[Federal Register: February 28, 2008 (Volume 73, Number 40)]
[Notices]
[Page 10897-10939]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr28fe08-124]
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Part III
Securities and Exchange Commission
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Progress Report of the SEC Advisory Committee on Improvements to
Financial Reporting; Notice
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SECURITIES AND EXCHANGE COMMISSION
[Release Nos. 33-8896; 34-57331; File No. 265-24]
Progress Report 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 its progress report and
is soliciting public comment. The progress report contains the
Committee's developed proposals, conceptual approaches, and matters for
future considerations on improving the financial reporting system in
the United States.
DATES: Comments should be received on or before March 31, 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 message to rule-comments@sec.gov. 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 Committee's progress
report. The full text of this progress report is attached and also may
be found on the Committee's web page at http://www.sec.gov/about/
offices/oca/acifr.shtml. The progress report contains the Committee's
developed proposals, conceptual approaches, and matters for future
considerations on improving the financial reporting system in the
United States. This progress report has been approved for issuance by
the Committee. It does not necessarily reflect any position or
regulatory agenda of the Commission or its staff.
All interested parties are invited to comment on the enclosed
progress report. Comments on the progress report are most helpful if
they (1) indicate the specific paragraph and/or page number 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: February 14, 2008.
Nancy M. Morris,
Committee Management Officer.
Appendix
Progress Report of the Advisory Committee on Improvements to Financial
Reporting to the United States Securities and Exchange Commission
February 14, 2008
Progress Report of the Advisory Committee on Improvements to Financial
Reporting to the United States Securities and Exchange Commission
Table of Contents
Transmittal Letter
Executive Overview
Introduction
Chapter 1: Substantive Complexity
Chapter 2: Standards-Setting Process
Chapter 3: Audit Process and Compliance
Chapter 4: Delivering Financial Information
Appendices
A--Separate Statement of Mr. Wallison
B--Examples of Substantive Complexity
C--Committee Members, Official Observers, and Staff
SEC Advisory Committee on Improvements to Financial Reporting,
Washington, DC 20549
February 14, 2008
The Honorable Christopher Cox
Chairman
Securities and Exchange Commission
100 F Street, NE., Washington, DC 20549-1070
Dear Chairman Cox:
It is my pleasure and privilege to present to you, and the other
Commissioners, on behalf of the Advisory Committee on Improvements to
Financial Reporting, a progress report of the Committee's developed
proposals, conceptual approaches, and currently identified matters for
future consideration.
Our Committee has worked diligently to provide an interim progress
report to you. The developed proposals in our progress report are
proposals that we believe could be implemented by the Commission, its
staff, or other bodies, as appropriate. These 12 proposals are
summarized in the executive overview of our progress report. Conceptual
approaches represent our initial views, which are based on discussions
on a particular subject, but which require additional vetting before
formalization into a developed proposal. Matters for future
consideration are areas in which deliberations and research have not
yet begun. After the conclusion of the Committee's work later this
year, we will issue a final report with written recommendations.
We commend the Commission for its initiative in creating the
Committee. You have been generous in furnishing staff and other
resources. We would like to thank the staff members whose participation
was invaluable during this phase of the Committee's work. These include
from the Commission staff:
Conrad Hewitt
John W. White
James Daly
Bert Fox
Stephanie Hunsaker
Nili Shah
Brett Williams
James Kroeker
Wayne Carnall
Adam Brown
Todd E. Hardiman
Shelly Luisi
Amy Starr
These also include Russell Golden, Holly Barker and Christopher
Roberge
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from the Financial Accounting Standards Board and Sharon Virag from the
Public Company Accounting Oversight Board.
We also want to thank our Official Observers whose participation
and counsel have been invaluable to the Committee during this time:
Robert Herz
Kristen Jaconi
Mark Olson
Charles Holm
Phil Laskawy
We look forward to working with the Committee staff and Official
Observers in the coming months as we develop our final report and
recommendations.
Respectfully submitted on behalf of the Committee,
/s/ Robert C. Pozen
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Robert C. Pozen
Committee Chairman
cc: Commissioner Paul S. Atkins
Commissioner Kathleen L. Casey
Members and Official Observers of the Committee
Conrad Hewitt
John White
James L. Kroeker
Nancy M. Morris
Executive Overview \1\
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\1\ This report has been approved by the Committee and reflects
the views of a majority of its members. It does not necessarily
reflect any position or regulatory agenda of the Commission or its
staff.
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In July 2007, the U.S. Securities and Exchange Commission (SEC or
Commission) chartered the Advisory Committee on Improvements to
Financial Reporting (Committee). The Committee's assigned objective is
to examine the U.S. financial reporting system in order to make
recommendations intended to increase the usefulness of financial
information to investors,\2\ while reducing the complexity of the
financial reporting system to investors, companies, and auditors.
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\2\ The term ``investor(s)'' is used throughout this progress
report to refer to investors, creditors, rating agencies, and other
users.
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After the conclusion of our work, we will issue a final report with
written recommendations to the Chairman of the SEC. In order to
maximize our effect, we intend to issue a limited number of focused
recommendations that address acknowledged problem areas and that we
believe can be adopted without legislation, rather than attempting to
address all perceived shortcomings in the financial reporting system.
All Committee members present at our February 11, 2008 meeting
voted unanimously to issue to the Chairman of the SEC this progress
report of the Committee's developed proposals, conceptual approaches,
and currently identified matters for future consideration and to
publish the progress report in order to encourage public feedback.
Developed proposals are proposals that we believe could be implemented
by the Commission, its staff,\3\ or other bodies, as appropriate; these
are summarized in the second part of this executive overview.
Conceptual approaches represent our initial views, which are based on
discussions on a particular subject, but which still require additional
vetting before formalization into a developed proposal. Matters for
future consideration are areas in which deliberations and research have
not yet begun.
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\3\ We note that some of our developed proposals, conceptual
approaches, and matters for future considerations may require SEC
action, while others may be implemented by SEC staff. We have,
however, generally adopted a convention of addressing these areas to
the SEC for convenience. We leave the determination of whether the
proposals require SEC or SEC staff action to the discretion of the
SEC and its staff.
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This progress report represents our work to date, which has
included four public meetings where these topics were deliberated by
the full Committee. In generating this progress report, we also
considered all of the public comments received to date on our work.\4\
All of the developed proposals, conceptual approaches and matters for
future consideration were adopted unanimously (except for one
dissenting vote on one proposal, as noted herein, which resulted in one
separate statement from Mr. Wallison, attached as appendix A of this
progress report).
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\4\ Comments to the Committee are available at http://
www.sec.gov/comments/265-24/265-24.shtml. We have and continue to
welcome feedback at any time from investors, registrants, auditors,
and others on our work. Information on how to submit comments is
available at: http://www.sec.gov/about/offices/oca/acifr.shtml.
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We explain each of our developed proposals, conceptual approaches
and matters for future consideration in the body of this progress
report. The progress report is organized by the topics considered by
the four subcommittees that were created in order to research, develop,
and propose preliminary recommendations to the full Committee for
discussion and decision-making. Thus, chapter one is on substantive
complexity; chapter two on the standards-setting process; chapter three
on audit process and compliance; and chapter four on delivery of
financial information. Later in 2008, we will also identify and analyze
some of the issues involved with the potential movement from a U.S.-
based accounting regime to a global accounting system.
This executive overview highlights the key themes that tie together
the chapters in this progress report, with a few examples to illustrate
each theme.\5\ The main themes are:
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\5\ We wish to emphasize that the examples we give are
illustrative only. We do not mean to imply any order of priority.
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1. Increasing emphasis on the investor perspective in the financial
reporting system.
2. Consolidating the process of setting and interpreting accounting
standards.
3. Promoting the design of more uniform and principles-based
accounting standards.
4. Creating a disciplined framework for the increased use of
professional judgment.
5. Taking steps to coordinate generally accepted accounting
principles in the U.S. (GAAP) with international financial reporting
standards (IFRS).
I. Themes
I.A. Investor Perspective
The current system of financial reporting, including the process by
which financial reporting standards are developed, attempts to balance
the interests of relevant parties such as preparers, auditors, and
investors. In practice, however, the system has sometimes been more
responsive to the interests of preparers and auditors than to the needs
of investor groups.
We believe that the financial reporting system should give pre-
eminence to the needs of investors, while not ignoring the interests of
other relevant parties. In this regard, we propose that investors be
better represented on the Financial Accounting Standards Board (FASB)
and the Financial Accounting Foundation (FAF). We also propose that the
determination of how to correct financial statement errors should be
based on the needs of current investors, who should, in any event, be
provided with more disclosure regarding such errors.
With regard to the delivery of financial information, we propose
that the SEC clarify certain legal issues related to the use of company
websites as a vehicle for providing useful information to different
types of investors in order to facilitate creative methods to present
such information, such as in tiered formats. We also propose a gradual
phase-in of interactive disclosure technology (i.e., XBRL-tagging) to
facilitate the ability of investors to more easily access comparative
arrays of company
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information, while minimizing the burdens on preparers (especially
smaller companies). A phase-in approach would allow for enhanced
understanding of the technology, proven use of the new XBRL U.S. GAAP
Taxonomy, and further development of tagging and rendering software.
I.B. Setting Standards and Interpretative Process
The current financial reporting system is characterized by a large
volume of standards, including individual standards that are too long
or complicated; interpretations; and detailed application guidance from
a variety of public and private sources. This volume and complexity
have led to concerns about whether the FASB is following appropriate
priorities within a consistent conceptual framework in adopting
standards, and whether investors, preparers, and auditors can
efficiently find the complete body of authoritative literature on an
accounting issue.
While the FASB has made considerable progress in addressing both
concerns, we believe that certain measures are needed to enhance the
process for adopting new standards and issuing interpretations of
existing standards.\6\ For example, we propose that the FASB should set
explicit priorities based on consultation with an Agenda Advisory
Group, which would include representatives of the SEC and the Public
Company Accounting Oversight Board (PCAOB), as well as representatives
from the investor, preparer, and auditor communities. Further, the FASB
should fully explain and expose for comment, in documents containing
proposed significant new standards, its process for conducting cost-
benefit studies, including field interviews and testing before
finalizing any significant new accounting standard. Also, we propose
that the FASB, with input from the Agenda Advisory Group, should
conduct periodic assessments of existing standards to determine if they
are operating as intended.
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\6\ We recognize that the FASB has processes that are moving in
the direction of the objectives underlying our interim developed
proposals. We look forward to further discussion with the FASB to
evaluate whether additional improvements would more effectively
achieve the desired objectives. We plan to consider this dialogue in
making final recommendations for process enhancements to the U.S.
standards-setter.
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With the implementation of these proposals, we propose that the
FASB should be, to the extent practicable, the sole standards-setter
for GAAP and the primary source of broad interpretations of existing
accounting standards. The FASB should perform these functions with a
high degree of independence, but it should coordinate closely with the
SEC, including through the proposed Agenda Advisory Committee. When it
is necessary for the SEC to issue broadly applicable interpretations,
we are considering the manner in which the SEC develops and
communicates those interpretations. Nevertheless, we believe the SEC
should continue to provide comments on registrant-specific matters, but
these comments should not be viewed as broadly applicable. We propose
that the authoritative source of GAAP should be limited, as much as
possible, to the contents of the FASB's codification project, which
will be updated on a regular basis.
I.C. Design of Standards
GAAP contains many detailed rules with several industry-specific
exceptions and alternative accounting policies for the same
transaction. Moreover, some of these rules have all-or-nothing results,
which stem from bright line tests. This combination allows companies
and auditors to reach a technically compliant conclusion that may be
inconsistent with the underlying economic substance of the transaction,
thereby potentially undermining an investor's complete and accurate
understanding of the transaction. For example, transactions involving
the right to use an asset for a promise to pay a series of payments in
the future can be kept off a company's balance sheet if detailed rules
are followed.
In response, we propose that the FASB move away from industry-
specific guidance to activity-based guidance (e.g., from banking as an
industry to lending as an activity by any company) and strive to reduce
the number of alternative ways available under GAAP to account for the
same transaction. We also plan to consider, among other possibilities,
the feasibility of proportionate recognition, rather than all-or-
nothing results, to better reflect the rights conveyed by agreements
and obligations incurred.
Some believe an increased use of fair value measurements will
better portray the current valuation of past transactions and improve
financial reporting. Others believe the increased use of fair value
measurements will cause unnecessary volatility, will decrease the
reliability of financial statements, and will only increase investor
confusion. We plan to deliberate whether, among other approaches, to
support the FASB's project to consider changing the income statement
format into two or more groupings designed to help investors better
understand the different sources of changes in a company's income--for
example, by separating cash or accrued earnings from changes resulting
from fluctuations in the fair value of assets such as publicly-traded
bonds.
More broadly, we will consider recommending that the FASB design
accounting standards with more general principles and fewer detailed
rules in order to prevent the manipulation of technical requirements to
reach pre-conceived accounting results.
I.D. Professional Judgment
The preparation and audit of financial statements have always
required the use of judgment. The recent evolution of accounting
requires even more judgment--for example, the more frequent use of fair
value involves estimates of value that may be less objectively
determined than historical cost measures. Similarly, the revised
auditing standards recently issued by the PCAOB emphasize the need for
professional judgment in taking a risk-based approach to performing
internal control audits.
As noted above, we are about to study the merits of moving in the
direction of more principles and fewer detailed rules. Also, as
mentioned below, international accounting standards, as they exist
today, contain less detailed guidance and fewer rules than GAAP.
Detailed rules not only increase the complexity of the financial
reporting system, but they also permit the structuring of transactions
to achieve a particular accounting result, even if the results are
inconsistent with the economic substance of the transactions or the
underlying purposes of the rules.
In recognition of the increasing use of accounting judgment, we are
making two developed proposals. First, we propose asking the FASB to
conduct post-adoption reviews of significant new standards, generally
within one to two years of their effective dates to ascertain the
degree of diversity in practice in using judgment when applying those
standards. If that diversity is too broad or otherwise inappropriate,
we would expect the FASB to amend the standard or issue interpretative
guidance.
Second, we propose that the SEC and PCAOB adopt frameworks for
reviewing the exercise of judgment. The framework applicable to
accounting judgments would require a disciplined process, including the
identification of available alternatives, analysis of the relevant
literature, review of the pertinent facts, and a well-reasoned
explanation of the conclusions--all
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documented contemporaneously with the making of the accounting
judgment. We believe adoption of these frameworks would encourage
executives and auditors to follow a disciplined process in making
judgments, and thereby give investors more confidence in the ways in
which accounting and auditing judgments are being exercised.
