
materiality of both large and small errors. We view this recommendation
as a modest clarification of the existing guidance to conform practice
to the standard established by the Supreme Court and not a wholesale
revision to the concepts and principles embedded in existing SEC staff
guidance in SAB Topic 1M.
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\43\ Some have argued that, under such guidance, a very large
error that affects meaningful financial statement metrics could be
deemed immaterial by virtue of qualitative factors. The Committee
believes that when one focuses on the total mix of information, the
probability of this situation occurring is remote.
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The following are examples of some of the qualitative factors that
could result in a conclusion that a large error is not material. (Note
that this is not an exhaustive list of factors, nor should this list be
considered a ``checklist'' whereby the presence of any one of these
items would make an error not material. Companies and their auditors
should continue to look at the totality of all factors when making a
materiality judgment):
The error impacts metrics that do not drive investor
conclusions or are not important to investor models.
The error is a one-time item and does not alter investors'
perceptions of key trends affecting the company.
The error does not impact a business segment or other
portion of the registrant's business that investors regard as driving
valuation or risks.
Finally, we recommend that the enhanced guidance suggest some
factors that are relevant to the analysis of errors in the cash flow
statement and the balance sheet. We note that the existing guidance
suggests factors that are relevant primarily to the analysis of the
materiality of an error in the income statement.
Internal education and external outreach efforts can be
instrumental in increasing the awareness of these concepts and ensuring
more consistent application of materiality. Many of the issues with
materiality in practice are caused by misunderstandings by preparers,
auditors and regulators. Elimination of these misunderstandings would
be a significant step toward reducing restatements that do not provide
useful information to investors.
Developed Proposal 3.2: The FASB or the SEC, as appropriate, should
issue guidance on how to correct an error consistent with the
principles outlined below:
All errors, other than clearly insignificant errors,
should be promptly corrected no later than in the financial statements
of the period in which the error is discovered. All material errors
should be disclosed when they are corrected.
Prior period financial statements should only be restated
for errors that are material to those prior periods.
The determination of how to correct a material error
should be based on the needs of current investors. For example, a
material error that has no relevance to a current investment decision
would not require amendment of the annual financial statements in which
the error occurred, but would need to be promptly corrected and
disclosed in the current period.
There may be no need for the filing of amendments to
previously filed annual or interim reports to reflect restated
financial statement, if the next annual or interim period report is
being filed in the near future and that report will contain all of the
relevant information.
Restatements of interim periods do not necessarily need to
result in a restatement of an annual period.
Corrections of large errors should always be disclosed,
even if the error was determined not to be material.
We believe that all errors, excluding clearly insignificant errors,
should be corrected no later than in the financial statements of the
annual or interim period in which the error is discovered. The
correction of errors, even errors that are not material, should not be
deferred to future periods. Rather, companies should be required to
correct all errors promptly and make appropriate disclosures about the
correction, particularly when the errors are material, and should not
have the option to defer recognition of errors until future financial
statements. Notwithstanding the foregoing, immaterial errors discovered
shortly before the issuance of the financial statements may not need to
be corrected until the next annual or interim period being reported
upon when earlier correction is impracticable.\44\
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\44\ We understand that sometimes there may be immaterial
differences between a preparer's estimate of an amount and the
independent auditor's estimate of an amount that exist when
financial statements are issued. These differences might or might
not be errors, and may require additional work to determine the
nature and actual amount of the error. This additional work is not
necessary for the preparer or the auditor to agree to release the
financial statements. Due care should be taken in developing any
guidance in this area to provide an exception for these legitimate
differences of opinion, and to ensure that any requirement to
correct all ``errors'' would not result in unnecessary work for
preparers or auditors.
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The current guidance that is detailed in SAB 108 (as codified in
SAB Topic 1N) may result in the restatement of prior annual periods for
immaterial errors occurring in those periods because the cumulative
effect of these prior period errors would be material to the current
annual period, if the prior period errors were corrected in the current
annual period. By correcting small errors when they are identified, a
company will eliminate the possibility that the continuation of the
error over a period of time will result in the total amount of the
error becoming material to a company's financial statements and
requiring correction at that time. Newly discovered errors that had
occurred over a period of time when they were not material, however,
would still trigger the need for correction. In the process of
reflecting these immaterial corrections to prior annual periods, some
believe that the prior annual period financial statements should
indicate that they have been restated.
[[Page 29823]]
There is diversity in practice on this issue, and clarification is
needed from the SEC on the intent of SAB Topic 1N. We believe that
prior annual period financial statements should not be restated for
errors that are immaterial to the prior annual period. Instead of the
approach specified in Topic 1N, we believe that, where errors are not
material to the prior annual periods in which they occurred but would
be material if corrected in the current annual period, the error could
be corrected in the current annual period \45\ with appropriate
disclosure at the time the current annual period financial statements
are filed with the SEC.
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\45\ We are focused on the principle that prior periods should
not be restated for errors that are not material to those periods.
Correction in the current period of errors that are not material to
prior periods could be accomplished through an adjustment to equity
or to current period income (which might potentially require an
amendment to GAAP). We believe that there are merits in both
approaches and that the FASB and the SEC, as appropriate, should
carefully weigh both approaches before determining the actual
approach to utilize.
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We believe that the determination of how errors should be corrected
should be based on the needs of investors making current investment
decisions. This determination should take into account the facts and
circumstances of each error. For example, a prior period error that was
material to that prior period but that does not affect the annual
financial statements or financial information included within a
company's most recent filing with the SEC may not need to be corrected
through an amendment to prior period filings if the financial
statements that contain the error are determined to be irrelevant to
investors making current investment decisions. Such errors would be
corrected in the period in which they are discovered with appropriate
disclosure about the error and the periods impacted. This approach
provides investors making current investment decisions with more timely
financial reports and avoids the costs to investors of delaying prompt
disclosure of current financial information in order for a company to
correct multiple prior filings.
For material errors that are discovered within a very short time
period prior to a company's next regularly scheduled reporting date, it
may be appropriate in certain instances to report the restatement in
the next filing with appropriate disclosure of the error and its impact
on prior periods, instead of amending previous filings with the SEC.
This option should be further studied with regard to the possibility of
abuse and, if appropriate, should be included in the overall guidance
on how to correct errors.
Assuming that there is an error in an interim period within an
annual period for which financial statements have previously been filed
with the SEC, the following guidance should be utilized:
If the error is not material to either the previously
issued interim period or to the previously issued annual period, the
previously issued financial statements should not be restated.
If the prior period error is determined to be material
only to the previously issued interim period, but not the previously
issued annual period, then only the previously issued interim period
should be restated (i.e., the annual period that is already filed
should not be restated and the Form 10-K should not be amended).
However, there should be appropriate disclosure in the company's next
Form 10-K to explain the discrepancy in the results for the interim
periods during the previous annual period on an aggregate basis and the
reported results for that annual period.
We believe that investors should be informed about all large errors
when they are corrected. Even if a large error is determined to be not
material because of qualitative factors, there should be appropriate
disclosure about the error in the period in which the error is
corrected.
