SEC posts Final Report of Advisory Committee on Improvements to Financial Reporting

By Cydney Posner

Earlier this month, the SEC posted the final report of its Advisory Committee on Improvements to Financial Reporting. I previously reported on the draft report that the committee had posted (see posting on 7/23/08). While the final report conforms largely to the most recent draft, there were a few notable changes. This email highlights a few of the more interesting changes in the final report.

The most extensive Committee debate, and the recommendations that apparently drew the most fire from investors, concerned materiality and restatements. In particular, financial statement users objected strenuously to the statement that "[j]ust 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." In current practice, materiality guidance related to the use of qualitative factors is interpreted generally as being one-directional, that is, as providing that qualitative considerations can result in a small error being considered material, while a large error is considered material without regard to qualitative factors. This practice has led to a large number of "mechanical' restatements and related unfortunate "black-out" periods. Accordingly, in the draft, the Committee recommended "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." Investor commenters, however, expressed concerns that, under this standard, managements might take the opportunity to view too many errors as immaterial. As a result, in the final draft, the recommendation was substantially diluted to remove the specific reference to the impact of qualitative factors on large errors and to refer instead only to the need for materiality to be determined through a consideration of qualitative and quantitative factors.

Although no significant cutback in a recommendation resulted, analysts commenters raised concerns regarding the recommendation that past financial statements should be restated only if the restatement would be material to investors making current investment decisions. The current guidance that is detailed in SAB 108 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). The Committee was concerned that this practice results in much unneeded cost and delay, along with the abhorred black-out periods. Analysts, however, were concerned that the failure by companies to correct past errors in earlier financial statements would simply shift the burden to the analysts to make those changes in connection with preparation of their models. The Committee consensus was that that these concerns should be assuaged by the recommendation that the uncorrected errors would but would be promptly corrected and prominently disclosed in the current period, would not have been material during the earlier reporting periods and that the current financial statements would need to include an explanatory footnote that should relieve much of the feared burdened.

Regarding the use of judgment, the Committee had recommended that the SEC and PCAOB issue statements of policy articulating how they each evaluate the reasonableness of accounting and auditing judgments, respectively, including factors considered when making this evaluation. With the increased use of principles-based standards, there has been an increasing focus on the use of judgment. While preparers appear to support the trend toward less prescriptive rules, there is a perception that, in evaluating judgments, regulators may not always respect those judgments. The Committee believes that a primary cause of this concern is a lack of clarity and transparency into the approach the SEC uses to evaluate the reasonableness of judgments. Conversely, regulators assert that they do respect judgments, but express concerns that some companies may defend certain errors inappropriately as "reasonable judgments." The Committee discussion of this recommendation made clear that its purpose was not only to establish standards of good practice (an "acceptable rigor" ) for judgment-making, but also to encourage an environment that would reduce second-guessing and defensiveness. However, the discussion also made clear that the recommendation was not to create a safe arbor or otherwise to preclude challenges of managements'' judgments by either auditors or regulators.

On a completely different topic, the Committee had originally recommended that a new primary financial statement be added to reconcile the statements of income and cash flows by major classes of measurement attributes. The reconciliation would address some of the problems inherent in the "mixed attribute" model (use of both historical value and fair value accounting) by disaggregating changes in assets and liabilities based on cash, accruals and changes in fair value, among others. The purpose of the presentation was to delineate the nature of changes in income (e.g., fair value volatility, changes in estimate) and allow investors to assess the degree to which management controls each one. Some commenters objected to the problems involved in preparing the reconciliation, and the recommendation was diluted just slightly to recommend only that a practical means be developed for reconciling the statements of income and cash flows by major classes of measurement attributes. (An example of the suggested reconciliation is contained in recommendation 1.1.)

The final report also contains Appendices that might be of some interest. For example, Appendix H includes an example of a Microsoft Summary Report Page that highlights performance, outlook and opportunities and provides tiering to segment and financial performance detail; some XBRL-tagged financial statement pages with hyperlinks; an example of a detailed schedule of key performance indicators (KPI) (one of the Committee's recommendations intended to capture important aspects of a company’s activities that may not be fully reflected in its financial statements or may be non-financial measures); and an example of an executive summary for an Annual Report that highlights CEO message, company financial highlights, segment highlights and CFO message, along with hyperlinks to further detail.

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