I.E. Global Convergence
At present, U.S. companies follow GAAP; in most other countries,
publicly-traded companies are increasingly following IFRS as adopted by
the International Accounting Standards Board (IASB). We support the
long-term goal of converging GAAP with IFRS in order to reduce
accounting costs to investors and others in an increasingly global
business environment. But we recognize that there are various paths to
convergence, and it may take years for full convergence to be achieved.
Therefore, we believe that it is quite useful to propose enhancements
to the financial reporting system in the U.S.
Later in 2008, we will identify and analyze some of the issues to
be resolved in the move toward global convergence of accounting
standards. At this time, we note that the principles contained in IFRS
are less encumbered by detailed rules than GAAP; accordingly, GAAP will
probably need to become less rules-based in order to promote the goal
of global convergence. We also note that IFRS has little industry-
specific guidance, and we encourage the IASB to continue in this
manner, consistent with our proposal that the FASB issue activity-based
standards rather than industry-specific accounting standards.
On the other hand, IFRS contains a number of alternative accounting
policies for the same activity, and there are political pressures to
add exceptions in certain countries. As part of the effort to promote
global convergence, we urge the IASB to continue to reduce the number
of alternative accounting policies currently available and to resist
the political pressures for country exceptions.
II. Summary of Developed Proposals
Summarized below are our developed proposals based on our work to
date. These developed proposals are discussed in greater detail in the
remainder of this progress report. These developed proposals are
numbered consecutively in this executive overview, with a reference in
parentheses to their position in the body of the report.
1. GAAP should be based on business activities,\7\ rather than
industries. As such, the SEC should recommend that any new projects
undertaken jointly or separately by the FASB be scoped on the basis of
business activities rather than industries. Any new projects should
include the elimination of existing industry-specific guidance in
relevant areas as a specific objective of those projects, unless, in
rare circumstances, retaining industry guidance can be justified on the
basis of cost-benefit considerations (discussed in section II.A of
chapter 1).
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\7\ As discussed in section II.B of chapter 1 regarding
management intent, we have not taken a position as to whether intent
is an appropriate basis of accounting. Similarly, we express no view
on whether intent provides a meaningful distinction between business
activities.
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The SEC should also recommend that, in conjunction with its current
codification project, the FASB add a project to its agenda to remove or
minimize existing industry-specific guidance that conflicts with
generalized GAAP, taking into account the pace of convergence
efforts.\8\ (Chapter 1--developed proposal 1.1)
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\8\ Some constituents understand ``convergence'' to mean that
GAAP and IFRS (as published by the IASB) will eventually be
harmonized, at which point no substantive differences will exist
between the two bodies of accounting literature. Others understand
it to mean a discrete transition from GAAP to IFRS at a specified
date without respect to whether the two bodies of literature are
substantially harmonized. The timing of these two approaches may
differ, which would likely impact the prioritization of this
proposal to eliminate existing U.S. industry-specific guidance on
the FASB's agenda. In either case, we believe industry-specific
guidance should be substantially eliminated prior to convergence--
either as a component of the convergence plan, or by establishing a
specified date after which the use of industry-specific guidance
would be prohibited.
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2. GAAP should be based on a presumption that formally promulgated
alternative accounting policies should not exist. The SEC should
recommend that any new projects undertaken jointly or separately by the
FASB not provide additional optionality, unless, in rare circumstances,
it can be justified. Any new projects should include the elimination of
existing alternative accounting policies in relevant areas as a
specific objective of those projects, unless, in rare circumstances,
the optionality can be justified. (Chapter 1--developed proposal 1.2)
3. Additional investor representation on standards-setting bodies
is central to improving financial reporting. Only if investor
perspectives are properly considered by all parties will the output of
the financial reporting process meet the needs of those for whom it is
primarily intended to serve. Therefore, the perspectives of investors
should have pre-eminence. To achieve that pre-eminence in standards-
setting, the SEC should encourage the following improvements:
Add investors to the FAF to give more weight to the views
of different types of investors, both large and small.
Give more representation on both the FASB and the FASB
staff to experienced investors who regularly use financial statements
to make investment decisions to ensure that standards-setting considers
fully the usefulness of the resulting information. (Chapter 2--
developed proposal 2.1)
4. The SEC should assist the FAF with enhancing its governance of
the FASB, as follows:
By encouraging the FAF to develop performance metrics to
assess the FASB's adherence to the goals in its mission statement,
objectives, and precepts and to improve its efficiency.
By supporting the FAF's changes outlined in its Request
for Comments on Proposed Changes to Oversight, Structure and Operations
of the FAF, FASB and GASB, with minor modifications regarding
composition of the FAF and the FASB, as proposed in section II of
chapter 2, and agenda-setting, as proposed in section IV of chapter 2.
By encouraging the FAF to amend the FASB's mission
statement, stated objectives, and precepts to emphasize that an
additional goal should be to minimize avoidable complexity. (Chapter
2--developed proposal 2.2)
5. The SEC should encourage the FASB to further improve its
standards-setting process and timeliness, as follows:
Create a formal Agenda Advisory Group that includes strong
representation from investors, the SEC, the PCAOB, and other
constituents, such as preparers or auditors, to make recommendations
for actively managing U.S. standards-setting priorities.
Refine procedures for issuing new standards by: (1)
Implementing investor pre-reviews designed to assess perceived benefits
to investors, (2) enhancing cost-benefit analyses, and (3) requiring
improved field visits and field tests.
Improve review processes for new standards by conducting
post-adoption reviews of every significant new standard, generally
within one to two years of its effective date, to address interpretive
questions and reduce the diversity of practice in applying the
standard, if needed.
Improve processes to keep existing standards current and
to reflect changes in the business environment by conducting periodic
assessments of
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existing standards. (Chapter 2--developed proposal 2.3)
6. The number of parties that either formally or informally
interprets GAAP and the volume of interpretative implementation
guidance should continue to be reduced. The SEC should coordinate with
the FASB to clarify roles and responsibilities regarding the issuance
of interpretive implementation guidance, as follows:
The FASB Codification, a draft of which was released for
verification on January 16, 2008, should be completed in a timely
manner. In order to fully realize the benefits of the FASB's
codification efforts, the SEC should ensure that the literature it
deems to be authoritative is integrated into the FASB Codification to
the extent possible, or separately re-codified, as necessary.
To the extent practical, going forward, there should be a
single standards-setter for all authoritative accounting standards and
interpretive implementation guidance that are applicable to a
particular set of accounting standards, such as GAAP or IFRS. For GAAP,
the FASB should continue to serve this function. To that end, the SEC
should only issue broadly applicable interpretive implementation
guidance in limited situations (see section VI of chapter 2).
All other sources of interpretive implementation guidance
should be considered non-authoritative and should not be required to be
given more credence than any other non-authoritative sources that are
evaluated using well-reasoned, documented professional judgments made
in good faith. (Chapter 2--developed proposal 2.4)
7. The FASB or the SEC, as appropriate, should issue guidance
reinforcing 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 quantitatively small error is material, qualitative factors also may
lead to a conclusion that a quantitatively large error is not material.
The evaluation of errors should be on a ``sliding scale.''
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.
(Chapter 3--developed proposal 3.1)
8. The FASB or the SEC, as appropriate, should issue guidance on
how to correct an error consistent with the principles outlined below:
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 investor's assessment
of the annual financial statements would not require restatement of the
annual financial statements in which the error occurred, but would need
to be disclosed in an appropriate document, and, to the extent that the
error remains uncorrected in the current period, corrected 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 statements, 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.
All errors, other than clearly insignificant errors,
should be 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.
The current disclosure during the period in which the
restatement is being prepared, about the need for a restatement and
about the restatement itself, is not consistently adequate for the
needs of investors and should be enhanced. (Chapter 3--developed
proposal 3.2)
9. 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 8 above. (Chapter 3--
developed proposal 3.3)
10. The SEC should adopt a judgment framework for accounting
judgments. The PCAOB should also adopt a similar framework with respect
to auditing judgments. Careful consideration should be given in
implementing any framework to ensure that the framework does not limit
the ability of auditors and regulators to ask appropriate questions
regarding judgments and take actions to require correction of
unreasonable judgments.
The proposed framework applicable to accounting-related judgments
would include the choice and application of accounting principles, as
well as the estimates and evaluation of evidence related to the
application of an accounting principle. We believe that a framework
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 important and would be
beneficial to investors, preparers, and auditors. Therefore, we propose
that the PCAOB develop a professional judgment framework for the
application and evaluations of judgments made based on PCAOB auditing
standards. (Chapter 3--developed proposal 3.4)
11. The SEC should, over the long-term, mandate the filing of XBRL-
tagged financial statements after the satisfaction of certain
preconditions relating to: (1) Successful XBRL U.S. GAAP Taxonomy
testing, (2) capacity of reporting companies to file XBRL-tagged
financial statements using the new XBRL U.S. GAAP Taxonomy on the SEC's
EDGAR system, and (3) the ability of the EDGAR system to provide an
accurately rendered version of all such tagged information. The SEC
should phase in XBRL-tagged financial statements as follows:
The largest 500 domestic public reporting companies based
on unaffiliated market capitalization (public float) should be required
to furnish to the SEC, as is the case in the voluntary program today, a
document prepared separately from the reporting companies' financial
statements that are filed as part of their periodic Exchange Act
reports. This document would contain the following:
[cir] XBRL-tagged face of the financial statements.\9\
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\9\ To allow this first phase, the SEC EDGAR system must permit
submissions using the new XBRL U.S. GAAP Taxonomy.
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[cir] Block-tagged footnotes to the financial statements.\10\
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\10\ We understand that tagging beyond the face of the financial
statements and block-tagging of footnotes, such as granular tagging
of footnotes and non-financial data, may require significant effort
and would involve a significant number of tags.
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Domestic large accelerated filers (as defined in SEC
rules, which would include the initial 500 domestic public reporting
companies) should be added
[[Page 10903]]
to the category of companies, beginning one year after the start of the
first phase, required to furnish XBRL-tagged financial statements to
the SEC.
Once the preconditions noted above have been satisfied and
the second phase-in period has been implemented, the SEC should
evaluate whether and when to move from furnishing to the SEC to the
official filing of XBRL-tagged financial statements with the SEC for
the domestic large accelerated filers, as well as the inclusion of all
other reporting companies, as part of a company's Exchange Act periodic
reports. (Chapter 4--developed proposal 4.1) \11\
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\11\ A dissenting vote on developed proposal 4.1 was cast by
Peter Wallison.
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12. The SEC should issue a new comprehensive interpretive release
regarding the use of corporate Web sites for disclosures of corporate
information, which addresses issues such as liability for information
presented in a summary format, treatment of hyperlinked information
from within or outside a company's Website, treatment of non-GAAP
disclosures and GAAP reconciliations, and clarification of the public
availability of information disclosed on a reporting company's Web
site.
Industry participants should coordinate among themselves to develop
uniform best practices on uses of corporate websites for delivering
corporate information to investors and the market. (Chapter 4--
developed proposal 4.2)
* * * * *
We believe publication of this progress report will increase the
chances of our recommendations being implemented. The developed
proposals in this progress report are described with enough detail to
enable the SEC and public commentators to evaluate whether regulatory
action in these areas is warranted. The description of conceptual
approaches in this progress report will hopefully stimulate discussion
and debate on these topics so that we can put forward additional
developed proposals later this year.
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\12\ This report has been approved by the Committee and reflects
the views of a majority of its members. It does not necessarily
reflect any position or regulatory agenda of the Commission or its
staff.
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Introduction\12\
I. Our Objective
In July 2007, the U.S. Securities and Exchange Commission (SEC or
Commission) chartered the Advisory Committee on Improvements to
Financial Reporting (Committee). The Committee's assigned objective is
to examine the U.S. financial reporting system in order to make
recommendations intended to increase the usefulness of financial
information to investors,\13\ while reducing the complexity of the
financial reporting system to investors, companies, and auditors.
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\13\ The term ``investor(s)'' is used throughout this progress
report to refer to investors, creditors, rating agencies, and other
users.
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More specifically, our charter identifies the following areas of
inquiry:
The current approach to setting financial accounting and
reporting standards, including: (1) The principles-based versus rules-
based standards, (2) the inclusion within standards of exceptions,
bright lines, and safe harbors, and (3) the process for providing
timely guidance on implementation issues and emerging issues.
The current process of regulating compliance with
accounting and reporting standards.
The current system for delivering financial information to
investors and accessing that information.
Other environmental factors that drive avoidable
complexity, including the possibility of being second-guessed, the
structuring of transactions to achieve an accounting result, and
whether there is a hesitance by professionals to exercise professional
judgment in the absence of detailed rules.
Whether there are current accounting and reporting
standards that do not result in useful information to investors, or
impose costs that outweigh the resulting benefits.
Whether the growing use of international accounting
standards has an impact on the relevant issues relating to the
complexity of U.S. accounting and reporting standards and the
usefulness of the U.S. financial reporting system.
II. Our Guiding Principles
We believe that financial reporting should provide information that
aids investors in making investment, credit, and similar resource
allocation decisions.\14\ However, some argue that, over time,
financial reporting has become a burdensome compliance exercise with
decreasing relevance to investors. This effect can be attributed, in
part, to: (1) The evolution of new business strategies and financing
techniques that stretch the limits of what the traditional reporting
framework can effectively convey, and (2) an overly litigious culture
that, arguably, results in financial reporting designed as much to
protect against liability as to inform investors. As a result, we
believe the disconnect between current financial reporting and the
information necessary to make sound investment decisions has become
more pronounced.
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\14\ Adapted from the FASB Preliminary Views document and IASB
Discussion Paper, Conceptual Framework for Financial Reporting:
Objective of Financial Reporting and Qualitative Characteristics of
Decision-Useful Financial Reporting Information (July 6, 2006),
which states, ``The objective of general purpose external financial
reporting is to provide information that is useful to present and
potential investors and creditors and others in making investment,
credit, and similar resource allocation decisions.''
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A key factor often cited as driving this disconnect is complexity,
which has rarely been defined in the context of financial reporting. We
have developed and applied the following definition of complexity in
this context to guide our deliberations:
Definition of Complexity
The state of being difficult to understand and apply. Complexity in
financial reporting refers primarily to the difficulty for:
1. Investors to understand the economic substance of a transaction
or event and the overall financial position and results of a company.
2. Preparers to properly apply generally accepted accounting
principles in the U.S. (GAAP) and communicate the economic substance of
a transaction or event and the overall financial position and results
of a company.
3. Other constituents to audit, analyze, and regulate a company's
financial reporting.
Complexity can impede effective communication through financial
reporting between a company and its stakeholders. It also creates
inefficiencies in the marketplace (e.g., increased investor, preparer,
audit, and regulatory costs) and suboptimal allocation of capital.
Causes of Complexity
The causes of complexity are many and varied. We have identified
the following significant causes of complexity:
1. Complex activities--The increasingly sophisticated nature of
business transactions can be difficult to understand, particularly with
respect to the growing scale and scope of companies with operations
that cross international boundaries and financial reporting regimes.