We believe that the issuance by the FASB or the SEC, as
appropriate, of guidance on how to correct and disclose errors in
previously issued financial statements will provide to investors higher
quality and more timely information (e.g., less delay occasioned by the
need for restatement of prior period financial statements for errors
that are not material and for errors that have no relevance to
investors making current investment decisions) and reduce the burdens
on companies related to the preparation of amended reports. Since our
proposal would require prompt correction and full disclosure about all
material errors, all large errors that are considered to be not
material as well as many other types of errors, it would enhance
transparency of accounting errors and help to eliminate the phenomenon
of so-called ``stealth restatements''--when an error impacts past
financial statements without disclosure of such error in current
financial filings.
Developed Proposal 3.3: The FASB or the SEC, as appropriate, should
issue guidance on disclosure during the period in which the restatement
is being prepared, about the need for a restatement and about the
restatement itself, to improve the adequacy of this disclosure based on
the needs of investors:
Typically, the restatement process involves three primary reporting
stages:
1. The initial notification to the SEC and investors that there is
a material error and that the financial statements previously filed
with the SEC can no longer be relied upon;
2. The ``dark period'' or the period between the initial
notification to the SEC and the time restated financial statements are
filed with the SEC; and
3. The filing of restated financial statements with the SEC.
We believe that a major effect on investors due to restatements is
the lack of information when companies are silent during stage 2, or
the ``dark period.'' This silence creates significant uncertainty
regarding the size and nature of the effects on the company of the
issues leading to the restatement. This uncertainty often results in
decreases in the company's stock price. In addition, delays in filing
restated financial statements may create default conditions in loan
covenants; these delays may adversely affect the company's liquidity.
We understand that, in the current legal environment, companies are
often unwilling to provide disclosure of uncertain information.
However, we believe that when companies are going through the
restatement process, they should be encouraged to continue to provide
any reasonably reliable financial information that they can,
accompanied by appropriate explanations of ways in which the
information could be affected by the restatement. Consequently,
regulators should evaluate the company's disclosures during the ``dark
period,'' taking into account the difficulties of generating reasonably
reliable information before a restatement is completed.
We believe that the current disclosure surrounding a restatement is
often not adequate to allow investors to evaluate the company's
operations and the likelihood that such errors could occur in the
future. Specifically, we believe that all companies that have a
restatement should be required to disclose information related to: (1)
The nature of the error, (2) the impact of the error, and (3)
management's response to the error, to the extent known, during all
three stages of the restatement process. Some suggestions of
disclosures that would be made by companies include the following:
Nature of error:
Description of the error;
Periods affected and under review;
[[Page 29824]]
Material items in each of the financial statements subject
to the error and pending restatement;
For each financial statement line item, the amount of the
error or range of potential error;
Identity of business units/locations/segments/subsidiaries
affected.
Impact of error:
Updated analysis on trends affecting the business if the
error impacted key trends;
Loan covenant violations, ability to pay dividends, and
other effects on liquidity or access to capital resources;
Other areas, such as loss of material customers or
suppliers.
Management Response
Nature of the control weakness that led to the restatement
and corrective actions, if any, taken by the company to prevent the
error from occurring in the future;
Actions taken in response to covenant violations, loss of
access to capital markets, loss of customers, and other consequences of
the restatement.
If there are material developments related to the restatement,
companies should update this disclosure on a periodic basis during the
restatement process, particularly when quarterly or annual reports are
required to be filed, and provide full and complete disclosure within
the filing with the SEC that includes the restated financial
statements.
Developed Proposal 3.4: The FASB or the SEC, as appropriate, should
develop and issue guidance on applying materiality to errors identified
in prior interim periods and how to correct these errors. This guidance
should reflect the following principles:
Materiality in interim period financial statements must be
assessed based on the perspective of the reasonable investor.
When there is a material error in an interim period, the
guidance on how to correct that error should be consistent with the
principles outlined in developed proposal 3.2.
Based on prior restatement studies, approximately one-third of all
restatements involved only interim periods. Authoritative accounting
guidance on assessing materiality with respect to interim periods is
currently limited to paragraph 29 of APB Opinion No. 28, Interim
Financial Reporting.\46\ Differences in interpretation of this
paragraph have resulted in variations in practice that have increased
the complexity of financial reporting. This increased complexity
impacts preparers and auditors, who struggle with determining how to
evaluate the materiality of an error to an interim period, and also
impacts investors, who can be confused by the inconsistency between how
companies evaluate and report errors. We believe that guidance as to
how to evaluate errors related to interim periods would be beneficial
to preparers, auditors and investors.
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\46\ Paragraph 29 of APB Opinion No. 28, Interim Financial
Reporting, states the following:
In determining materiality for the purpose of reporting the
cumulative effect of an accounting change or correction of an error,
amounts should be related to the estimated income for the full
fiscal year and also to the effect on the trend of earnings. Changes
that are material with respect to an interim period but not material
with respect to the estimated income for the full fiscal year or to
the trend of earnings should be separately disclosed in the interim
period.
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We have observed that a large part of the dialogue about interim
materiality has focused on whether an interim period should be viewed
as a discrete period or an integral part of an annual period.
Consistent with the view expressed at the outset of this section, we
believe that the interim materiality dialogue could be greatly
simplified if that dialogue were refocused to address two sequential
questions: (1) What principles should be considered in determining the
materiality of an error in interim period financial statements? and (2)
How should errors in previously issued interim financial statements be
corrected? We believe that additional guidance on these questions,
which are extensions of the basic principles outlined in developed
proposals 3.1 and 3.2 above, would provide useful guidance in assessing
and correcting interim period errors. We believe that while these
principles would assist in developing guidance related to interim
periods, additional work should also be performed to fully develop
robust guidance regarding errors identified in interim periods.
We believe that the determination of whether an interim period
error is material should be made based on the perspective of a
reasonable investor, not whether an interim period is a discrete
period, an integral part of an annual period, or some combination of
both. An interim period is part of a larger mix of information
available to a reasonable investor. As one example, a reasonable
investor would use interim financial statements to assess the
sustainability of a company's operations and cash flows. In this
example, if an error in interim financial statements did not impact the
sustainability of a company's operations and cash flows, the interim
period error may very well not be material given the total mix of
information available. Similarly, just as a large error in annual
financial statements does not determine by itself whether an error is
material, the size of an error in interim financial statements should
also not be necessarily determinative as to whether an error in interim
financial statements is material.
We believe that applying the principles set forth above would
reduce restatements by providing a company the ability to correct in
the current period immaterial errors in previously issued financial
statements and as a practical matter obviate the need to debate whether
the interim period is a discrete period, an integral part of an annual
period, or some combination of both.
We also note that these principles will provide a mechanism, other
than restatement, to correct through the current period a particular
error that has often been at the center of the interim materiality
debate--a newly discovered error that has accumulated over one or more
annual or interim periods, but was not material to any of those prior
periods.
