Report of SEC's Advisory Committee on Improvements to Financial Reporting

By Cydney Posner

In July 2007, the SEC chartered the Advisory Committee on Improvements to Financial Reporting for the purpose of making recommendations intended to increase the usefulness of financial information to investors, while reducing the complexity of the financial reporting system to investors, preparers and auditors. This month, the committee posted its draft 180-page Report, some of which is practically revolutionary in its common sense. The committee is scheduled to issue the final Report to the SEC on July 31. While the Report does not directly focus on the issue of convergence with international financial reporting standards (IFRS), the committee notes that it is broadly supportive of the effort and believes that its recommendations will continue to be relevant, even if convergence is adopted. These reports can be highly influential, often leading to SEC proposals. (Consider, for example, the impact of the report of the SEC Advisory Committee on Smaller Public Companies, whose recommendations were described in the posting on 4/20/06.)

Below are some of the key recommendations in the Report.

Errors and Restatements

One of the more significant areas of the Report relates to errors and restatements. Since the adoption of SOX, the number of restatements has increased significantly; however, frequently, the restatement may relate to matters that are not necessarily of interest to investors. For example, where the error in a line item is large, a restatement may be required, even though the line item itself may be of absolutely no interest to shareholders. As a result, the current approach to restatements can be unnecessarily costly and time-consuming, without, in some cases, providing much benefit for shareholders. The Report notes that in "2006 and 2007, 9% to 10% of all U.S. public companies restated their financial statements because of accounting errors, although the number may be beginning to decline. Moreover, there is considerable evidence that the accounting errors leading to financial restatements were less significant in the last few years than in the period before 2002. The restatement process, which may take longer than 12 months, imposes significant costs on investors as well as preparers. During that process, companies normally go into a 'dark period' and issue very little financial information to the public." To address these problems, the Report recommends that the determination of whether an accounting error is material be separated from the decision on how to correct the error.

With regard to determinations of materiality of errors:

• Materiality of an error should be judged based upon the perspective of a reasonable investor, that is, 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.

With regard to correction of errors:

• Any accounting error should be promptly corrected and not deferred until future financial statements.
• All material errors in previously issued financial statements should be prominently disclosed when they are corrected.
• Prior period financial statements should be restated only for errors that are material to those prior periods.
• To limit the possibility of "stealth" restatements, the SEC should amend the instructions to Form 8-K to clarify that the report must be filed for all determinations of non-reliance on prior financial statements.
• The SEC or FASB should provide guidance that the correction and disclosure of any accounting error should not automatically result in the amendment of prior financial statements; rather, past financial statements should be restated only if the restatement would be material to investors making current investment decisions. For example, a material error that is not important to a current investment decision would not require restatement of the financial statements in which the error occurred, but would need to be promptly corrected and prominently disclosed in the current period.
• Amendments to previously filed annual or interim reports to reflect restated financial statement may not be necessary 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 in previously issued financial statements should always be disclosed in the filing, even if the error is determined not to be material.
• Guidance, based on the needs of investors, should be issued regarding disclosure of financial information during the period in which the restatement is being prepared, as well as disclosure about the need for a restatement and about the restatement itself.

Reasonableness of Judgments

• The SEC and PCAOB should issue statements of policy articulating how they each evaluate the reasonableness of accounting and auditing judgments, respectively, including factors considered when making this evaluation.
• The statement of policy applicable to accounting-related judgments should address the choice and application of accounting principles and estimates and evidence related to the application of an accounting principle, as well as the reasonableness of preparers' accounting judgments.
• The statement of policy applicable to auditing-related judgments should address the reasonableness of judgments made based on PCAOB auditing standards.
• The PCAOB’s 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.

Presentation of Financial and Other Information

• The SEC should require a short, layered, plain English executive summary at the beginning of a company’s annual and quarterly reports, about two pages in length, which provides a cross-referenced roadmap to the rest of the report and covers the company’s main business units, GAAP and non-GAAP measures, key metrics for its past performance and an outline of its business outlook.
• The private sector should develop key performance indicators (KPIs), on an activity and industry basis, which would capture important aspects of a company’s activities that may not be fully reflected in its financial statements or may be non-financial measures, but would be useful disclosure in periodic reports.
• The different sources of changes in a company’s income should be clarified, for example, by clearly distinguishing cash receipts from unrealized changes in fair value.
• FASB should develop a 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.
• The SEC should phase-in the use of XBRL.
• The SEC should issue a new comprehensive interpretive release regarding the use of corporate websites for disclosures of financial information, which should address issues such as liability for information presented in a summary format, treatment of hyperlinked information, treatment of non-GAAP disclosures and GAAP reconciliations, and clarification of the public availability of information disclosed on a reporting company’s website.

Reducing Complexity

• FASB should delineate authoritative from non-authoritative interpretive guidance by completing the codification of all U.S. GAAP and establishing FASB as the single authoritative standard setter for U.S. GAAP, with non-authoritative guidance not required to be given more credence than any other non-authoritative sources.
• FASB should move away from industry-specific guidance in authoritative literature, eliminate alternative accounting methods for the same transaction (unless the alternative has a compelling rationale), and minimize the use of scope exceptions.
• The SEC should regularly update and, as appropriate, remove portions of its disclosure requirements as new FASB standards are issued.
• The SEC should focus on registrant-specific guidance and refer to FASB those accounting issues of relatively broad significance identified by the staff in the process of reviewing filings by registrants.
• The SEC staff should emphasize that its published comment letters and "preclearance" processes are registrant-specific and do not represent binding precedent on other registrants.
• FASB should opt for intermediate approaches, such as proportionate recognition, consideration of qualitative factors and enhanced disclosures, in lieu of all-or-nothing bright-line tests, to more fairly present a company’s financial condition and operating results.
• Investors, preparers, auditors and regulators should be trained to consider the economic substance and business purpose of transactions in determining the appropriate accounting, rather than relying on mechanical compliance with rules.
• FASB should be judicious in issuing new standards and interpretations that expand the use of fair value until various plans and frameworks have been completed.
• FASB should assign a single presumptive measurement attribute, such as amortized cost, within each business activity to the maximum extent feasible, which is consistent across the financial statements.
• FASB should aggregate business activities into operating, investing and financing sections.