2. Incomparability and inconsistency--Incomparable reporting of
activities within and across entities
[[Page 10904]]
arises because of factors such as exceptions to general principles,
bright lines, and the mixed attribute model. Some of this guidance
permits the structuring of transactions in order to achieve particular
financial reporting results. Further, to the extent new pronouncements
are adopted prospectively, past and present periods of operating
results are not comparable. This is compounded by the rapid pace at
which new accounting pronouncements are being adopted, which hinders
the ability of all constituents to understand and apply new guidance in
relatively short timeframes.
3. Nature of financial reporting standards--Standards can be
difficult to understand and apply for several reasons, including:
The existence of opposing points of view that were taken
into account when developing standards--most importantly, the attempts
by public companies to smooth amounts that vary from period to period,
versus the requests from those who want such amounts marked to market
each period.
The challenge of describing accounting principles in
simple terms (i.e., plain English) for highly sophisticated
transactions.
The presence of detailed guidance for numerous specific
fact patterns.
The impact of multiple bodies setting standards.
The development of such standards on the basis of an
incomplete and inconsistent conceptual framework.
4. Volume--The vast number of formal and informal accounting
standards, regulations, and interpretations, including redundant
requirements, make finding the appropriate standard or interpretation
challenging for particular fact patterns.
5. Audit and regulatory systems that challenge the use of
professional judgment--The risk of litigation and the fear of being
``second-guessed'' results in (1) a greater demand for detailed rules
on how to apply accounting standards to an ever increasing set of
specific situations, (2) unnecessary restatements that are not
meaningful to investors, and (3) legalistic disclosures that are
difficult to understand.
6. Educational shortcomings--Undergraduate and graduate education
in accounting has traditionally emphasized the mechanics of double-
entry bookkeeping, which favors the use of detailed rules rather than
the full understanding of relevant principles. The same approach is
evident in the certified public accountant exam, as well as continuing
professional education requirements.
7. Information delivery--The need for information varies by
investor type and is often driven by a legal, rather than an investor,
perspective. In addition, the amount and timing of information, as well
as the method by which it is transmitted, may result in complex and
hard-to-navigate disclosures that cause investors to sort through
material that they may not find relevant in order to identify pieces
that are. These factors make it difficult to distinguish the sustaining
elements of an entity from non-operating or other influences.
We observe that two types of substantive complexity exist: (1)
Unavoidable complexity, which is a function of the underlying
transaction or item being accounted for, such as the first cause of
complexity noted above, and (2) avoidable complexity, which is
introduced from other sources. Our focus is on avoidable complexity,
with an emphasis on improvements that are feasible in the near-term.
III. Our Scope
We have limited our deliberations to matters involving SEC
registrants. While financial reporting matters and, more specifically,
GAAP, also apply to private entities, including nonprofit
organizations, our focus is consistent with our role as an advisory
committee to the SEC.
We have also focused our scope as it relates to international
matters. The SEC recently amended its rules to eliminate the
requirement for a GAAP reconciliation for foreign private issuers
reporting under international financial reporting standards (IFRS) as
issued by the International Accounting Standards Board (IASB), and
issued a concept release to explore a more far-reaching prospect--the
possibility of giving domestic issuers the alternative to report using
IFRS. We have proceeded based on two premises: (1) That, despite any
potential actions by the Commission to permit IFRS reporting by
domestic issuers, GAAP will continue to be utilized by many U.S. public
companies for a significant number of years, and (2) that the
convergence process between GAAP and IFRS will continue. As a result,
we believe it is productive to make recommendations on improving GAAP,
as well as the related processes at the Financial Accounting Standards
Board (FASB or the Board), the Public Company Accounting Oversight
Board (PCAOB), and the SEC. At the same time, we will point out how our
developed proposals can be coordinated with the work of the IASB and
the development of IFRS, with the objective of promoting convergence.
IV. Our Approach
After the conclusion of our work, we will issue a final report with
written recommendations to the Chairman of the SEC. In order to
maximize our effect, we intend to issue a limited number of focused
recommendations that address acknowledged problem areas and that we
believe can be adopted without legislation, rather than attempting to
address all perceived shortcomings in the financial reporting system.
To facilitate the development of these recommendations, we have
created subcommittees that report to the full Committee for discussion
and deliberation. The subcommittees are:
1. Substantive Complexity.
2. Standards-Setting Process.
3. Audit Process and Compliance.
4. Delivering Financial Information.
Matters related to international coordination will be addressed, as
appropriate, as part of our deliberations later in 2008.
The purpose of this progress report is to present our developed
proposals, conceptual approaches, and matters for future considerations
based on our work to date. Developed proposals are proposals that we
believe could be implemented by the Commission, its staff,\15\ or other
bodies, as appropriate. Conceptual approaches represent our initial
views, which are based on discussions on a particular subject, but
which still require additional vetting before formalization into a
developed proposal. Matters for future considerations are areas in
which deliberations and research have not yet begun.
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\15\ We note that some of our developed proposals, conceptual
approaches, and matters for future considerations may require SEC
action, while others may be implemented by SEC staff. We have,
however, generally adopted a convention of addressing these areas to
the SEC for convenience. We leave the determination of whether the
proposals require SEC or SEC staff action to the discretion of the
SEC and its staff.
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Our work to date has included four public meetings where these
topics were deliberated by the full Committee. In generating this
progress report, we also considered all of the public comments received
to date on our work.\16\ All of the developed proposals, conceptual
approaches and matters for future consideration were adopted
unanimously (except for one dissenting vote on one proposal, as noted
herein, which resulted in one separate
[[Page 10905]]
statement from Mr. Wallison, attached as appendix A of this progress
report).
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\16\ Comments to the Committee are available at http://
www.sec.gov/comments/265-24/265-24.shtml. We have and continue to
welcome feedback at any time from investors, registrants, auditors,
and others on our work. Information on how to submit comments is
available at: http://www.sec.gov/about/offices/oca/acifr.shtml.
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Chapter 1: Substantive Complexity
I. Introduction
Public companies in the U.S. submit financial statements to the SEC
so investors can monitor their financial performance and make decisions
about capital allocation. Traditionally, those financial statements are
prepared using a common framework referred to as GAAP. A casual review
of audited financial statements might create a perception that amounts
reported in a balance sheet or income statement are mechanical and
precise, when they in fact reflect a great deal of choices, estimation
and judgment.
While ideally GAAP should provide clear and consistent guidance for
preparing financial statements, this is not always true. A number of
factors undermine this ideal, including the causes of complexity
enumerated in the Introduction to this progress report. As a result,
certain parts of GAAP may actually hinder effective comparison of
financial performance between companies. For instance, a large company
may purchase a smaller company to acquire a newly-developed patent that
the smaller company obtained to protect a promising new product. In
that scenario, the purchasing company would record the patent as an
asset under GAAP. However, if the smaller company was not purchased,
but continued developing the product on its own, it would be prohibited
by GAAP from recording an asset to reflect the patent on its balance
sheet.
This example is just one illustration of the avoidable complexity
embedded in the current substantive standards of GAAP. We have
identified what we consider to be the three most pressing forms of
avoidable substantive complexity that currently exist in financial
reporting: (1) Exceptions to general principles, (2) bright lines, and
(3) the mixed attribute model that blends the use of fair value and
historical cost.
Exceptions to general principles create complexity because they
deviate from established standards that are applicable to most
companies. In effect, investors and preparers no longer speak a uniform
language to communicate financial information; they must learn new
dialects. Other constituents in that communication process are
similarly impacted. Our work in this area is divided into four
categories. First, there are many examples of industry-specific
guidance, some of which conflict with more generalized GAAP that
applies across most industries.\17\ Second, alternative accounting
policies give preparers options among acceptable practices, such as
whether or not to apply hedge accounting,\18\ which reduce
comparability across companies. Third, scope exceptions other than
industry-specific guidance represent departures from a principle and
require detailed analyses to determine whether they apply. Fourth,
competing models create requirements to apply different accounting
models to similar types of transactions or events, depending on the
balance sheet or income statement items involved. This diversity
requires all constituents to understand assorted implementation
methods, even though they are based on similar fundamental principles.
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\17\ See comparison of Statement of Financial Accounting
Standard (SFAS) No. 51, Financial Reporting by Cable Television
Companies, with SEC Staff Accounting Bulletin (SAB) 104, Revenue
Recognition (as codified in SAB Topic 13), later in this chapter.
\18\ Hedge accounting guidance is provided in SFAS No. 133,
Accounting for Derivatives and Hedging Activities.
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Bright lines are problematic because they create superficial
borders along a continuous spectrum of transactions. More
fundamentally, certain reporting standards require drastically
different accounting treatments on either side of a bright line. Lease
accounting is often cited as an illustration of bright lines. 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,\19\ where a mere 1%
difference leads to very different accounting.
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\19\ See discussion of bright lines below for further details.
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The mixed attribute model results in amounts that are a blend of
accounting conventions. Some assets and liabilities are measured at
historic cost, others at lower of cost or market, and still others at
fair value. Combinations or subtotals of these numbers thus may not be
intuitively useful to investors. While some advocate using fair value
for the entire balance sheet as a solution, this would exacerbate the
existing questions about relevance and reliability, including
considerable subjectivity in the valuation of thinly-traded assets and
liabilities.
The remainder of this chapter discusses each of these areas and the
manner in which they contribute to complexity in greater depth. It also
contains developed proposals or conceptual approaches to reduce their
effects. The sequence in which these areas are presented does not
necessarily indicate their relative priority to one another. Rather,
certain areas warrant additional research and deliberation before
reasonable proposals can be fully developed, such as those related to
the mixed attribute model and more meaningful groupings of individual
line items on the financial statements. We intend to pursue these
topics during the course of our work later in 2008. Lastly, while
deliberations have been conducted primarily in the context of GAAP, we
believe that our analyses and proposals are similarly applicable under
IFRS.
II. Exceptions to General Principles
II.A. Industry-Specific Guidance
Developed Proposal 1.1: GAAP should be based on business
activities,\20\ rather than industries. As such, the SEC should
recommend that any new projects undertaken jointly or separately by the
FASB be scoped on the basis of business activities rather than
industries. Any new projects should include the elimination of existing
industry-specific guidance in relevant areas as a specific objective of
those projects, unless, in rare circumstances, retaining industry
guidance can be justified on the basis of cost-benefit considerations
(discussed below).
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\20\ As discussed in section II.B of this chapter regarding
management intent, we have not taken a position as to whether intent
is an appropriate basis of accounting. Similarly, we express no view
on whether intent provides a meaningful distinction between business
activities.
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The SEC should also recommend that, in conjunction with its current
codification project, the FASB add a project to its agenda to remove or
minimize existing industry-specific guidance that conflicts with
generalized GAAP, taking into account the pace of convergence
efforts.\21\
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\21\ Some constituents understand ``convergence'' to mean that
GAAP and IFRS (as published by the IASB) will eventually be
harmonized, at which point no substantive differences will exist
between the two bodies of accounting literature. Others understand
it to mean a discrete transition from GAAP to IFRS at a specified
date without respect to whether the two bodies of literature are
substantially harmonized. The timing of these two approaches may
differ, which would likely impact the prioritization of this
proposal to eliminate existing U.S. industry-specific guidance on
the FASB's agenda. In either case, we believe industry-specific
guidance should be substantially eliminated prior to convergence--
either as a component of the convergence plan, or by establishing a
specified date after which the use of industry-specific guidance
would be prohibited.
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[[Page 10906]]
Background
Industry-specific guidance refers to: (1) Exceptions to general
accounting standards for certain industries, (2) industry-specific
guidance created in the absence of a single underlying standard or
principle, and (3) industry practices not specifically addressed or
based in GAAP. Industries covered by this guidance include, but are not
limited to, the insurance, utilities, oil and gas, mining, cable
television, financial, real estate, casino, broadcasting, and film
industries.\22\
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\22\ Refer to appendix B for additional examples.
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Industry-specific guidance has developed for a number of reasons.
These include multiple standards-setters issuing guidance without
consistently coordinating their efforts, a desire to enhance uniformity
throughout an industry, and efforts to customize accounting standards
for allegedly ``special'' transactions or investor needs. In some
cases, industries have developed their own practices in the absence of
applicable authoritative literature.
Industry-specific guidance contributes to avoidable complexity by
making financial reports less comparable.\23\ This is evident across
industries, when conflicting accounting models are used for similar or
identical transactions. It may also be used as an improper analogy to
achieve desired results or to require more conservative accounting
treatments (e.g., by auditors).\24\ In addition, the use of an industry
to define an accounting treatment raises serious questions about which
companies are within the scope of specific guidance. This issue is
especially pronounced for diversified companies, which may be involved
in a number of different industries.
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\23\ As noted previously in the 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):
The proliferation of specialized industry standards creates two
problems that can hinder standard setters' efforts to issue
subsequent standards using a more objectives-oriented regime.
The existence of specialized industry practices may
make it more difficult for standard setters to eliminate scope
exceptions in subsequent standards (e.g., many standards contain
exceptions for insurance arrangements subject to specialized
industry accounting)
The specialized standards may create conflicting GAAP,
which makes it more difficult for accounting professionals to
determine the appropriate accounting.
\24\ For instance, some auditors may use concepts in revenue
recognition from the software industry (Statement of Position (SoP)
97-2) as a basis for postponing the revenue recognition of companies
in other industries without on-point literature. Opponents of this
practice argue such revenue deferral is too conservative and does
not adequately portray the extent to which a company may have
satisfied its product or service obligations in a long-term or
multiple-element contract.
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Further, industry-specific guidance unnecessarily increases the
volume of accounting literature. This, in turn, adds to the costs of
implementing such literature and maintaining it (e.g., monitoring it
for interaction with other new and existing standards and expanding the
size and scope of technical resources and databases). Industry-specific
guidance also increases the cost of training accountants and retaining
industry experts, while compounding the complexity that investors
experience in understanding the present variety of accounting and
disclosure standards. Lastly, it hinders more widespread use of XBRL by
increasing the number of data tags that need to be created, maintained,
and properly used to deliver financial information.
On the other hand, industry-specific guidance may alleviate
complexity by allowing industry reporting to better meet the specific
investor needs in that industry and enhancing comparability across
entities within an industry. Further, it may depict important
differences in the economics of an industry, particularly where
application of a generalized principle may not result in accounting
that is faithful to a transaction's substance. We also note that
historically, some industry-specific guidance has filled a need where
GAAP is otherwise lacking, and simplified or reduced the amount of
guidance a preparer in an industry would need to consider (even though
it might increase complexity across industries generally). Finally,
specialized guidance has been able to address prevalent industry issues
quickly because it was written for a narrower audience than generalized
GAAP.