III. Judgment
III.A. Background
Overview
Judgment is not new to the areas of accounting, auditing, or
securities regulation--the criteria for making and evaluating judgment
have been a topic of discussion for many years. The recent increased
focus on judgment, however, comes from several different developments,
including changes in the regulation of auditors and a focus on more
``principles-based'' standards--for example, FASB standards on fair
value and IASB standards. Investors will benefit from more emphasis on
``principles-based'' standards, since ``rules-based'' standards (as
discussed in chapters 1 and 2) may provide a method, such as through
exceptions and bright-line tests, to avoid the accounting objectives
underlying the standards. If properly implemented, ``principles-based''
standards should improve the information provided to investors while
reducing the investor's concern about ``financial engineering'' by
companies using the ``rules'' to avoid accounting for the substance of
a transaction. While preparers appear supportive of a move to less
prescriptive guidance, they have expressed concern regarding the
perception that current practice by regulators in evaluating judgments
does not provide an environment in which such judgments may be
generally respected. This, in turn, can lead to repeated calls for more
rules, so that the
[[Page 29825]]
standards can be comfortably implemented.
Many regulators also appear to encourage a system in which
preparers can use their judgment to determine the most appropriate
accounting and disclosure for a particular transaction. Regulators
assert that they do respect judgments, but may also express concerns
that some companies may attempt to inappropriately defend certain
errors as ``reasonable judgments.'' Identifying standard processes for
making judgments and criteria for evaluating those judgments, after the
fact, may provide an environment that promotes the use of judgment and
encourages consistent evaluation practices among regulators.
Goals of Potential Guidance on Judgments
The following are several issues that any potential guidance
related to judgments may help address:
a. Investors' lack of confidence in the use of judgment--Guidance
on judgments may provide investors with greater comfort that there is
an acceptable rigor that companies follow in exercising reasonable
judgment.
b. Preparers' concern regarding whether reasonable judgments are
respected--In the current environment, preparers may be afraid to
exercise judgment for fear of having their judgments overruled, after
the fact by regulators.
c. Lack of agreement in principle on the criteria for evaluating
judgments--The criteria for evaluating reasonable judgments, including
the appropriate role of hindsight in the evaluation, may not be clearly
defined and thus may lead to increased uncertainty.
d. Concern over increased use of ``principles-based'' standards--
Companies may be less comfortable with their ability to implement more
``principles-based'' standards if they are concerned about how
reasonable judgments are reached and how they will be assessed.
Categories of Judgments That Are Made in Preparing Financial Statements
There are many categories of accounting and auditing judgments that
are made in preparing financial statements, and any guidance should
encompass all of these categories, if practicable. Some of the
categories of accounting judgment are as follows:
1. Selection of accounting standard.
In many cases, the selection of the appropriate accounting standard
under GAAP is not a highly complex judgment (e.g., leases would be
accounted for using lease accounting standards and pensions would be
accounted for using pension accounting standards). However, there are
cases in which the selection of the appropriate accounting standard can
be highly complex.
For example, the standards on accounting for derivatives contain a
definition of a derivative and provide scope exceptions that limit the
applicability of the standard to certain types of derivatives. To
evaluate how to account for a contract that has at least some
characteristics of a derivative, one would first have to determine if
the contract met the definition of a derivative in the accounting
standard and then determine if the contract would meet any of the scope
exceptions that limited the applicability of the standard. Depending on
the nature and terms of the contract, this could be a complex judgment
to make, and one on which experienced accounting professionals can have
legitimate differing, yet acceptable, opinions.
2. Implementation of an accounting standard.
After the correct accounting standard is identified, there are
judgments to be made during its implementation.
Examples of implementation judgments include determining if a hedge
is effective, if a lease is an operating or a capital lease, and what
inputs and methodology should be utilized in a fair value calculation.
Implementation judgments can be assisted by implementation guidance
issued by standards-setters, regulators, and other bodies; however,
this guidance could increase the complexity of selecting the correct
accounting standard, as demonstrated by the guidance issued on
accounting for derivatives.
Further, many accounting standards use wording such as
``substantially all'' or ``generally.'' The use of such qualifying
language can increase the amount of judgment required to implement an
accounting standard. In addition, some standards may have potentially
conflicting statements.
3. Lack of applicable accounting standards.
There are some transactions that may not readily fit into a
particular accounting standard. Dealing with these ``gray'' areas of
GAAP is typically highly complex and requires a great deal of judgment
and accounting expertise. In particular, many of these judgments use
analogies from existing standards that require a careful consideration
of the facts and circumstances involved in the judgment.
4. Financial Statement Presentation.
The appropriate method to present, classify and disclose the
accounting for a transaction in a financial statement can be highly
subjective and can require a great deal of judgment.
5. Estimating the actual amount to record.
Even when there is little debate as to which accounting standard to
apply to a transaction, there can be significant judgments that need to
be made in estimating the actual amount to record.
For example, opinions on the appropriate standard to account for
loan losses or to measure impairments of assets typically do not
differ. However, the assumptions and methodology used by management to
actually determine the allowance for loan losses or to determine an
impairment of an asset can be a highly judgmental area.
6. Evaluating the sufficiency of evidence.
Not only must one make a judgment about how to account for a
transaction, the sufficiency of the evidence used to support the
conclusion must be evaluated. In practice, this is typically one of the
most subjective and difficult judgments to make.
Examples include determining if there is sufficient evidence to
estimate sales returns or to support the collectability of a loan.
Levels of Judgment
There are many levels of judgment that occur related to accounting
matters. Preparers must make initial judgments about uncertain
accounting issues; the preparer's judgment may then be evaluated or
challenged by auditors, investors, regulators, legal claimants, and
even others, such as the media. Therefore, in developing potential
guidance, differences in role and perspective between those who make a
judgment and those who evaluate a judgment should be carefully
considered. Guidance should not make those who evaluate a judgment re-
perform the judgment according to the guidance. Instead, guidance
should provide clarity to those who would make a judgment on factors
that those who would evaluate the judgment would consider while making
that evaluation.
Hindsight
The use of hindsight to evaluate a judgment where the relevant
facts were not available at the time of the initial release of the
financial statements (including interim financial statements) is not
appropriate. Determining at what point the relevant facts were known to
management, or should have been
[[Page 29826]]
known,\47\ can be difficult, particularly for regulators who are often
evaluating these circumstances after substantial time has passed.
Therefore, the use of hindsight should only be used based on the facts
reasonably available at the time the annual or interim financial
statements were issued.
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\47\ We believe that those making a judgment should be expected
to exercise due care in gathering all of the relevant facts prior to
making the judgment.
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Form of Potential Guidance
We believe that there are many different ways that potential
guidance on judgment could be provided. To be successful, however, we
believe that guidance on judgment should not eliminate debate, nor be
inflexible or mechanical in application. Rather, the guidance should
encourage preparers to organize their analysis and focus preparers and
others on areas to be addressed; thereby improving the quality of the
judgment and likelihood that regulators will accept the judgment. Any
guidance issued should be designed to stimulate a rigorous, thoughtful
and deliberate process rather than a checklist-based approach for
making and evaluating judgments.
One potential way to accomplish the goals we set forth earlier as
well as to guard against the potential that such guidance would develop
into a checklist-based approach is for the SEC to formally state its
approach to evaluating judgments. As discussed earlier in this report,
one of the major concerns surrounding the use of judgment is the
possibility of a regulator ``second guessing'' the reasonableness of a
judgment after the fact. We believe that a primary cause of this
concern is a lack of clarity and transparency into the process the SEC
uses to evaluate the reasonableness of judgments. The SEC has
articulated its policies in the past with success. Examples of previous
articulations of policy by the SEC include the ``Seaboard'' report
(October 23, 2001) relating to the impact of a company's cooperation on
a potential SEC enforcement case and the SEC's framework for assessing
the appropriateness of corporate penalties (January 4, 2006). We
believe that a statement of policy could implement the goals we have
articulated and therefore recommend that the SEC and the PCAOB issue
statements of policy describing how they evaluate the reasonableness of
accounting and auditing judgments.
The Nature and Limitations of GAAP
Some have suggested that potential judgment guidance for the
selection and implementation of GAAP be a requirement to reflect the
economic substance of a transaction or be a standard of selecting the
``high road'' in accounting for a transaction. We agree that
qualitative standards for GAAP such as these would be desirable and we
encourage regulators and standards-setters to move financial reporting
in this direction. However, such standards are not always present in
financial reporting today and we cannot recommend the articulation of
such standards in an SEC statement of policy without anticipating a
fundamental long-term revision of GAAP--a change that would be beyond
our purview and one that would not be doable in the near- or
intermediate-term.
For example, there is general agreement that accounting should
follow the substance and not just the form of a transaction or event.
Many believe that this fundamental principle should be extended to
require that all GAAP judgments should reflect economic substance.
However, reasonable people disagree on what economic substance actually
is, and many would conclude that significant parts of current GAAP do
not require and do not purport to measure economic substance (e.g.,
accounting for leases, pensions, certain financial instruments and
internally developed intangible assets are often cited as examples of
items reported in accordance with GAAP that would not meet many
reasonable definitions of economic substance).
Similarly, some would like financial reporting to be based on the
``high road''--a requirement to use the most preferable principle in
all instances. Unfortunately, today a preparer is free to select from a
variety of acceptable methods allowed by GAAP (e.g., costing inventory,
measuring depreciation, and electing to apply hedge accounting are just
some of the many varied methods allowed by GAAP) without any
qualitative standard required in the selection process. In fact, a
preferable method is required to be followed only when a change in
accounting principle is made, and a less preferable alternative is
fully acceptable absent such a change.
We believe that adopting a requirement that accounting judgments
reflect economic substance or the ``high road'' would require a
revolutionary change not achievable in the foreseeable future. Our
suggestion that the SEC issue a statement of policy relating to its
evaluation of judgments could and we believe would enhance adherence to
GAAP, but it cannot be expected to correct inherent weaknesses in the
standards to which it would be applied.
III.B. Developed Proposals
We have developed the following proposal:
Developed Proposal 3.5: The SEC should issue a statement of policy
articulating how it evaluates the reasonableness of accounting
judgments and include factors that it considers when making this
evaluation. The PCAOB should also adopt a similar approach with respect
to auditing judgments.
The statement of policy applicable to accounting-related judgments
should address the choice and application of accounting principles, as
well as estimates and evidence related to the application of an
accounting principle. We believe that a statement of policy that is
consistent with the principles outlined in this developed proposal to
cover judgments made by auditors based on the application of PCAOB
auditing standards would be very beneficial to auditors. Therefore, we
propose that the PCAOB develop and articulate guidance related to how
the PCAOB, including its inspections and enforcement divisions, would
evaluate the reasonableness of judgments made based on PCAOB auditing
standards. The PCAOB statement of policy should acknowledge that the
PCAOB would look to the SEC's statement of policy to the extent the
PCAOB would be evaluating the appropriateness of accounting judgments
as part of an auditor's compliance with PCAOB auditing standards.
We believe that it would be useful if the SEC also set forth in the
statement of policy factors that it looks to when evaluating the
reasonableness of preparers' accounting judgments.
The Concept of Judgment in Accounting Matters
Judgment, with respect to accounting matters, should be exercised
by a person or persons who have the appropriate level of knowledge,
experience, and objectivity and form an opinion based on the relevant
facts and circumstances within the context provided by applicable
accounting standards. Judgments could differ between knowledgeable,
experienced, and objective persons. Such differences between reasonable
judgments do not, in themselves, suggest that one judgment is wrong and
the other is correct. Therefore, those who evaluate judgments should
evaluate the reasonableness of the judgment, and should not base their
evaluation on whether the judgment is different from the opinion that
would have been reached by the evaluator.
[[Page 29827]]
We have listed below various factors that we believe preparers
should consider when making accounting judgments. The SEC may want to
take these factors into account in developing its statement of policy.
We also believe that a suggestion by the SEC that preparers should
carefully consider these factors when making accounting judgments would
be beneficial in not only increasing the quality of judgments, but also
in making sure that the SEC and preparers will be able to more
efficiently resolve potential differences during the SEC's review of
preparer's filings. The mere consideration by a preparer of these
factors in a SEC statement of policy would not prevent a regulator from
asking appropriate questions about the accounting judgments made by the
preparer or asking companies to correct unreasonable judgments,
however. In fact, there is no guarantee that the preparer's
consideration of the SEC's suggested factors articulated in a statement
of policy would result in a reasonable judgment being reached. Rather,
the statement of policy should be designed to encourage preparers to
organize their analysis and focus preparers and others on areas that
would be the focus of the SEC's review, thereby improving the quality
of the judgment and likelihood that regulators will accept the
judgment. We encourage the SEC to seek to accept a range of alternative
reasonable judgments when preparers make good faith attempts to reach a
reasonable judgment. A preparer's failure to follow the SEC's suggested
factors in its statement of policy, however, would not imply that the
judgment is unreasonable.
We would expect that, in the evaluation of judgments made using the
factors that are cited below, the focus would be on significant matters
requiring judgment that could have a material effect on the financial
statements taken as a whole. We recognize that the facts and
circumstances of each judgment may indicate that certain factors are
more important than others. These factors would have a greater
influence in an evaluation of the reasonableness of a judgment made by
a preparer.
Factors to Consider When Evaluating the Reasonableness of a Judgment
While we believe that the SEC should articulate the factors that it
uses when evaluating the reasonableness of a judgment, we believe that
the statement of policy would be even more useful to preparers if the
SEC also made suggestions for ways in which accounting judgments could
be made.