Industry-specific guidance can be broken into three categories.
First, some industry-specific guidance is explanatory in nature and
consistent with generalized GAAP, such as portions of AICPA Accounting
and Auditing Guides that assist preparers interpret and apply existing,
generalized GAAP. Second, other industry-specific guidance is
inconsistent with generalized GAAP. For example, SFAS No. 51, Financial
Reporting by Cable Television Companies, requires that initial hookup
revenue (a type of nonrefundable upfront fee) is recorded to the extent
of direct selling costs incurred; the remainder is deferred and
recorded in income over the estimated average period that subscribers
are expected to remain connected to the system. However, generalized
guidance indicates this practice is inappropriate unless it is
specifically prescribed elsewhere (such as SFAS No. 51).\25\ Therefore,
similar activities like upfront fees for gym memberships are not
afforded equal treatment. Third, still other industry-specific guidance
was created in the absence of a general principle that applies across
industries. For instance, while there is no comprehensive revenue
recognition standard, SoP 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts, discusses
revenue and cost recognition in areas such as the construction
industry.
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\25\ SAB Topic 13.
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Discussion
We generally believe that industry-specific guidance should be
eliminated to reduce avoidable complexity, particularly as generalized
GAAP is developed. However, we acknowledge that industry-specific
guidance has merit when cost-benefit considerations indicate that the
enhanced information investors would receive under generalized GAAP is
not justified by the direct costs to preparers and the indirect costs
to investors to account for activities in that manner. In such cases,
the SEC should encourage the FASB to work with the relevant industry
participants to identify long-term ways to improve the benefits and
mitigate the costs of the general standard. After making these changes,
the related industry-specific guidance should be phased out as
efficiently as possible. Towards that end, the SEC should encourage the
FASB to provide sufficient time to allow companies to adopt generalized
GAAP with minimal transition costs.
Similarly, we recognize that industry-specific guidance may be
helpful in situations in which: (1) It interprets, rather than
contradicts, principles, and (2) the activities in question are
legitimately different, which are expected to be rare. But to the
extent that such guidance interprets principles (i.e., relates to
implementation), we generally believe it should not be considered
authoritative GAAP.\26\ Further, to the extent that it applies to
[[Page 10907]]
activities that are legitimately different, such guidance should be
scoped and applied on the basis of business activities, rather than
industries.
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\26\ We are aware of constituents, such as the AICPA, that have
historically issued industry-specific implementation guidance. We
generally believe such guidance should not be considered
authoritative. Rather, all authoritative guidance should continue to
be issued by designated standards-setters, such as the FASB in the
U.S., as discussed in chapter 2 of this progress report. If a
designated standards-setter issues implementation guidance for
activities that are prevalent in particular industries, we believe
it should be applicable to all transactions of the type in question,
regardless of the industry in which a company operates.
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In implementing this proposal, we note that the FASB's codification
project can be used to sort existing industry-specific guidance into
one of the three categories identified above (consistent with GAAP,
inconsistent with GAAP, or there is no comparable GAAP). We believe
efforts to reduce existing industry-specific guidance should focus
primarily on cases in which it is inconsistent with generalized GAAP.
Further, as the FASB develops new generalized guidance in areas like
revenue recognition, it should eliminate industry-specific guidance to
the maximum extent feasible. Similarly, the SEC should eliminate its
industry-specific guidance in related areas, if any.
From an international perspective, we note that IFRS currently
contains less industry-specific guidance than GAAP and that such
guidance focuses more on the nature of the business activity (e.g.,
agriculture, insurance contracts, exploration and evaluation of mineral
resources). Nonetheless, the SEC should encourage the IASB to be
mindful of developed proposal 1.1 as it continues to develop a more
comprehensive body of standards. The SEC might also encourage the IASB
to limit future industry-specific guidance to activities whose
economics are legitimately different from other business activities.
Otherwise, we believe specialized accounting for only certain subsets
of similar activities will create avoidable complexity.
We acknowledge that the elimination of existing industry-specific
guidance may result in more complexity over the short-term to the
industries losing special treatment. Nonetheless, we believe it is an
acceptable cost for a long-term reduction in avoidable complexity.
II.B. Alternative Accounting Policies
Developed Proposal 1.2: GAAP should be based on a presumption that
formally promulgated alternative accounting policies should not exist.
The SEC should recommend that any new projects undertaken jointly or
separately by the FASB not provide additional optionality, unless, in
rare circumstances, it can be justified. Any new projects should
include the elimination of existing alternative accounting policies in
relevant areas as a specific objective of those projects, unless, in
rare circumstances, the optionality can be justified.
Background
Alternative accounting policies refer to optionality in GAAP. The
following discussion addresses formally-promulgated options in GAAP,
but does not address choices available to preparers at more of a
practice or implementation level.\27\ Examples of optionality in GAAP
include:\28\
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\27\ For example, companies are free to choose from among
several depreciation methods--straight-line, double-declining
balance, etc.
\28\ Refer to appendix B for additional examples.
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The indirect versus the direct method of presenting
operating cash flows on the statement of cash flows.
The application of hedge accounting.\29\
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\29\ We have noted complexities arising from the application of
hedge accounting, which allows entities to mitigate reported
volatility over the life of the hedge relationship. In this regard,
we generally feel that instead of assessing hedge effectiveness to
determine whether companies qualify for this alternative accounting
treatment, a better policy would be to simply record the ineffective
portion of a hedge in earnings (i.e., a proportionate approach
versus an all-or-nothing approach). We are also aware of the FASB's
derivatives project in this area and are generally supportive of its
progress.
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The option to measure certain financial assets and
liabilities at fair value.
The immediate or delayed recognition of gains/losses
associated with defined benefit pension and other post-retirement
employee benefit plans.
The successful efforts or full cost accounting method
followed by oil and gas producers.
Alternative accounting policies arise for a number of reasons.
These reasons include circumstances in which the pros and cons of
competing policies may be balanced and thus do not result in a single,
clearly preferable approach. Other causes encompass political pressure
that results in standards-setters providing for a preferred and an
alternative accounting method, high administrative costs of the
preferred alternative to preparers (e.g., cost-benefit considerations),
and a portrayal of differences in management intent.
Alternative accounting policies contribute to avoidable complexity
by making financial reports less comparable. This is evident across
companies when identical activities are accounted for differently. Such
alternatives may permit accounting that is less reflective of economic
substance to the extent that they are based on political pressure, and
facilitate differences in accounting policies selected by preparers to
achieve the most favorable treatment. The unnecessary proliferation of
accounting literature to codify these alternatives also adds to
avoidable complexity.
On the other hand, alternative accounting policies may alleviate
complexity by allowing preparers to determine the best accounting for
particular entities based on cost and economic substance, to the extent
that more than one accounting policy is conceptually sound. In
addition, certain alternative policies may be developed more quickly
than a final ``perfect'' standard to minimize the effect of other
unacceptable practices. In other words, they may function as a short-
term fix on the road to ideal accounting.
Management Intent
Some alternative accounting policies are based on management
intent.\30\ Management intent is a present assertion about management's
plans for future courses of action.\31\
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\30\ For example, SFAS No. 115 Accounting for Certain
Investments in Debt and Equity Securities, allows management to
classify certain debt instruments as either a held-to-maturity, an
available-for-sale, or a trading security based on the company's
intent and ability with respect to the holding period of its
investment. The financial statement treatment differs for all three
categories.
\31\ The definition of management intent and certain other
concepts in the discussion of alternative accounting policies are
adapted from a FASB Special Report: Future Events: A Conceptual
Study of Their Significance for Recognition and Measurement (1994).
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We have separately considered the merits of alternative accounting
policies arising from differences in management intent. Opponents of
the use of management intent as a basis for accounting believe that
because intentions are subjective, it is difficult to use intent as a
basis for accounting. Opponents also believe that intent does not
change the economics of a transaction and thus, would not be a
representationally faithful basis of accounting.
Proponents assert that the economics of a transaction do, in fact,
change based on the nature of the activity, which is driven by
management intent. Proponents also note that, while management intent
is subjective and could change, this characteristic is no different
from a management estimate, which is common in financial reporting.
Proponents further argue that financial reporting that ignores
management intent results in irrelevant information for investors, for
instance, reporting the fair value of a held-to-maturity security that
will not be settled for 30 years.
Due to the varying levels of management intent throughout GAAP and
the merits of the arguments both for and against its use, we have
determined that accounting based on management intent is too dependent
on facts and circumstances to feasibly address within our timeframe.
[[Page 10908]]
Discussion
Setting aside any consideration of management intent, we believe
alternative accounting policies should be eliminated, except in limited
circumstances in which they may have merit. Possible justifications for
retaining alternative accounting policies include situations in which:
(1) Multiple accounting alternatives exist that are consistent with the
conceptual framework, and none are determined to provide significantly
better information to investors than others, and (2) an alternative or
interim treatment can be developed more quickly than a final
``perfect'' standard to minimize the effect of other unacceptable
practices.
If one or both of the justifications above apply, we believe that
the provision of alternative accounting principles should be coupled
with a long-term plan by the FASB to eliminate the alternative(s)
through the use of sunset provisions and that the effect of applying
the alternative policy not selected by preparers should be clearly and
succinctly communicated to investors (e.g., through footnote
disclosure).
Further, as new guidance is issued, including that which is issued
through the convergence process, the SEC should eliminate its
alternative accounting policies in related areas, if any.
From an international perspective, we note that IFRS currently
permits numerous alternative accounting policies. While we acknowledge
the IASB's efforts in reducing some of these alternative treatments, we
nonetheless believe that the SEC should encourage the IASB, like the
FASB, to be mindful of this proposal, and seek to eliminate
alternatives as part of its standards-setting projects.
III. Bright Lines
Conceptual Approach 1.A: We are considering recommending expanded
use of the following, in place of the current use of bright lines, to
better reflect the economic substance of an activity:
Proportionate recognition--We use the term ``proportionate
recognition'' in contrast to the current all-or-nothing recognition
approach in GAAP. 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
$40 \32\ 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.
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\32\ Calculated as (4 year lease/10 year useful life) x $100
machine value. The example is only intended to be illustrative and
is not prescriptive. For instance, the basis of proportionate
recognition may be an asset's estimated useful life, future cash
flows, or the share of a company's liabilities in a structured
investment vehicle. We are planning additional deliberations in this
regard.
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Additional disclosure--We recognize that proportionate
recognition is not universally applicable. In those cases, enhanced
disclosure may be more appropriate. We have yet to define the possible
scope of proportionate recognition and/or enhanced disclosure, but it
may extend to areas such as leases, consolidation policy and off-
balance sheet activity.
Rules-of-thumb or presumptions, both coupled with
additional considerations--We use rule-of-thumb and presumption to
describe a method by which an accounting conclusion may be initially
favored, subject to the consideration of additional factors. These are
less stringent than bright lines, and may be appropriate where
proportionate recognition may not apply.
Conceptual Approach 1.B: Further, we are considering a
recommendation related to the education of students, as well as to the
continuing education of investors, preparers, and auditors. The
recommendation would encourage understanding of the economic substance
and business purposes of transactions, in contrast to mechanical
compliance with rules without sufficient context.
Background
Bright lines refer to two main areas: quantified thresholds and
pass/fail tests.\33\
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\33\ Refer to appendix B for additional examples other than
those discussed in this section.
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Quantified thresholds include hard-and-fast cutoffs, as well as
rules-of-thumb or presumptions--both coupled with additional
considerations. 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,\34\ where a mere 1%
difference in the results of the quantitative tests leads to very
different accounting.
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\34\ 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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With respect to rules-of-thumb, consolidation guidance \35\
generally requires at least a 10% equity investment in a company (i.e.,
the equity investment expressed as a percentage of total assets) to
demonstrate that the investee company is not considered a variable
interest entity (VIE). The determination as to whether an entity is a
VIE drives who, if anyone, ultimately consolidates the VIE in its
financial statements. However, entities with investments above and
below the 10% level can still be considered VIEs, depending on the
particular facts and circumstances. That is, the 10% rule-of-thumb is
not determinative in its own right.
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\35\ FASB Interpretation No. (FIN) 46 (revised December 2003),
Consolidation of Variable Interest Entities (FIN 46R).
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Similarly, the business combination literature \36\ contains an
example of a presumption coupled with additional considerations. There
are situations in which selling shareholders of a target company are
hired as employees by the purchaser. For instance, 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
[[Page 10909]]
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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\36\ Emerging Issues Task Force (EITF) 95-8, Accounting for
Contingent Consideration Paid to the Shareholders of an Acquired
Enterprise in a Purchase Business Combination. We note 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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As indicated above, 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 reasons 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 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
We are still in the process of debating when, if at all, bright
lines are justified in accounting literature. We note that even if the
FASB limits the issuance of bright lines, other parties might continue
to create similar non-authoritative guidance. As such, recommendations
to limit bright lines would require a cultural shift towards acceptance
of more judgment. Accordingly, any recommendations in the context of
bright lines will incorporate our consideration of a professional
judgment framework, as discussed in chapter 3, and our consideration of
interpretive implementation guidance and a new design approach to
accounting standards, as discussed in chapter 2.
IV. Mixed Attribute Model and the Appropriate Use of Fair Value
Conceptual Approach 1.C: Measurement framework--While we may not
have time to fully address when fair value is the appropriate
measurement attribute, we understand that the FASB's joint conceptual
framework project includes a measurement phase. We intend to study this
project further and are considering a recommendation for the SEC to
endorse that, as part of this project, the FASB develop a decision
framework to provide a systematic approach for consistently determining
the most appropriate measurement attribute for similar activities or
assets/liabilities based on consideration of the trade off between
relevance and reliability, and the various constituents involved in the
financial reporting process.
Conceptual Approach 1.D: Judicious Use of Fair Value--Due to
implementation complexities, as noted below, we are considering whether
the SEC should request that the FASB be judicious about issuing new
standards and interpretations that require the expanded use of fair
value in areas where it is not already required, until completion of a
measurement framework. Over the long-term, this framework would be used
to determine measurement attributes systematically.\37\ We will also
consider whether improvements related to certain existing,
particularly-complex, standards that incorporate fair value, such as
SFAS Nos. 133 \38\ and 140,\39\ are warranted in the near-term.
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\37\ We recognize that the joint FASB/IASB conceptual framework
project, including the measurement phase, is a significant
undertaking that most likely will not be completed in the near-term.
Consequently, we may explore whether a recommendation is warranted
for a formal SEC study regarding when fair value is appropriate in
financial reporting. The study's report could then be incorporated
in future standards-setting activity.
\38\ Accounting for Derivatives and Hedging Activities.
\39\ Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities.
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Conceptual Approach 1.E: Groupings in Financial Statement
Presentation--We believe that a more consistently aggregated
presentation of financial statements would alleviate some of the
confusion and concerns regarding the use of fair value. Such
presentation should result in the grouping of amounts and line items by
nature of activity and measurement attribute within and across
financial statements. We believe such a grouping would be more
understandable to investors, particularly as it would more clearly
delineate the nature of changes in income (e.g., fair value volatility,
changes in estimate, and business activity). This presentation might
also help investors assess the degree to which management controls each
source of income.
As part of the financial statement presentation project, the FASB
has tentatively decided to segregate the financial statements into
business (further divided into operating and investing) and financing
activities. The FASB has also tentatively decided to require a
reconciliation of the statement of cash flows to the statement of
comprehensive income. This reconciliation would disaggregate changes in
assets and liabilities based
[[Page 10910]]
on cash, accruals, and changes in fair value, among others.
We intend to study this project further and consider whether it
would address the our leanings in this area and sufficiently facilitate
investors' understanding of fair value.
Conceptual Approach 1.F: Additional Disclosure--We have identified
potential areas for additional disclosure to more effectively signal to
investors the level of uncertainty associated with fair value
measurements in financial statements.\40\ Specifically, we note that in
some 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. Potential areas to be considered for additional
disclosure may include:
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\40\ We acknowledge uncertainty also exists in other measurement
attributes, such as historic cost, which may warrant similar
disclosure.
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The valuation model.
Statistical confidence intervals associated with certain
valuation models.
Key assumptions, including projections.
Sensitivity analyses depending on the selection of key
assumptions.
The entity's position versus that of the entire market.
Conceptual Approach 1.G: Disclosure Framework--We seek to balance
additional disclosure requirements, including, if any, those under
conceptual approach 1.F, with: (1) The perception that amounts
recognized in financial statements are generally subject to more
precise calculations by preparers and higher degrees of scrutiny by
investors compared to merely disclosing such amounts in the footnotes,
and (2) concerns regarding disclosure redundancies. To minimize the
effect of diminishing returns on potential new disclosure improvements
identified during the course of our efforts and future standards-
setting activity, we are considering recommending: (1) That the SEC
request the FASB to develop a disclosure framework that integrates
existing disclosure requirements into a cohesive whole (e.g., eliminate
redundant disclosures and provide a single source of disclosure
guidance across all accounting standards), (2) improvement to the
piecemeal approach to establishing disclosures (i.e., standard-by-
standard), and (3) that the SEC develop a process to regularly evaluate
and, as appropriate, update its disclosure requirements as new FASB
standards are issued.
Background
As previously noted, the mixed attribute model is one in which the
carrying amounts of some assets and liabilities are measured based on
historical cost, others at lower of cost or market, and still others at
fair value. This complexity is compounded by requirements to record
some adjustments to carrying amounts in earnings and others in
comprehensive income.
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.
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 avoidable 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, we assume 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: (1) Are averse to market-driven volatility, and as a result,
(2) incorporate unfavorable assumptions or discounts within their
assessments of a company's financial performance. 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.
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
[[Page 10911]]
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 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. Fair value might also 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 discussed in section II.B of this chapter,
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
We acknowledge the view that a complete transition to fair value
would alleviate avoidable complexity resulting from the mixed attribute
model. However, we also recognize that expanded use of fair value would
increase avoidable complexity, as discussed above, unless numerous
implementation questions related to relevance and reliability are
addressed, which extend beyond the scope of our work.
In light of our limited duration, we recognize that we may not
independently develop a comprehensive measurement framework, but we
plan to provide input to the FASB's projects in this area (see
conceptual approach 1.C on the measurement framework and conceptual
approach 1.E on groupings in financial statement presentation). As a
result, we believe that recommendations requiring a systematic
measurement framework and better communication of measurement
attributes would more feasibly reduce avoidable complexity resulting
from the mixed attribute model. Such communication encompasses footnote
disclosure of each measurement attribute's characteristics (e.g.,
uncertainty associated with fair value), as well as a more systematic
presentation of distinct measurement attributes on the face of the
primary financial statements.
V. Future Considerations
As noted in the introduction to this chapter, exceptions to general
principles create complexity because they deviate from established
standards that are applicable to most companies. Our developed
proposals with respect to industry-specific guidance and alternative
accounting policies address two forms of this diversity. We intend to
deliberate two remaining forms of such diversity during the course of
our work later in 2008.
Scope Exceptions in GAAP Other Than Industry-Specific Guidance \41\
As noted previously, scope exceptions other than industry-specific
guidance represent departures from a principle. They contribute to
avoidable complexity because they result in different accounting for
similar activities, require detailed analyses to determine whether or
not they apply in particular situations, and increase the volume of
accounting literature. On the other hand, the value of scope exceptions
will be considered in light of cost-benefit considerations, practical
approaches to issuing guidance in the near-term before more principled
standards can be developed, and the magnitude of change that would
result from eliminating or reducing them.
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\41\ We have limited our focus to scope exceptions, while
acknowledging there are other types of exceptions in GAAP. This
limited approach was considered appropriate in light of our short
duration.
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Examples of scope exceptions include: (1) A contract that has the
characteristics of a guarantee under FIN 45, Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness to Others, but is treated as contingent rent under SFAS
No. 13, Accounting for Leases; (2) the business scope exception to the
applicability of FIN 46R, Consolidation of Variable Interest Entities,
subject to certain criteria; and (3) the application of SFAS No. 157,
Fair Value Measurements, to share-based payment transactions.
Competing Models
Competing models are distinguished here from alternative accounting
policies. Alternative accounting policies, as explained above, 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 include different methods of asset
impairment testing such as inventory, goodwill, and deferred tax
assets, etc.\42\ 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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\42\ 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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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,
the value of competing models will be considered in light of cost-
benefit considerations, practical approaches to issuing guidance in the
near-term before more principled standards can be developed, and the
[[Page 10912]]
magnitude of change that would result from eliminating or reducing
them. We will also explore the relationship between competing models
and the FASB's conceptual framework.
Chapter 2: Standards-Setting Process
I. Introduction
A robust standards-setting process is the foundation of an
efficient system of financial accounting and reporting, on which
capital providers may rely to make investment decisions. Although the
U.S. approach to financial reporting has been quite effective in
achieving that overarching objective, GAAP has evolved over many years
to a point whereby some of the basic principles are obfuscated by
detailed interpretive rules, as well as various exceptions and
alternatives, which reduce the usefulness of the resulting financial
reporting. Historically, interpretative rules on how to implement GAAP
(interpretive implementation guidance) have proliferated from a variety
of sources and, intentionally or not, have become perceived as
additional GAAP. This increases the complexity of the financial
reporting system and reduces its transparency for investors, especially
when questions exist about the authoritative nature of such guidance or
conflicts exist between interpretations.
This chapter advances developed proposals, conceptual approaches,
and matters for future consideration intended to alleviate some of
these concerns. Specifically, after examining the U.S. standards-
setting process, we propose changes in the following areas:
Increased investor representation in standards-setting.
Enhancements in governance and oversight.
Improvements in the process of setting new standards.
Narrowing the sources of interpretive implementation
guidance.
In general, we believe the design of the U.S. financial reporting
system and the role played by each participant are appropriate.
However, improvements to the existing standards-setting process,
including the process of issuing interpretive implementation guidance,
may significantly influence behaviors and thereby help financial
reporting better serve the needs of investors.
Some of our proposals may be partially or substantially addressed
by actions recently taken or in the process of being taken by the FAF,
the FASB, and the SEC, which we reference where applicable. Other
aspects of our proposals are already in place or occur informally in
practice, but may not be fully effective or well understood.
Nevertheless, our proposals are designed to increase the effectiveness
and transparency of these processes.
II. Investor Representation
Investor representation in standards-setting is critical to
maintaining an effective system of financial reporting, yet the
intricacy of certain accounting matters has sometimes made it difficult
to attract meaningful investor participation. Our proposals are
intended to underscore the pre-eminence of investor perspectives in
developing and administering a well-designed and effective system of
financial reporting. The current standards-setting process attempts to
balance the views of different stakeholders. However, the financial
reporting system would best be served by recognizing that the
perspectives of investors should be pre-eminent when competing
interests cannot be aligned, because all stakeholders benefit from a
system that allocates capital more efficiently.
We acknowledge the FASB's significant recent efforts to increase
investor participation in standards-setting. Specifically, the FASB
leveraged a number of existing advisory groups and created additional
advisory groups to increase investor involvement. Our proposal below is
intended to provide the FASB with more focused, efficient, and timely
feedback from investors, both large and small.
Developed Proposal 2.1: Additional investor representation on
standards-setting bodies is central to improving financial reporting.
Only if investor perspectives are properly considered by all parties
will the output of the financial reporting process meet the needs of
those for whom it is primarily intended to serve. Therefore, the
perspectives of investors should have pre-eminence. To achieve that
pre-eminence in standards-setting, the SEC should encourage the
following improvements:
Add investors to the Financial Accounting Foundation (FAF)
to give more weight to the views of different types of investors, both
large and small.
Give more representation on both the FASB and the FASB
staff to experienced investors who regularly use financial statements
to make investment decisions to ensure that standards-setting considers
fully the usefulness of the resulting information.
FAF: Our proposal complements the FAF's recently proposed
governance reforms.\43\ The FAF proposes to expand the sources of FAF
Trustee nominations, change terms of service, and create flexibility in
the size of the FAF itself. We support these proposals, particularly
the decision to reduce reliance on constituent-based sponsoring
organizations to put forward FAF Trustees. However, we believe
additional investor representation on the FAF should also be
emphasized. Such representation should strive to consider differing
perspectives in the investing community.
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\43\ FAF, Request for Comments on Proposed Changes to Oversight,
Structure and Operations of the FAF, FASB and GASB (December 18,
2007). Our deliberation of the FAF request for comments focused on
the FAF and FASB proposals, as the Governmental Accounting Standards
Board (GASB) is outside of our scope.
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FASB and FASB Staff: Increasing direct investor involvement on the
Board would benefit the FASB by bringing investor perspectives to the
forefront of standards-setting and the process of issuing interpretive
implementation guidance. We propose that the composition of the Board
include no fewer than one, and perhaps more than one, experienced
investor who regularly uses third-party financial statements to make
investment decisions.
Our proposal assumes that the FAF will implement its proposed
reduction in the size of the FASB from seven to five members. If this
reduction is made, we believe the composition of the Board should be
reconsidered to require that a preparer, an auditor, and at least one
experienced investor who regularly uses third-party financial
statements to make investment decisions are all represented. In our
view, although academic representation on the Board should be actively
sought, it should not be mandated. If the FASB consists of five
members, our suggested approach would increase the influence of
investors. While we recognize that workload capacity concerns may be
created by a reduction in the size of the Board, we believe that these
concerns may be mitigated by more delegation of responsibilities to
senior staff members and a possible increase in the size of the FASB
staff. On the other hand, if the FAF does not reduce the FASB's size,
at least two investors should be required on the Board. The remaining
at-large Board members should be selected from the most qualified
individuals who possess a breadth of experiences that will ensure that
the perspectives of investors are carefully considered.
There may be opportunities to increase investor representation on
the FASB staff as well. The FASB has a few staff with professional
investing experience. The FASB also has had a fellowship program for
many years, but
[[Page 10913]]
fellows usually come from the auditor and preparer communities. The
FASB has approached investor groups about the possibility of sponsoring
fellows, but, thus far, has had limited success. Investors should
promote the fellowship positions and encourage qualified applicants to
join the FASB staff to help enhance investor input in standards-
setting.
In addition, the FAF should consider staffing alternatives that
make greater use of part-time Board members or part-time senior staff
for particular projects or purposes. However, we recognize that
conflict of interest and independence issues would have to be resolved.
III. FAF and FASB Governance
The FAF Board of Trustees is responsible for the oversight,
funding, and appointment of Board members of the FASB and the GASB.
While the FAF Board of Trustees does not direct the standards-setting
activities of the FASB, it does have a responsibility to periodically
review the FASB's structure and governance to assess its effectiveness
and efficiency. The FAF has always maintained oversight of the FASB as
one of its main priorities. Our proposal below is designed to promote
more active FAF oversight of the FASB--in order to shorten the time
taken to develop standards, as well as to improve their quality:
Developed Proposal 2.2: The SEC should assist the FAF with
enhancing its governance of the FASB, as follows:
By encouraging the FAF to develop performance metrics to
assess the FASB's adherence to the goals in its mission statement,
objectives, and precepts and to improve its efficiency.
By supporting the FAF's changes outlined in its ``Request
for Comments on Proposed Changes to Oversight, Structure and Operations
of the FAF, FASB and GASB,'' with minor modifications regarding
composition of the FAF and the FASB, as proposed in section II of this
chapter, and agenda-setting, as proposed in section IV of this chapter.
By encouraging the FAF to amend the FASB's mission
statement, stated objectives, and precepts to emphasize that an
additional goal should be to minimize avoidable complexity.
Performance Metrics: The FAF should develop performance metrics to
assess the FASB's adherence to the goals in its mission statement,
objectives, and precepts. These metrics should track the timeliness and
effectiveness of the FASB's standards-setting process. Such metrics
would not have a detrimental impact on the FASB's independence. Rather,
they would improve accountability in standards-setting.
Proposed FAF Governance Changes: We support the FAF's governance
proposals as outlined below, with minor modifications regarding
composition of the FAF and the FASB, as proposed in section II of this
chapter, and agenda-setting, as proposed in section IV of this chapter:
FAF Oversight: The FAF proposes to increase its active oversight of
the FASB. We support this proposal, but we note that the FAF has not
described how it intends to implement it. Many of the developed
proposals and conceptual approaches in this chapter provide input
regarding how and in what areas to strengthen such oversight.
FASB Voting: The FAF proposal maintains the FASB's current simple
majority voting requirement. We support simple majority rather than
supermajority voting to promote the timeliness of standards-setting.
Mission and Objectives: The FASB's mission statement, objectives,
and precepts acknowledge that efficient capital markets rely on
credible, concise, and understandable financial information. They also
recognize the importance of the following:
Improving the usefulness of financial information by
focusing on relevance, reliability, comparability, and consistency.
Keeping standards current.
Considering promptly significant areas of deficiency that
need improvement.
Promoting international convergence.
Improving the understanding of the nature and purpose of
information in financial reports.
Being objective in decision-making and promoting
neutrality of information.
Weighing carefully the views of constituents.
Satisfying the cost-benefit constraint.
Minimizing disruption by providing reasonable effective
dates and transition provisions.
Reviewing the effects of past decisions in a timely
fashion to interpret, amend, or replace standards, when necessary.
Following an open, orderly process for standards-setting.
We believe minimizing avoidable complexity should be added to this
list. Although we do not believe the FASB sets out to issue complex
standards, amending the mission statement, stated objectives, and
precepts may promote more explicit consideration of less complex
accounting alternatives during standards-setting.