We believe that accounting judgments should be based on a critical
and reasoned evaluation made in good faith and in a rigorous,
thoughtful and deliberate manner. We believe that preparers should have
appropriate controls in place to ensure adequate consideration of all
relevant factors. Factors applicable to the making of an accounting
judgment include the following:
1. The preparer's analysis of the transaction, including the
substance and business purpose of the transaction;
2. The material facts reasonably available at the time that the
financial statements are issued;
3. The preparer's review and analysis of relevant literature,
including the relevant underlying principles;
4. The preparer's analysis of alternative views or estimates,
including pros and cons for reasonable alternatives;
5. The preparer's rationale for the choice selected, including
reasons for the alternative or estimate selected and linkage of the
rationale to investors' information needs and the judgments of
competent external parties;
6. Linkage of the alternative or estimate selected to the substance
and business purpose of the transaction or issue being evaluated;
7. The level of input from people with an appropriate level of
professional expertise; \48\
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\48\ In many cases, input from professional experts would
include consultation with a preparer's independent auditors or other
competent external parties, such as valuation specialists, actuaries
or counsel.
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8. The preparer's consideration of known diversity in practice
regarding the alternatives or estimates; \49\
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\49\ If there is not diversity in practice, it would be
significantly harder to select a different alternative.
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9. The preparer's consistency of application of alternatives or
estimates to similar transactions;
10. The appropriateness and reliability of the assumptions and data
used;
11. The adequacy of the amount of time and effort spent to consider
the judgment.
When considering these factors, it would be expected that the
amount of documentation, disclosure, input from professional experts,
and level of effort in making a judgment would vary based on the
complexity, nature (routine versus non-routine) and materiality of a
transaction or issue requiring judgment.
Material issues or transactions should be disclosed appropriately.
We note that existing disclosure requirements should be sufficient to
generate \50\ transparent disclosure that enables an investor to
understand the transaction and assumptions that were critical to the
judgment. The SEC has provided in the past, and should continue to
consider providing, additional guidance on existing disclosure
requirements to encourage more transparent disclosure. In addition,
when evaluating the reasonableness of a judgment, regulators should
take into account the disclosure relevant to the judgment.
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\50\ Existing disclosure requirements would include the guidance
on critical accounting estimates in the Commissions Release No. 33-
8350 ``Commission Guidance Regarding Management's Discussion and
Analysis of Financial Condition and Results of Operations, the
Commissions Release No. 33-8040 ``Cautionary Advice Regarding
Disclosure About Critical Accounting Policies'' and Accounting
Principles Board Opinion No. 22 ``Disclosure of Accounting
Policies''. We also encourage the SEC to continue to remind
preparers of ways to improve the transparency of disclosure, such as
through statements like the Sample Letter sent to Public Companies
on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value
Measurements) issued by the Division of Corporation Finance in March
2008.
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Documentation--The alternatives considered and the conclusions
reached should be documented contemporaneously. The lack of
contemporaneous documentation may not mean that a judgment was
incorrect, but would complicate an explanation of the nature and
propriety of a judgment made at the time of the release of the
financial statements.
Exhibit D
SEC Advisory Committee on Improvements to Financial Reporting
Delivering Financial Information Subcommittee Update
May 2, 2008 Full Committee Meeting
I. Introduction
The SEC's Advisory Committee on Improvements to Financial Reporting
(Committee) issued a progress report (Progress Report) on February 14,
2008.\51\ In chapter 4 of the Progress Report, the Committee discussed
its work-to-date in the area of delivering financial information
including its developed proposals relating to XBRL tagging of financial
information and improved use of corporate Web sites and its future
considerations relating to disclosure of key performance indicators,
improved quarterly press release disclosures and timing, and the
inclusion of executive summaries in public company periodic reports.
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\51\ Refer to Progress Report at http://www.sec.gov/rules/other/2008/33-8896.pdf.
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Since the issuance of the Progress Report, the delivering financial
information subcommittee (Subcommittee IV) has deliberated further the
areas of improved use of
[[Page 29828]]
corporate Web sites, disclosure of key performance indicators, improved
quarterly press release disclosures and timing and inclusion of
executive summaries. This report represents Subcommittee IV's latest
thinking, including its consideration of input received through comment
letters and received orally at the March 14, 2008 Committee meeting in
San Francisco and subsequent Subcommittee meeting with industry
participants. Subject to further public comment, Subcommittee IV will
recommend the following preliminary hypotheses to the full Committee
for its consideration in developing the final report, which it expects
to issue in July 2008.
II. XBRL
In the Progress Report, the Committee issued a developed proposal
regarding XBRL (developed proposal 4.1). Refer to the Progress Report
for additional discussion of this developed proposal. At the Committee
meeting on March 14, 2008 held in San Francisco, the Committee received
oral and written input from market participants regarding the XBRL
developed proposal. The Subcommittee understands the SEC has scheduled
an open meeting on May 14, 2008 to consider whether to propose
amendments to provide for corporate financial statement information to
be filed with the SEC in interactive data format, and a near- and long-
term schedule therefore. Subcommittee IV proposes no revisions at this
time to the developed proposal.
III. Use of Corporate Web Sites
In the Progress Report, the Committee issued a developed proposal
regarding the use of corporate Web sites and the development of uniform
best practices regarding corporate Web site use by industry
participants (developed proposal 4.2). Refer to the Progress Report for
additional discussion of this developed proposal. The Committee heard
additional input from industry participants, including newswire
services, reporting companies, investors, and securities lawyers
regarding the developed proposal as part of the comments received on
the Progress Report. The Subcommittee heard from companies and
investors about the value of corporate Web site disclosures as an
additional, though not exclusive, means of providing information to the
market in a timely manner available to all persons. Subcommittee IV
proposes no significant revisions at this time to the developed
proposals regarding corporate Web sites and industry developed best
practice guidelines.
IV. Disclosures of KPIs and Other Metrics To Enhance Business Reporting
Preliminary Hypothesis 1
The SEC should encourage private sector initiatives targeted at
best practice development of company use of Key Performance Indicators
(KPIs) in their business reports. The SEC should encourage private
sector dialogue, involving preparers, investors, and other interested
industry participants, such as consortia that have long supported KPI-
like concepts, to generate understandable, consistent, relevant and
comparable KPIs on an industry-specific and relevant activity basis.
The SEC also should encourage companies to provide, explain, and
consistently disclose period-to-period company-specific KPIs. The SEC
should consider reiterating and expanding its interpretive guidance
regarding disclosures of KPIs in MD&A and other company disclosures.
The Committee should further acknowledge the useful work of those
consortia that endeavor to go beyond the limited scope of the
Committee's recommendation to provide an overall structure which
provides a linking of financial and KPI indicators into a seamless
whole.
Background
As the Committee noted in the Progress Report, enhanced business
reporting and key performance indicators (KPIs) are disclosures about
the aspects of a company's business that provide significant insight
into the sources of its value. The Enhanced Business Reporting
Consortium,\52\ has stated that the value drivers for a business ``can
be measured numerically through KPIs or may be qualitative factors such
as business opportunities, risks, strategies and plans--all of which
permit assessment of the quality, sustainability and variability of its
cash flows and earnings.'' KPIs include supplemental non-GAAP financial
reporting disclosures that proponents have stated can improve
disclosures by public companies. Such KPIs also may include non-
financial measures. KPIs are leading indicators of financial results
and intangible assets that are not necessarily encompassed on a
company's balance sheet and can provide more transparency and
understanding about the company to investors. Proponents of the use of
KPIs note that they are important because they inform judgments about a
company's future cash flows--and form the basis for a company's stock
price. Managers and boards of directors of companies use KPIs to
monitor performance of companies and of management. Market participants
and the SEC have identified KPIs as important supplements to GAAP-
defined financial measures.
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\52\ The Enhanced Business Reporting Consortium was founded by
the AICPA, Grant Thornton LLP, Microsoft Corporation, and
PricewaterhouseCoopers in 2005 upon the recommendation of the AICPA
Special Committee on Enhanced Business Reporting. The EBRC is an
independent, market-driven non-profit collaboration focused on
improving the quality, integrity and transparency of information
used for decision-making in a cost-effective, time efficient manner.
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The Committee understands that investment professionals concur that
investors are very interested in non-financial information as a way to
better understand the businesses they invest in. They recognize that
financial reports provide an accounting of past events and a current
view of the financial condition of the company. The financials are
viewed as an end-of-process result delivered as a combination of market
conditions and company business strategies, processes and execution.
The financials are, by their nature, not necessarily forward-looking
indicators. Of interest to many investors from a business reporting
standpoint is information regarding the fundamental drivers of the
business and metrics used to give evidence as to how the business is
being managed in the environment it finds itself in. Financial
reporting captures some aspects of this but not all and, in fact,
financial statements are not currently designed to provide a broader
picture of the company and its operations.
From a corporate preparer standpoint, management uses KPIs as key
metrics with which to direct the company as part of the strategic
planning process both in terms of goal setting and as a way to provide
analysis and feedback. In that regard the degree to which companies are
comfortable sharing these metrics with shareholders, communication
would be greatly enhanced. By its very nature such communication would
increase the fundamental transparency of the business. Numerous prior
studies have shown that greater transparency on the part of
corporations reduces the company's cost of capital and no doubt
improves market efficiency.
Recognizing this, the SEC encourages extensive discussion of the
condition of the business in the MD&A. The SEC, in its 2003 MD&A
Interpretive Release, stated ``[o]ne of the principal objectives of
MD&A is to give readers a view of the company through the eyes of
management by providing both a short- and long-term analysis of the
business. To do this, companies should `identify
[[Page 29829]]
and address those key variables and other qualitative and quantitative
factors which are peculiar to and necessary for an understanding and
evaluation of the individual company'.'' In this regard, the SEC noted
the importance of disclosures of key performance measures--``when
preparing MD&A, companies should consider whether disclosure of all key
variables and other factors that management uses to manage the business
would be material to investors, and therefore required. These key
variables and other factors may be non-financial, and companies should
consider whether that non-financial information should be disclosed.''
The SEC went on to state that ``[i]ndustry-specific measures can also
be important for analysis, although common standards for the measures
also are important. Some industries commonly use non-financial data,
such as industry metrics and value drivers. Where a company discloses
such information, and there is no commonly accepted method of
calculating a particular non-financial metric, it should provide an
explanation of its calculation to promote comparability across
companies within the industry. Finally, companies may use non-financial
performance measures that are company-specific.'' \53\
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\53\ SEC, Commission Guidance Regarding Management's Discussion
and Analysis of Financial Condition and Results of Operations,
Securities Act Release No. 33-8350 (December 19, 2003) (2003 MD&A
Interpretive Release).
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This discussion is intended to give information about the business
in a way that is consistent with the manner in which the business is
run.
Discussion
The Subcommittee's hypothesis extends beyond a narrow definition of
financial reporting to business reporting more generally. The
Subcommittee has been evaluating whether public companies should
increase their voluntary disclosure of financial and non-financial
performance measures or indicators, such as KPIs. The Subcommittee has
examined the current practices of public companies and notes that many
companies are already disclosing some company-specific KPIs in their
periodic reports filed with the SEC or in other public statements, but
these company-specific measures may not necessarily be consistently
reported by companies from period-to-period, are not necessarily well-
defined, and may not be commonly used by other companies in the same
industry so that they lend themselves to comparisons between and among
companies. Therefore, as part of its review of KPI disclosure, the
Subcommittee has evaluated the kinds of KPIs that should be made
available, in what format, and whether they should be consistently
defined over time. The Subcommittee has found that various groups,
within and outside industries, are working on developing industry-
specific and activity-specific KPIs in order to improve comparability
of companies on an industry basis.
In developing its preliminary hypothesis on KPIs and other possible
metrics to enhance business reporting, the Subcommittee consulted with
industry members and others who have been working on this subject. As a
result of these discussions and its evaluation of other materials, the
Subcommittee preliminarily believes that further exploration of the use
of KPIs and other metrics by public companies would be constructive.
Accordingly, for KPI reporting to be most effective and improve
user understanding, the Subcommittee is considering that the full
Committee recommend that companies should consider the following to
improve KPI disclosures.\54\
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\54\ The Subcommittee notes that the SEC has provided guidance
as to some of these matters as well in its 2003 MD&A Interpretive
Release as discussed above. The SEC noted that ``[t]he focus on key
performance indicators can be enhanced not only through the language
and content of the discussion, but also through a format that will
enhance the understanding of the discussion and analysis.''
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Understandability--The Subcommittee believes that a given
KPI term, such as ``same store sales,'' would be most useful in
evaluating the relevant industry or activity if it had a standard
agreed definition in the industry. For that reason, as part of its
preliminary hypothesis, the Subcommittee notes that the SEC should
explore ways to encourage private initiatives in various industries for
the development of standard KPI definitions. It is presumed that there
would be some terms that would be macro in nature that companies from
all industries would make use of and thus would be activity-based, but
it is assumed that many KPI terms would be industry-specific. Once a
term has been defined by industry, the SEC and other global regulators
should work with industry to support the use of such term in periodic
and other company reports, with such modified or additional disclosures
as the SEC and other global regulators deem necessary or appropriate.
Companies should be encouraged to use such industry-defined terms and
to disclose any differences in their use of terms from any industry-
defined and accepted definition. Companies would still have the freedom
to use whatever terms they wished in describing their businesses but
would be expected to make clear any differences between their
definitions and those that have been industry defined.
Consistency--Whether or not a company uses an industry-
defined term for its KPI disclosures, the KPI that is used should be
reported consistently from period-to-period. Any changes in the
definition of a KPI should be disclosed, along with the reasons for the
change. KPIs should be reported not just for the current period but for
prior periods as well so that investors can assess the company's
development from period-to-period or year-to-year.
Relevancy--KPI that are disclosed should be important to
an understanding and tracking of the business or business segments for
which they are used and should align with how reporting companies run
their business.