IV. Standards-Setting Process Improvements
The U.S. standards-setting process requires significant due
process. The FASB's activities are open to public participation and
observation, and the FASB actively solicits the views of its various
constituents on accounting issues. We believe the FASB's approach to
obtaining significant input through its open due process is fitting,
although there is a difficult trade-off between a transparent due
process and expediency.
We believe the FASB's processes need improvement. Critics argue
that it may take too long for the issuance of new accounting standards
or interpretive implementation guidance in response to changes in
business practices or the economic environment. They point to projects
that have been on the FASB's agenda for years to illustrate that
fundamental issues are routinely given low priorities. They further
argue that new standards are not always consistent and may be based on
several different, or even conflicting, principles. This may be due to
a number of reasons, including the lack of a completed conceptual
framework, competing priorities placed on the Board, or the
evolutionary nature of standards-setting in the U.S.
Due to its practice of being continually open to constituent input,
the FASB may receive conflicting advice regarding its agenda. Projects
are frequently added to the agenda in response to requests from
constituents, but projects not being actively considered are seldom
removed. The FASB may be working on projects that could be better
addressed in other ways, or not at all. In either case, such projects
divert resources from other important agenda items. Further, even
though the FASB has a transparent due process, new standards are often
met with requests for interpretive implementation guidance,
implementation deferral, or amendment.
Our proposal below is designed to further enhance the U.S.
standards-setting process and its timeliness.
Developed Proposal 2.3: The SEC should encourage the FASB to
further improve its standards-setting process and timeliness, as
follows:
Create a formal Agenda Advisory Group that includes strong
representation from investors, the SEC, the PCAOB, and other
constituents, such as preparers or auditors, to make recommendations
for actively managing U.S. standards-setting priorities.
Refine procedures for issuing new standards by: (1)
Implementing investor
[[Page 10914]]
pre-reviews designed to assess perceived benefits to investors, (2)
enhancing cost-benefit analyses, and (3) requiring improved field
visits and field tests.
Improve review processes for new standards by conducting
post-adoption reviews of every significant new standard, generally
within one to two years of its effective date, to address interpretive
questions and reduce the diversity of practice in applying the
standard, if needed.
Improve processes to keep existing standards current and
to reflect changes in the business environment by conducting periodic
assessments of existing standards.
Some of our proposed process improvements call for formalizing or
improving existing processes, or implementing new processes to improve
standards-setting outputs. Our proposed Agenda Advisory Group would
help the FASB, the SEC, and other participants in the financial
reporting community focus efforts on the most meaningful activities and
centralize constituent input to improve the timeliness of standards-
setting.
Agenda Advisory Group: The first step in standards-setting is
agenda-setting. The FASB receives many requests to act on various
topics from many constituents, including the SEC. The FASB also needs
to fulfill its obligations under the Memo of Understanding with the
IASB regarding international convergence. Requests for interpretations
or amendments divert attention from other critical agenda items. FASB
agenda decisions often add rather than delete projects. Further, given
the volume of activity on the FASB agenda, Board and staff
prioritization conclusions are not always clear to constituents. What
may result is that projects being addressed may not be responsive to
widely acknowledged needs, or projects may not have sufficiently-
defined scopes to address these needs in a timely fashion. The FASB has
a number of existing advisory groups and committees that it consults
about issues that may affect its agenda and project priorities;
however, we believe there needs to be increased accountability to the
FAF on agenda-setting and project priorities.
An Agenda Advisory Group that includes strong representation from
investors, the SEC, the FASB, and the PCAOB, as well as other
interested parties such as preparers and auditors, should be created to
provide advice on agenda-setting. By identifying emerging issues and
building consensus about which group is best positioned to deal with
them (e.g., the FASB, the EITF, or the SEC) and in what form, the
Agenda Advisory Group would give immediate input about how best to
prioritize near-term versus long-term priorities. The main goals of
such a group would be to:
Help standards-setting become more nimble.
Assist the FASB is setting an achievable, strategic
agenda, rather than one that includes projects proposed for many years
with little progress.
Recommend when it is appropriate for the SEC or other
parties to issue interpretive implementation guidance related to
emerging issues and issues observed by the SEC in its registrant
reviews.
Help the FASB maintain the usefulness of its authoritative
guidance by recommending areas that need to be kept current.
Shield the FASB from influence by any single group of
constituents, thereby protecting its independence.
Inject accountability into agenda-setting for all involved
parties.
Our proposal complements the FAF's proposed changes to the FASB's
agenda-setting process in which the FAF would give the FASB Chairman
control over the FASB's agenda. We believe instilling more decision-
making authority in the FASB Chairman, combined with a requirement to
consult with the proposed Agenda Advisory Group, would be a positive
step toward increasing the FASB's efficiency.
In creating such an Agenda Advisory Group, the SEC and the FASB
should consider ways to implement the following objectives:
Timeliness. The Agenda Advisory Group should be convened
both on a regular schedule and on short notice telephonically to deal
with urgent matters, as necessary.
Accountability. The Agenda Advisory Group should vote on
certain aspects of the standards-setting agenda and provide that
information in an advisory capacity to the FASB Chairman, who would
then make the final agenda decision. Part of the rationale for calling
a vote would be to increase accountability of the FASB Chairman to the
FAF regarding agenda-setting effectiveness.
Active involvement of key groups of investors. Key
investor groups should be actively involved in agenda-setting to
maintain an appropriate focus on investor needs.
Involvement of the SEC. Due to the SEC's oversight
responsibility for standards-setting, one or more senior
representatives from the SEC Office of the Chief Accountant (OCA)
should be on the Agenda Advisory Group, as the SEC typically identifies
practice issues before the FASB does. In addition, active involvement
by the SEC will allow coordination of how and by whom guidance should
be issued, thereby reducing the impetus for the SEC to issue
interpretive implementation guidance separately from the codified
version of GAAP (see section VI of this chapter).
Involvement of the FASB. All Board members should be
invited as official observers.
Involvement of the PCAOB. A senior representative from the
PCAOB should be invited as an official observer, as actions taken by
the PCAOB significantly impact behavior of participants in the U.S.
financial reporting community.
Involvement of others. Constituents otherwise not
represented should be able to submit agenda requests and track agenda
decisions, similar to the way in which the EITF functions.
Formulating and Proposing New Standards: The FASB has an elaborate
process for formulating and proposing new standards. This process is
designed to ensure that proposed standards properly address significant
issues, are consistent with business practices and economics, and have
benefits that justify accounting changes. It involves staff preparation
of a draft proposal, publication of the proposal with an opportunity
for public comment, and approval of the final standard. Throughout the
process, the FASB consults with and receives input from a diverse group
of constituents. This process is time consuming, often taking many
years, and could be made more efficient. The Board's outreach to
certain constituents sometimes seeks advice only on detailed issues
rather than the scope of projects and broad matters. Our proposal would
increase the efficiency and effectiveness of standards-setting by
obtaining more focused inputs at an earlier stage through investor pre-
reviews, enhanced cost-benefit analyses, and more field visits and
field testing.
Investor Pre-Reviews: Although the FASB regularly consults with a
number of standing investor advisory groups, we believe that there may
be opportunities to both increase and more effectively manage investor
involvement, so that interested parties know when and how to engage the
FASB and its staff to assist in standards-setting. Specifically, the
FASB should implement a scalable investor pre-review to assess
perceived investor benefits prior to exposing new standards for public
comment. The FASB should consider the following attributes when
designing such a pre-review:
[[Page 10915]]
Seek detailed comments from a diverse panel of investors
(e.g., buy-side analysts, sell-side analysts, and rating agencies), all
of whom should have strong interests in the outcome.
Ask investors to consider the accounting guidance through
the eyes of a serious retail investor to determine whether the new
information provided would be decision-useful (whether it will provide
better information than what is currently available). This should
entail an evaluation of the costs and benefits of updating data
analysis models with the new or improved information, as necessary.
Revisit or even discontinue standards-setting projects
based on the feedback received.
Cost-Benefit Analyses: The FASB evaluates whether the benefits of a
proposed standard justify its costs prior to exposing it for public
comment. However, participants in standards-setting have long
acknowledged that reliable, quantitative cost-benefit calculations are
seldom feasible, in large part because of the lack of available
information on the costs and the difficulty in quantifying the
benefits. Further, the magnitude of the benefits and costs is difficult
to assess prior to actual implementation of the standard. As a result,
cost-benefit considerations are often based on anecdotal evidence and
do not always include useful input from preparers, auditors, investors,
and regulators. Cost-benefit analyses should be a more rigorous,
essential part of standards-setting and should be given more weight
than they are today.
The FASB is currently considering new initiatives to improve its
cost-benefit analyses. We support these efforts and, to complement
them, the FASB should consider the following enhancements to its cost-
benefit procedures:
Select preparers, auditors, investors, and regulators to
be involved based on their interest in the standard or interpretive
implementation guidance being developed. Such participants should be
involved in the process of assessing costs and benefits, as well as
performing field visits and field testing, to the extent feasible.
Expose the entire cost-benefit analysis for public comment
(rather than a summary or abstract), thereby enhancing the ability of
interested constituents to comment on the conclusions reached and the
basis for these conclusions.
Attempt to better quantify the costs (in addition to
providing qualitative assessments). If there is concern about the
accuracy or reliability of the data, frame these concerns in the
analysis rather than omitting the data. The FASB should request a cost
estimate and underlying methodology from constituents who claim that
costs are excessive.
Use information collected in the investor pre-review to
supplement the assessment of the benefits.
Refrain from discussing costs and benefits on a net basis,
as this sometimes creates opacity around the data underlying such
conclusions. The analyses of costs and benefits should be prepared
separately, with an indication of how the Board weighed the evidence in
its conclusion.
Add auxiliary information to put the accounting standard
or interpretive implementation guidance in context (e.g., include an
expectation of the number of companies to be impacted by the standard,
their overall market capitalization, or other metrics).
Improve the documentation of the cost-benefit conclusions
in new standards so that they may be referred to over time.
Consider hiring an economist to assist in preparing and
reviewing cost-benefit analyses.
Field Visits and Field Testing: Throughout the deliberation
process, the FASB meets with a number of interested constituents
regarding proposed standards (referred to as ``field visits''). Once
the proposed standard is exposed for public comment, the FASB at its
discretion may conduct field tests, in which the implementation of a
proposed standard is beta tested so that issues may be identified and
resolved prior to final issuance of the new standard. However, as a
practical matter, and because of resource constraints, robust field
testing has not been part of the process for setting many recent
standards. As a result, new standards are often met with requests for
interpretive implementation guidance, implementation deferral, or
amendment.
Whenever possible, scalable field visits and field tests should be
a required part of standards-setting for all significant new standards
to identify and resolve as many conceptual and implementation issues as
practicable prior to issuance. These procedures may also identify less
costly alternative accounting treatments. The rigor required for these
procedures should be scaled based on the difficulty and length of time
required to implement and the magnitude of the impact of the standard
or interpretive implementation guidance. In addition, whenever
possible, field visits and field testing should occur
contemporaneously, to improve the focus and efficiency of receiving
constituent input. Although robust field testing and field visits
require resources and time, combining these efforts will make efficient
use of the Board's and its staff's time. Moreover, by researching
implementation questions prior to issuing a new standard, the FASB
would reduce the amount of time spent considering possible interpretive
implementation guidance, implementation deferral, or amendment.
The FASB also should leverage work already being done by preparers,
auditors, and investors to assess the costs, benefits, operationality,
and auditability of proposed standards. Requesting assistance from
preparers, auditors, and investors, either directly or through task
forces and resource groups (perhaps on more of a rotational basis than
is done in practice today), would bring additional subject matter
expertise and recent business experience to each field visit and field
test.
Post-Adoption Reviews of New Standards: We acknowledge that it is
difficult to identify and address all possible implementation issues in
a new standard prior to it being issued and adopted. Issues and
questions are often identified during the initial implementation phase
as preparers and auditors begin to apply a new standard in practice.
Preparers, auditors, and others often monitor and take measures to
reduce diversity in practice when implementing new standards by
conferring amongst themselves and issuing non-authoritative
interpretive implementation guidance. During this initial period,
requests are often made of the FASB and the SEC to provide interpretive
implementation guidance for new standards.
In the current financial reporting environment, preparers and
auditors are sometimes viewed as being penalized for implementing their
understanding of new accounting standards immediately after adoption.
This is because any ambiguity or substantial gaps identified in the
implementation period may lead the regulators to issue interpretive
implementation guidance that differs from conclusions originally
reached by the preparers and auditors.
The FASB should improve existing processes to consistently ensure
timely consideration of implementation issues for new accounting
standards. The goal of post-adoption reviews of new standards would be
to determine if the new standard is accomplishing its intended purpose
or whether it has unintended consequences that need to be resolved. The
FASB currently does address questions that arise after new
[[Page 10916]]
standards are issued--it regularly receives input from various
constituents and periodically revisits some standards. However, the
process of completing post-adoption reviews should be formalized in
policy, be more systematic, involve input from a broader range of
constituents, and be monitored using relevant performance metrics.
Specifically, the FASB should perform a post-adoption review for
every significant new standard. The review should be completed no more
than one to two years after the effective date of the standard, with
completion sooner if the scale of the new standard is narrow or a large
number of implementation questions arise. At the end of the review
period, the FASB should reach a formal conclusion on each new standard
to determine if interpretive implementation guidance would serve the
needs of investors by reducing diversity in practice or otherwise
improving the application of the standard (e.g., by resolving
ambiguities in the wording or filling-in unintended gaps in the
standard).
We believe that, when necessary, interpretive implementation
guidance for new standards is best given by the FASB using:
A transparent due process with public comment.
Appropriate transition guidance and required disclosures
that will provide investors with useful information regarding possible
changes in accounting.
The codified version of GAAP.
Understandably, some interpretive implementation guidance may be of
such an urgent nature that a transparent due process would not be
responsive to the needs of market participants. Therefore, we envision
that the SEC or other parties, through representation on the Agenda
Advisory Group, could assist by agreeing to issue interpretive
implementation guidance in such situations (see section VI of this
chapter).
Under our proposal, it is not contemplated that preparers would
have the flexibility to implement new standards at different times nor
have the ability to adopt early or late. Following the recent policy
decision by the FASB precluding early adoption of new standards, our
proposal contemplates transition guidance for a new standard with a
stated, required implementation date. Similarly, this proposal is not a
safe harbor. Violations of GAAP will continue to be dealt with by the
SEC through the review, comment, restatement, and enforcement
processes. However, the SEC should give appropriate consideration to
situations in which there were ambiguities or gaps in the new standards
that could be subject to more than one reasonable interpretation. For
example, it may be inappropriate for the SEC to bring an SEC
enforcement proceeding based on a new accounting standard if, after
careful analysis and due diligence made in good faith, the registrant
took a reasonable and supportable view of that standard, which was
subsequently changed by formal amendment or published interpretation.