Presentability--When companies disclose KPIs in their
reports and other releases, they should make clear to ordinary
investors that the information is intended to provide information about
the business of the company that is separate from and supplemental to
the financial statements. This could either be done in a separate KPI
section in MD&A or in subsections of parts of the MD&A, such as the
general business discussion or the discussion by business segment.
Segment reporting of KPIs, given the logical connection to business
line activities, could be very useful. The inclusion of tabular
presentations showing current and prior periods should be seriously
considered.
Comparability--Encouraging companies to use industry-
defined KPI's would enable investors to compare companies within and
across industries and would also be quite useful at the industry
segment level. Once industry-defined KPIs are available, the
Subcommittee would hope that investor interest would encourage
companies to use commonly defined KPI terms.
The Subcommittee has heard that some companies may be hesitant
about increased disclosure of KPIs because of concern that disclosure
of these metrics may compromise competitive information.\55\ Neither
the Subcommittee nor investors want companies to give away the ``crown
jewels.'' The Subcommittee has also heard questions about the validity
of many of such competitive harm claims, particularly where information
is widely known within a particular
[[Page 29830]]
industry. The Subcommittee has heard that there is already so much
information about companies that disclosure of unique competitive
information would be rare. Nevertheless, the Subcommittee preliminarily
believes that if a particular KPI could require the disclosure of
competitively important information, the affected company could decline
to disclose it.
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\55\ The Subcommittee also heard a question as to the liability
treatment of KPIs.
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In an ideal disclosure system, non-financial and financial
indicators and elements would be presented within a cohesive framework
that combines KPIs and other indicators with GAAP data and text
discussion in order to create a complete picture of a company. At this
time, the Subcommittee believes that having the Committee propose to
mandate or suggest such an organized structure is outside the scope of
what the Subcommittee is evaluating, might be premature and
inappropriate for a regulator or standard setter, possibly being too
prescriptive.
Rather, the Subcommittee's preliminary hypothesis believes that the
SEC should encourage an industry driven initiative with significant
investor involvement to develop best practices that companies could
follow in developing and disclosing KPIs. Just as financial reporting
standards and the recently developed XBRL taxonomy may improve business
reporting by creating standardized language, the Subcommittee believes
the development of a KPI dictionary, developed on an industry basis but
also allowing for company-specific definitions, also could provide
valuable information to investors.
Thus, the Subcommittee has developed a preliminary hypothesis that
is based on a number of industry-driven initiatives, with significant
investor involvement, to develop best practices and common definitions
for KPIs that companies could follow in disclosing KPIs. The hypothesis
suggests that companies, investors, and business reporting consortiums
should work together to develop industry-wide and activity-specific
KPIs that conform to uniform or standard definitions, as well as
company-specific KPIs. These KPIs should then be disclosed in a
company's periodic reports, as well as other disclosure formats such as
earnings releases. The hypothesis suggests that the KPIs:
Be clearly and consistently defined to allow investors
understanding of the meanings of the KPIs;
Be disclosed, as relevant, on a company and/or segment
basis; and
Permit cross-company and cross-industry comparisons.
The Subcommittee does not believe that the mandatory reporting of
KPIs is desirable at this time. Instead, the Subcommittee believes that
the Committee should consider encouraging the SEC to promote the
development of commonly recognized and defined KPIs by industry groups.
Integration With Other Proposals
The Subcommittee preliminarily believes that the formalization of
KPI disclosures through commonly recognized definitions, will enhance
the benefits that will come from other proposals from the Committee.
For example, disclosing KPIs on company Web sites would allow investors
and other users of the reported information to gain an improved
understanding of the prospects for a company and could lead to better
capital market pricing.
V. Improved Quarterly Press Release Disclosures and Timing
Preliminary Hypothesis 2
Industry groups, including the National Investor Relations
Institute, FEI, and the CFA Institute should update their best
practices for earnings releases. Such updated best practices guidance
should cover, among other matters, the type of information that should
be provided in earnings releases and the need for investors to receive
information that is consistent from quarter to quarter, with an
explanation of any changes in disclosures from quarter to quarter.
Further, the best practices guidance should consider recommending that
companies include in their earnings releases the income statement,
balance sheet and cash flow tables, locate GAAP reconciliations in
close proximity to any non-GAAP measures presented, and provide more
industry and company specific key performance indicators.
The SEC should consider reinforcing its view that disclosures in
connection with earnings calls posted on company Web sites should be
maintained and available on such sites for at least 12 months.
Background
As noted in the Progress Report, the quarterly earnings release,
often the first corporate communication about the result of the quarter
just ended, is viewed as an important corporate communication. This
communication often receives more attention than the formal Form 10-Q
submission which often occurs a week or two later.
The quarterly earnings release is not currently required to contain
mandated information other than that required by the application of
Regulation G to the presentation of non-GAAP measures and the antifraud
provisions of the federal securities laws. Industry groups have
previously coordinated in developing best practices for reporting
companies to follow in preparing their earnings releases. In addition,
under SEC rules, companies must furnish earnings releases to the
Commission on a Form 8-K. Investors and other market participants have
expressed concern about the matters relating to earnings releases,
including consistency of information provided in such releases, the
timing of such releases in relation to the filing of the applicable
periodic report, and the inclusion of earnings guidance in such
earnings releases.
Discussion
The Subcommittee has been examining a number of issues relating to
the earnings release, including with regard to its consistency,
understandability, timeliness, and the continued public availability of
earnings conference calls. The Subcommittee had an opportunity to
discuss the quarterly earnings release and these related matters with
investor and company representatives. In addition, the Subcommittee
considered the consistent provision of income statement, balance sheet
and cash flow tables in the quarterly earnings release as well as the
positioning and prominence of GAAP and non-GAAP figures, GAAP
reconciliation, the consistent placement of topics, and clear
communication of any changes to accounting methods or key assumptions.
The Subcommittee viewed the goal for the earnings release to be a
consistent, reliable communication form that all investors can easily
navigate.
The Subcommittee also briefly discussed the advisability of
requiring the issuance of the earnings releases on the same day that
the periodic report (e.g., Form 10-Q) is filed, in contrast to the
current practice in which the earnings release often is issued before
the periodic report is filed. The Subcommittee heard from company and
investor representatives in this regard and took note of the comments
that the SEC received in connection with a prior request for comment to
tie the filing of the quarterly report to the issuance of an earnings
release. The Subcommittee understood that the practices of companies in
this regard may differ depending on the size of the company and the
company's own disclosure practices. For example, the Subcommittee
understands that some large companies issue their earnings release at
the same time as the filing of
[[Page 29831]]
their quarterly reports. The Subcommittee also heard that smaller
companies tended to wait to issue their earnings releases so that their
news would not be eclipsed by news of larger and more well followed
companies. While investors noted an interest in having the earnings
release issued at the same time as the Form 10-Q is filed to avoid
duplication of effort in analyzing the company's disclosures,
representatives of companies and others expressed concern about the
effect of delays in disclosing material non-public information about
the quarter or year end. Investors also expressed concern regarding the
trading of company stock by executives after the issuance of the
earnings release but before the filing of the Form 10-Q and questioned
whether executives could be prohibited from engaging in trading until
after the Form 10-Q was filed.
The Subcommittee determined not to include a preliminary hypothesis
that would change current market practice regarding the issuance of
earnings releases but would suggest that, instead, the SEC monitor
company practices in regard to the timing of the earnings release in
relation to the filing of the relevant periodic report with the SEC.
The Subcommittee also heard concerns that companies were not
keeping their earnings calls and related information posted on their
Web sites for more than one quarter after the call, thus making
quarterly comparisons difficult. The Subcommittee noted that the SEC
had suggested that companies keep their Web site disclosures regarding
GAAP reconciliations for non-GAAP measures presented on earnings calls
available on their Web sites for at least a 12-month period and the
Subcommittee's preliminary hypothesis would suggest that the SEC
reiterate this guidance.\56\
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\56\ See SEC Conditions for Use of Non-GAAP Measures, Exchange
Act Release No. 34-47226 (Jan. 22, 2003).
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The Subcommittee briefly discussed the practices of some companies
in providing earnings guidance or public projections of next quarter's
earnings by company officials, since some believe that this practice is
an important underlying source of reporting complexity and other
accounting problems. The Subcommittee also discussed the provision of
annual guidance that may be updated quarterly. The Subcommittee does
not intend to continue its evaluation of quarterly earnings guidance or
to suggest any preliminary hypothesis regarding the provision of
quarterly earnings guidance at this time because it notes that many
others are evaluating the issues arising from the provision of
quarterly earnings guidance.
VI. Use of Executive Summaries in Exchange Act Periodic Reports
Preliminary Hypothesis 3
The SEC should mandate the inclusion of an executive summary in the
forepart of a reporting company's filed annual and quarterly reports.
The executive summary should provide summary information, in plain
English, in a narrative and perhaps tabular format of the most
important information about a reporting company's business, financial
condition, and operations. As with the MD&A, the executive summary
should be required to use a layered approach that would present
information in a manner that emphasizes the most important information
about the reporting company and include cross-references to the
location of the fuller discussion in the annual report. The requirement
for the executive summary should build on the company's MD&A overview
and essentially be principles-based, other than a limited number of
required disclosure items such as:
A summary of a company's current financial statements;
A digest of the company's GAAP and non-GAAP KPIs (to the
extent disclosed in the company's 10-Q or 10-K);
A summary of key aspects of company performance;
A summary of business outlook;
A brief description of the company's business, sales and
marketing; and
Page number references to more detailed information
contained in the document (which, if the report is provided
electronically, could be hyperlinks).
Background
Reporting companies are not currently required to include any type
of summary in their periodic reports, although a summary of the company
and the securities it is offering is a line-item disclosure in
Securities Act registration statements. Companies, therefore, are
familiar with the concept of summarizing the important aspects of their
business and operations at the time they are raising capital. The
Subcommittee has heard that retail investors find it difficult at times
to navigate through a company's periodic reports, including its Form
10-K annual report. The Subcommittee has been evaluating the use of an
executive summary in the forepart of a company's annual and quarterly
Exchange Act reports to facilitate the ready delivery of important
information to investors by providing them a roadmap of the disclosures
contained in such reports.
Discussion
The Subcommittee has been exploring a requirement to include an
executive summary in reporting company annual and quarterly Exchange
Act reports (Forms 10-K and 10-Q). The Subcommittee has met with
investor and company representatives as well as securities counsel. The
Subcommittee understands that a summary report prepared on a stand-
alone basis would not necessarily provide investors with information
they need in a desired format and that investors would not use such a
summary. However, the Subcommittee understands that an executive
summary included in the forepart of an Exchange Act periodic report may
provide investors, particularly retail investors, with an important
roadmap to the company's disclosures located in the body of such a
report.\57\ The executive summary in the Exchange Act periodic report
would provide summary information, in plain English, in a narrative and
perhaps tabular format of the most important information about a
reporting company's business, financial condition, and operations. As
with the MD&A, the executive summary would use a layered approach that
would present information in a manner that emphasizes the most
important information about the reporting company and include cross-
references to the location of the fuller discussion in the annual
report.
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\57\ Such reports generally are posted on company Web sites as
well so that the executive summaries would be electronically
available with hyperlinks to the more detailed information in the
relevant report.
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As noted in the Progress Report and as contemplated in the
Subcommittee's preliminary hypothesis, the goal of the executive
summary would be to help investors fundamentally understand a company's
businesses and activities through a relatively short, plain English
presentation. An executive summary in a periodic report may be most
useful if it includes high-level summaries across a broad range of key
components of the annual or quarterly report, rather than detailed
discussion of a limited number of variables. The executive summary
approach may be an efficient way to provide all investors, including
retail investors, with a concise overview of a company, its business,
and its financial condition. For the more sophisticated investor, an
executive summary may be
[[Page 29832]]
helpful in presenting the company's unique story which the
sophisticated investor could consider as it engages in a more detailed
analysis of the company, its business and financial condition.
The executive summary in a periodic report should be brief, and it
might fruitfully build on the overview that the SEC has identified
should be in the forepart of the MD&A disclosure. The MD&A overview is
expected to ``include the most important matters on which a company's
executives focus in evaluating the financial condition and operating
performance and provide context.'' \58\ The executive summary should
build on the MD&A overview disclosure and include the following:
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\58\ See 2003 MD&A Interpretive Release above.
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1. A summary of a company's current financial statements;
2. A digest of the company's GAAP and non-GAAP KPIs (to the extent
disclosed in the company's 10-Q or 10-K);
3. A summary of key aspects of company performance;
4. A summary of business outlook;
5. A brief description of the company's business, sales and
marketing;
6. Page number references to more detailed information contained in
the document (which, if the report is provided electronically, could be
hyperlinks).
The Subcommittee's preliminary hypothesis provides that the
executive summary should be required to be included in the forepart of
a reporting company's annual or quarterly report filed with the SEC or,
if a reporting company files its annual report on an integrated basis
(the glossy annual report is provided as a wraparound to the filed
annual report), the executive summary instead could be included in the
forepart of the glossy annual report. If the executive summary was
included in the glossy annual report, it would not be considered filed
with the SEC. The Subcommittee understands that the inclusion of a
summary in the body of the periodic report should not give rise to
additional liability implications.
VII. Continued Need for Improvements in the MD&A and Other Public
Company Financial Disclosures
The Committee noted in chapter 4 of the Progress Report that while
investors and other market participants believe that while there has
been some improvement in the MD&A disclosures since publication of the
SEC's interpretive release in 2003, significant improvement is still
needed. The Subcommittee evaluated the MD&A and other public company
disclosures in the context of its preliminary hypotheses regarding
disclosures of key performance indicators, earnings releases, and use
of executive summaries in periodic reports.
[FR Doc. E8-11276 Filed 5-21-08; 8:45 am]
BILLING CODE 8010-01-P