Periodic Assessment of Existing Standards: After a new accounting
standard has been in place for a reasonable period, more data is likely
to be available to evaluate its benefits and costs. Further, over time
economic conditions and business practices may change, such that older
accounting standards may lose their relevance and effectiveness. Some
participants in the financial reporting community have commented that
numerous accounting standards or models need immediate reevaluation. In
today's economic environment, the accounting for securitizations and
structured products with off-balance sheet risk are cited as needing
reevaluation.\44\ The accounting for financial guarantees, convertible
debt, and derivatives and hedging activities are also frequently cited
areas for improvement.
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\44\ SEC Staff, Report and Recommendations Pursuant to Section
401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-
Balance Sheet Implications, Special Purpose Entities, and
Transparency of Filings by Issuers (June 2005).
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The process by which the FASB receives, evaluates, and addresses
concerns about the usefulness of standards in a timely fashion is
critical to the proper functioning of the U.S. capital markets. The
FASB should improve and formalize this process to ensure that standards
continue to be useful in the current economic and business environment.
This should be done by formalizing the process of periodically
requesting feedback from investors, preparers, auditors, and regulators
regarding what areas of GAAP need reevaluation because they create
practice problems or are unnecessarily complex. In addition, to
identify other specific areas of GAAP in need of review, the FASB
should consider the following:
Restatement activity.
Emerging issues and the amount of interpretive
implementation guidance issued on particular standards.
Changes in business practices and the economy.
New cost-benefit information as it becomes available.
Further, when evaluating the feedback received from constituents
and the results of its own research, the FASB should seek advice from
the Agenda Advisory Group to help prioritize its agenda.
V. Interpretive Implementation Guidance
We believe that there are too many sources of interpretive
implementation guidance. Historically, this guidance proliferated from
a variety of sources, which intentionally or not, has been viewed as
additional GAAP. In other words, interpretive implementation guidance
that is not formally authoritative often is erroneously perceived by
participants in the financial reporting and legal communities to be
quasi-authoritative. The key risks associated with a proliferation of
interpretive implementation guidance are that: (1) The appropriate rule
may not be identified and considered, and (2) it may conflict with
authoritative guidance, as well as with other non-authoritative
guidance, causing uncertainty in application and legal risk.
Over the past few years, the FASB and the SEC have taken steps
intended to reduce the proliferation of interpretive implementation
guidance from different authoritative bodies. For example, the SEC
recognized the standards of the FASB as generally-accepted, and the
FASB limited the ability of other bodies to create authoritative
guidance without FASB ratification. Nevertheless, the SEC staff
continues to be a source of interpretive implementation guidance in its
own right, through such vehicles as comment letters, staff speeches,
SABs, and other forms of exchange that, although typically non-
authoritative, are perceived as quasi-authoritative. Similarly, actions
taken by the FASB and the SEC have not sufficiently curbed the creation
of other non-authoritative interpretive implementation guidance, such
as that from audit firms, preparer and industry groups, academia, the
Center for Audit Quality (CAQ), and other regulators.
Our proposal below, which should be read in conjunction with
conceptual approach 2.A, is designed to recognize recent
accomplishments in this area, clarify what guidance is authoritative
and non-authoritative, and further influence the behaviors that have
led to the desire for more guidance:
Developed Proposal 2.4: The number of parties that either formally
or informally interprets GAAP and the volume of interpretative
implementation guidance should
[[Page 10917]]
continue to be reduced. The SEC should coordinate with the FASB to
clarify roles and responsibilities regarding the issuance of
interpretive implementation guidance, as follows:
The FASB Codification, a draft of which was released for
verification on January 16, 2008, should be completed in a timely
manner. In order to fully realize the benefits of the FASB's
codification efforts, the SEC should ensure that the literature it
deems to be authoritative is integrated into the FASB Codification to
the extent possible, or separately re-codified, as necessary.
To the extent practical, going forward, there should be a
single standards-setter for all authoritative accounting standards and
interpretive implementation guidance that are applicable to a
particular set of accounting standards, such as GAAP or IFRS. For GAAP,
the FASB should continue to serve this function. To that end, the SEC
should only issue broadly applicable interpretive implementation
guidance in limited situations (see section VI).
All other sources of interpretive implementation guidance
should be considered non-authoritative and should not be required to be
given more credence than any other non-authoritative sources that are
evaluated using well-reasoned, documented professional judgments made
in good faith.
FASB Codification: The FASB has undertaken a significant project to
develop a comprehensive, integrated Codification of existing accounting
literature organized by subject matter that is intended to become an
easily retrievable single source of GAAP. To that end, on January 16,
2008, the FASB released a draft of the FASB Codification that will be
subject to a one-year verification period. We applaud the FASB's
foresight on such a project and recognize the significant effort the
project has entailed. The FASB Codification:
Brings together all GAAP from all authoritative sources
except the SEC and classifies it by topic into a single, searchable
database so that it may be more easily researched.
Clarifies what guidance is authoritative versus non-
authoritative.
Puts accounting standards into a consistent format, to the
extent possible.
Although the FASB Codification does not change the substance of
GAAP, it should make its application easier. However, SEC literature,
which has developed through different mechanisms, is not as easily
integrated into the FASB Codification.\45\ Similarly, the FASB
Codification does not deal with either the root causes of the
proliferation of interpretive implementation guidance or the behavior
of participants in the U.S. financial reporting community that caused
the complexity. Notwithstanding these concerns, we support the FASB's
efforts to verify the Codification. To further improve the
Codification, the SEC should re-codify its guidance using a consistent
format, and the FASB and the SEC should consider a second phase of the
codification project that would systematically revisit GAAP, as
discussed in section VI of this chapter.
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\45\ Two of the benefits of the FASB Codification are its search
feature and decimal system, which consistently organizes topics and
subtopics within GAAP. No SEC guidance is currently included in the
FASB Codification. To improve its usability in the future, the
Codification will include authoritative content issued by the SEC,
as well as selected SEC staff interpretations. However, the
inclusion of SEC guidance will be for administrative convenience and
will not supersede such guidance in its current form. Further, the
SEC guidance will not follow the same organizational structure as
the rest of GAAP.
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Non-Authoritative Guidance: Although the FASB Codification will
help clarify the roles of authoritative and non-authoritative guidance,
meaningful improvements in financial reporting will be difficult if
non-authoritative interpretive implementation guidance continues to be
perceived, as it is today, as having quasi-authority in the
marketplace. Our proposal is intended to foster acceptance of
reasonable professional judgments made in good faith when they are
supportable under GAAP. Specifically, non-authoritative interpretive
implementation guidance should not be used to force restatements when
other reasonable views exist that are supportable under GAAP.
We recognize there is often a need for interpretive implementation
guidance and that such guidance can serve an important purpose. The
volume of interpretative implementation guidance should be reduced, and
it should be clearly identified as non-authoritative.
VI. Conceptual Approaches and Future Considerations
As discussed more fully below, we are considering a number of
conceptual approaches and matters for future consideration to improve
standards-setting:
Conceptual Approach 2.A: To further reduce interpretive
implementation guidance associated with GAAP, we are considering
proposing that the SEC further clarify its role vis-[agrave]-vis the
FASB, as well as its internal roles and responsibilities, to mitigate
the risk of its actions unintentionally driving behavior by market
participants, as follows:
The SEC should clarify that registrant-specific matters
are not authoritative forms of interpretive implementation guidance
under GAAP and, accordingly, registrants other than the specific
registrant in question are not required to take into account such
registrant-specific matters.
The SEC staff should refrain from informally communicating
broadly applicable interpretive implementation guidance (e.g., staff
speeches) that are likely to be perceived as changing the application
of GAAP. Rather, such communications should be used to highlight
authoritative interpretive implementation guidance that has already
been issued.
In instances in which the SEC staff identifies registrant-
specific accounting matters that it believes may result in the need for
broader interpretive implementation guidance or a clarification of an
accounting standard under GAAP, the SEC staff should refer these items
to the FASB as part of the Agenda Advisory Group.
When it is necessary for the SEC or its staff to issue
broadly applicable interpretive implementation guidance, it should try
to provide such guidance: (1) In a clear communication identified as
authoritative, (2) so that it can easily and immediately be integrated
into a codification of SEC literature (as proposed in section V of this
chapter), and (3) when expected to significantly change the application
of GAAP, only after transparent due process and public comment to the
extent practicable.
The SEC staff should revisit internal procedures and take
further steps necessary to improve the consistency of its views on the
application of GAAP.
The SEC sometimes issues rules and interpretations that comprise
part of authoritative GAAP. The SEC's rule-making activities are
generally open to public participation and observation. However, other
activities of the SEC and its staff do not occur with the same level of
transparent due process and public comment. As discussed below,
registrant-specific guidance is published in the form of comment
letters, but appropriately does not need to be proposed in advance or
subject to public comment. On the other hand, to the extent the SEC
promulgates interpretive implementation guidance that is broadly
applicable and is expected to significantly change the application of
GAAP, we are considering whether it should do so only after public
notice and comment, whenever practicable.
[[Page 10918]]
Registrant-Specific Guidance: The SEC Division of Corporation
Finance (Corp Fin) reviews and comments on financial reports filed by
registrants that are not investment companies. Corp Fin has a process
for facilitating the public availability of comment letters and
registrant responses to these comment letters on the SEC's Web site
upon completion of the review process. Corp Fin also receives letters
from specific registrants requesting concurrence on various reporting
and disclosure issues. Similarly, OCA and Corp Fin receive requests
from specific registrants for concurrence on specific interpretative
implementation issues. These letters are commonly referred to in the
marketplace as ``pre-clearance'' letters.
Preparers and auditors may misconstrue registrant-specific
accounting outcomes as quasi-authoritative. However, registrant-
specific matters are appropriately not subject to the same public
deliberation and comment as SEC rule-making, because they are
registrant-specific and are not intended to be applied more broadly.
Nevertheless, preparers and auditors may overreact by applying these
outcomes to similar, yet different, transactions, sometimes believing
that restatement is required.
We are deliberating whether the SEC should make clear that comments
provided to a specific registrant are not binding on other registrants.
Clarifying that such comments are non-authoritative would help:
Prevent preparers and auditors from giving undue
significance to SEC staff comments made to individual registrants.
Reduce the need for other parties to issue interpretive
implementation guidance.
Support our proposal to refer broadly applicable
accounting matters that require interpretive implementation guidance to
the FASB.
Broadly Applicable Guidance: To inform the public about broadly
applicable interpretive implementation guidance, the SEC uses various
forms of communication, including SABs,\46\ letters to industry, staff
speeches, public announcements, and training manuals. In addition, Corp
Fin publishes and maintains interpretive implementation guidance on the
SEC's Web site. While all of these publications contain disclaimers as
to their non-authoritative nature, many participants in the financial
reporting community consider these disclaimers to be boilerplate and
regard such interpretive implementation guidance as quasi-
authoritative.
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\46\ The SEC authorized the use of SABs in 1975 to achieve a
wider dissemination of the administrative interpretations and
practices utilized by the SEC staff in reviewing financial
statements. There had been concern that smaller audit firms and
issuers would be disadvantaged because there had previously been no
formal dissemination of staff practices. SABs were also designed to
provide a means by which new or revised interpretations and
practices could be quickly and easily communicated to registrants
and their advisors. As they are designed to disseminate staff
administration practices on a timely basis to the broader public,
SABs are generally not exposed for public comment before release.
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These publications are typically viewed by the SEC staff as
confirmations of existing accounting standards, rather than as
supplemental interpretive implementation guidance. However, many of
these publications have and continue to influence market behavior
because they sometimes include SEC staff views that do, in fact,
supplement existing GAAP. The SEC staff sometimes refers registrants to
these publications to support their views on registrant-specific
matters. As such, many argue that these documents exemplify the SEC
staff effectively setting standards without transparent due process and
public comment and point to restatements sometimes following the
release of these documents as evidence of their quasi-authoritative
nature in practice.
In addition, other individual sources of non-authoritative
implementation guidance (e.g., audit firms and the CAQ) often publish
their own guidance to broadly communicate what they perceive to be SEC
staff's views and to drive consistency in practice. However, as
discussed below, if the SEC were to increase its formal referral of
broadly applicable interpretive matters to the FASB, which could issue
guidance in an authoritative, timely fashion, the overall volume of
interpretive implementation guidance would be reduced, as would
conflicts between interpretations from different sources. We believe
this would further influence behaviors that have led to the desire for
more guidance.
We recognize that the SEC staff publishes guidance to address
issues other than the application of GAAP. This conceptual approach is
not directed towards such publications. We also recognize that the SEC
staff, based on its review of thousands of filings each year, is in a
unique position to publish its comment letters. Such publications are
intended to reduce comments that each registrant receives in the review
process by promoting a high degree of compliance with GAAP. We continue
to consider what proposals to make in this area, but believe that the
SEC staff should be diligent when preparing this information not to
present comments in a manner that is likely to be perceived as
interpretative implementation guidance.
Referral of Issues to the FASB: As discussed in section IV of this
chapter, there were a number of standards that were communicated to the
FASB that were in need of improvement that have yet to be improved. The
SEC should formalize the mechanism by which it refers issues to the
FASB, and one of the goals of SEC representation on the proposed Agenda
Advisory Group would be to strengthen such a referral mechanism. This
will permit the FASB to address the need for authoritative interpretive
implementation guidance that is broadly applicable in a codified form,
thereby reducing the need for the SEC to do so. It will also give the
SEC greater insight into when the FASB and the EITF do not intend to
issue interpretive implementation guidance, which will allow the SEC to
be more responsive by issuing guidance, in the limited circumstances
when necessary.
Consistency: We are considering whether there is a need for more
coordination between the various offices and divisions within the SEC
to improve the consistency of accounting advice given by the SEC staff.
Although there are processes in place to build consensus on accounting
matters within the SEC, there may be room for improvement.
The possibility of inconsistent accounting advice emanating from
the SEC staff creates confusion in the marketplace.
Two processes exist (one in Corp Fin and one in OCA) for
registrants to request reconsideration of conclusions expressed in
either comment letters or in pre-clearance letters when registrants
disagree with staff guidance or believe they are receiving inconsistent
advice compared to other registrants. However, registrants may not
always use these processes for a number of reasons, such as: (1) To
avoid additional delays and missed market opportunities, (2) to avoid
the risk of opening other accounting conclusions to reconsideration,
and (3) fear of possible retribution (misguided or not). Therefore,
although the SEC staff has created checks-and-balances in the form of
reconsideration processes, they may not be utilized as anticipated.
We do not intend to limit the ability of the SEC staff to carry out
its regulatory responsibilities in a timely fashion. That is why we
have not yet proposed a specific course of action. We understand the
SEC staff is reviewing its procedures in many of these areas and
expects to unveil a number of changes in the coming months, including
new procedures to enhance the consistency
[[Page 10919]]
of registrant-specific accounting interpretations during filing reviews
and increasing the understanding and usefulness of its reconsideration
processes. We support these efforts and plan to review progress with
the SEC staff in the coming months as we continue our deliberations.
Conceptual Approach 2.B: We are considering proposing that the SEC
continue to encourage improvement in the way standards are written, as
follows:
By supporting the writing of accounting standards
according to an agreed-upon framework of what constitutes an optimal
standard. Such standards should not strive to answer every question and
close every loophole, but should be written with more clearly stated
objectives and principles that may be applied to broad categories of
transactions.
By supporting the writing of accounting standards in a
manner that promotes trust and confidence in efficient markets by
encouraging the use of professional judgments made in good faith.
Specifically, preparers and auditors should apply the standards
faithfully, and regulators should monitor and address abusive
application of the standards.
Optimal Design of Standards: Some participants in the U.S.
financial reporting community believe that certain accounting standards
do not clearly articulate the objectives and principles upon which they
are based, because they are sometimes obscured by detailed rules,
examples, scope exceptions, safe harbors, cliffs, thresholds, and
bright lines. In addition, GAAP is often not written in plain English.
This can create uncertainty in the application of GAAP, as rules cannot
cover all possibilities and the underlying principles and objectives
may not be clear.
Another significant concern about the current system of accounting
standards is that the proliferation of accounting rules fosters
accounting-motivated structured transactions. As discussed further in
chapter 1, 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 more objectives-oriented (or
principles-based) standards may ultimately improve the quality of the
financial reporting upon which investors rely.
The question of how to design standards going forward 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 principles-
based (or objectives-oriented) standards.\47\ The question of how
standards should be designed going forward is a critical aspect of the
standards-setting process.
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\47\ 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.
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Rather than engaging in a debate over terms such as ``principles-
based,'' ``objectives-oriented,'' or ``rules-based,'' we prefer to
think of the design of accounting standards in terms of the
characteristics they should possess. We are considering various
suggestions for the optimal design of standards, including the work of
the CEOs of the World's Six Largest Audit Networks. These CEOs are
attempting to build consensus in the financial reporting community
about what optimal accounting standards should look like in the future
and whether a framework could be created that the standards-setters may
refer to over time to ensure that these characteristics are optimized.
Their proposed framework was presented at the Global Public Policy
Symposium in January 2008, which recommends that optimal accounting
standards have the following characteristics:
Faithful presentation of economic reality.
Responsive to investors' needs for clarity and
transparency.
Consistency with a clear conceptual framework.
Based on an appropriately-defined scope that addresses a
broad area of accounting.
Written in clear, concise, and plain language.
Allows for the use of reasonable judgment.\48\
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\48\ In his testimony before the U.S. Senate Subcommittee on
Securities, Insurance and Investment (October 24, 2007), the
Chairman of the IASB, Sir David Tweedie, noted a similar set of four
characteristics, two of which augment the aforementioned six,
including whether they: (1) Can be explained simply in a matter of a
minute or so, and (2) make intuitive sense.
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As we continue to deliberate this and other work, we are
considering supporting the increased use of objectives-oriented
standards.
Future Considerations: We also plan to deliberate what optimal
transition provisions should be in the future and whether new standards
should be applied prospectively or retrospectively. The goal of such
deliberations will be to balance the investor need for consistent
information with preparer and auditor concerns about feasibility and
the costs of recasting historical information.
Conceptual Approach 2.C: In addition to considering the other
proposals in this report (and subject to the conclusions reached in our
future deliberations of international considerations), we are
considering proposing that the SEC encourage a re-prioritization of the
standards-setting agenda that balances the need for international
convergence, improvements to the conceptual framework, and maintaining
existing GAAP. Further, we are deliberating whether the FASB and the
SEC should add to their agendas a second phase of the codification
project to consider systematically revisiting GAAP to:
Be more coherent after codification.
Remove conflicts between standards or with the conceptual
framework.
Be less complex, where possible.
Be designed more optimally as discussed above.
Readdress frequent practice problems (as identified by
restatement volumes, input from the SEC, implementation guidance
issued, or frequently asked questions).
Remove redundancies between SEC disclosure requirements
and other sources of GAAP.
Amend, replace, or remove outdated standards.
As part of our deliberation of the Agenda Advisory Group proposed
in section IV of this chapter, we are also deliberating a conceptual
approach regarding immediate standards-setting priorities in the
current environment. We plan to finalize a proposal after completing
deliberations on international considerations later in 2008, which may
significantly affect our approach. In fact, some participants in the
U.S. financial reporting community have indicated that a full-scale
adoption of IFRS in the U.S. may be the most expeditious way to shorten
the lengthy timeline that would be required to complete such a list of
priorities.
Second Phase of Codification: As noted above, the Codification does
not
[[Page 10920]]
change the substance of GAAP, which continues to be encumbered by
detailed rules, bright lines, scope exceptions, industry guidance,
accounting alternatives, and other forms of complexity. Because of the
evolutionary nature of U.S. standards-setting, the Codification does
not read consistently in all parts. Further, even after any needed re-
codification of SEC literature proposed in section V of this chapter,
there will be opportunities to remove redundancies between SEC and FASB
disclosure requirements and make other simplifications. Therefore, we
are deliberating whether and when the FASB and the SEC should perform a
second phase of the codification project, which would involve a
comprehensive periodic assessment of existing accounting standards like
the one we proposed previously in this chapter.
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 \49\ and correction of errors; and professional judgment:
Specifically, whether a judgment framework would enhance the quality of
judgments and the willingness of others to respect judgments made.
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\49\ 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 \50\ in the U.S. financial
markets has been increasing significantly over recent years, reaching
approximately 1,600 companies in 2006.\51\ 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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\50\ 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.
\51\ 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 discussions regarding
materiality in SAB 99, Materiality (as codified in SAB Topic 1M)--that
is, resulting in errors being deemed to be material when an investor
may not consider them to be important.
It is essential that companies, auditors, and regulators strive to
reduce the frequency and magnitude of errors in financial reporting.
However, the goal is not to reduce the number of restatements per se.
Indeed, 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.\52\ 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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\52\ A Glass Lewis & Co. report, Brief Alert Weekly Trend
(December 17, 2007), shows that restatements in companies subject to
section 404 of the Sarbanes Oxley Act have declined for two
consecutive years, although the total number of restatements has
been increasing.
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While reducing errors is the primary goal, it is also important to
reduce the number of unnecessary restatements (i.e., those that do not
provide important information to current investors). Unnecessary
restatements can be costly for companies and auditors, may reduce
confidence in reporting, and may create 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 on
restatements.\53\ We are also aware that the Treasury Department has
recently selected University of Kansas Professor Susan Scholz to
conduct an examination of the impact of and the reasons for
restatements of public company financial statements. We will review the
Treasury Department's study and consider its findings as they are made
available.
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\53\ Studies considered include the 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.
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The restatement studies we have reviewed all indicate that the
total number of restatements has increased in recent years. Market
reaction to restatements may be one indicator as to whether
restatements contain information considered by investors to be
material. While there are limitations \54\ to using market reaction as
a proxy for materiality, based on these studies, it would appear to us
that there may be restatements occurring that investors may not
consider important due to a lack of a statistically significant market
reaction. We, therefore, believe additional guidance on determining
whether an error is material and whether a restatement is necessary
would be beneficial in reducing the frequency of unnecessary
restatements.
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\54\ 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.
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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
[[Page 10921]]
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 attempting to
eliminate unnecessary restatements, 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.\55\
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\55\ We have developed principles that we believe will be
helpful in reducing unnecessary restatements. 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
issue guidance reinforcing 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 quantitatively small error is material, qualitative factors also may
lead to a conclusion that a quantitatively large error is not material.
The evaluation of errors should be on a ``sliding scale.''
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.
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 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. It is possible that an error that results in a
misclassification on the income statement (without a change in net
income) may not be deemed to be material, while an error of the same
magnitude that impacts net income may be deemed material based on the
effect of the error on the total mix of information available to a
reasonable investor.
We believe that, in current practice, materiality guidance such as
SAB Topic 1M is interpreted as being one-directional in that
qualitative considerations can make a quantitatively small error
material, but a quantitatively large error is material without regard
to qualitative factors. We believe that qualitative factors not only
can increase, but also can decrease, the importance of an error to the
reasonable investor. Specifically, we believe that there should be a
``sliding scale'' for evaluating errors. On this scale, the higher the
quantitative significance of an error, the stronger the qualitative
factors must be to result in a judgment that the error is not material.
Conversely, the lower the quantitative significance of an error, the
stronger the qualitative factors must be to result in a judgment that
the error is material.
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 reasonable
investor conclusions or are not important to reasonable 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.
The error relates to financial statement items whose
measurement is inherently highly imprecise.
Education and 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 unnecessary restatements.
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:
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 investor's assessment
of the annual financial statements would not require restatement of the
annual financial statements in which the error occurred, but would need
to be disclosed in an appropriate document, and, to the extent that the
error remains uncorrected in the current period, corrected in the
current period.
There may be no need for the filing of amendments to
previously filed
[[Page 10922]]
annual or interim reports to reflect restated financial statements, 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.
All errors, other than clearly insignificant errors,
should be 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.
The current disclosure during the period in which the
restatement is being prepared, about the need for a restatement and
about the restatement itself, is not consistently adequate for the
needs of investors and should be enhanced.
The current guidance that is detailed in SAB 108 (as codified in
SAB Topic 1N) may result in the correction 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. 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. 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 or corrected 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 \56\ with appropriate disclosure at the time the current
annual period financial statements are filed with the SEC.
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\56\ 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 for 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 current investors. This determination
should be based on the facts and circumstances of each error. For
example, an error that does not affect the annual financial statements
included within a company's most recent filing with the SEC may be
determined to not be relevant to current investors. For errors that do
not require restatement but were material in the annual period in which
they occurred, companies could be required to provide appropriate
disclosure about the error and the periods impacted.
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 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. That being
said, there should be a practicality exception for immaterial errors
discovered shortly before the issuance of the financial statements, but
in this case, the errors should be corrected in the next annual or
interim period being reported upon.\57\ Nevertheless, all material
errors should be disclosed during the period in which they are
corrected.
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\57\ 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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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
[[Page 10923]]
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.
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.
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 information (e.g., prior periods would not be restated for
immaterial items and for errors that have no relevance to current
investors, and more consistently good disclosure would be made during
and about the restatement process) and reduce the burdens on companies
related to unnecessary restatements. In addition, since our proposals
would require that all material errors be disclosed, relevant
information about such errors would be communicated to investors.
Developed Proposal 3.3: 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.\58\ 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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\58\ 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. Professional Judgment
III.A. Background
Overview
Professional judgment is not new to the areas of accounting,
auditing, or securities regulation--the criteria for making and
evaluating professional judgment have been a topic of discussion for
many years. The recent increased focus on professional judgment,
however, comes from several
[[Page 10924]]
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 both auditors and issuers appear
supportive of a move to less prescriptive guidance, they have expressed
concern regarding the perception that current practice by auditors and
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 standards can be
comfortably implemented.
Many regulators also appear to encourage a system in which
professionals 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 and auditors may attempt to inappropriately defend
certain errors as ``reasonable judgments.'' Identifying standard
processes for making professional 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 a Framework
The following are several issues that a potential framework may
help address:
a. Investors' lack of confidence in the use of judgment--A
professional judgment framework may provide investors with greater
comfort that there is an acceptable rigor that companies follow in
exercising reasonable professional judgment.
b. Preparers' and auditors' concern regarding whether reasonable
judgments are respected--In the current environment, preparers and
auditors may be afraid to exercise judgment for fear of having their
judgments overruled, after the fact, by auditors, regulators and legal
claimants.
c. Lack of agreement in principle on the criteria for evaluating
judgments--The criteria for evaluating reasonable judgment, 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, auditors and investors may be less comfortable in their
ability to implement more ``principles-based'' standards if there is a
concern over 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 a framework 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.
[[Page 10925]]
Levels of Judgment
There are many levels of judgment that occur related to accounting
and auditing. 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. Similarly, planning and performing an
audit requires numerous judgments. These judgments are also potentially
subject to evaluation and challenge by investors, regulators, legal
claimants and others, especially when, in hindsight, it has become
clear that the auditor failed to detect material errors in the
financial statements. Therefore, in developing a potential framework,
differences in role and perspective between those who make a judgment
and those who evaluate a judgment should be carefully considered. A
framework should not make those who evaluate a judgment (auditors,
regulators, and others) re-perform the judgment according to the
framework. Instead, a framework should provide guidance to those who
would evaluate a judgment on factors to consider while making that
evaluation.
Hindsight
One appropriate tool used in auditing is hindsight--the ability of
the auditor to use facts that are available through the completion of
the audit work to evaluate the sufficiency of management's estimates
and assumptions based on actual facts that become available after those
estimates are made.
For example, auditors will frequently test the accuracy of the
company's accounts payable balance at period-end by looking at cash
disbursements made after the period-end. This evidence allows the
auditor to determine whether the accrual for unpaid expenses at year-
end is adequate.
However, 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 the auditor, or should have been known,\59\ 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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\59\ 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 Framework
Some have proposed that a ``safe harbor'' be developed that
protects the exercise of judgment in accordance with a specified
framework. That approach would seem to provide greater support to
auditors and preparers than a statement of policy. However, it is
unclear to us whether a legal or regulatory safe harbor (i.e., an
effective legal or regulatory defense based on conformity with the
framework) could be adopted by the SEC or whether it would require
changes to existing statutes.
Another approach is for the SEC and the PCAOB to issue policy
statements that describe a framework for the exercise of professional
judgment and state that auditors, the SEC or the PCAOB, as applicable,
would take into account the implementation of the framework in
evaluating a judgment made by a registrant or an auditor. The SEC has
utilized similar frameworks in the past with success. Examples of
previous frameworks by the SEC include the ``Seaboard'' report (October
23, 2001) on the relationship of cooperation by a company to taking
action in an enforcement case and the SEC's framework for assessing the
appropriateness of corporate penalties (January 4, 2006).
While not an automatic defense of the registrant's or auditor's
judgment, a framework would provide more support to registrants and
auditors that the applicable regulator would be likely to accept a
judgment made if the registrant or the auditor had fully implemented
the framework. The framework is likely to enhance the quality of
judgments by providing incentives to follow a rigorous process for
making accounting and auditing judgments. The increased use of this
rigorous process should, in turn, provide more comfort to investors
about the quality of accounting judgments made in connection with
financial statements.
It is unclear to us whether, as a matter of regulatory strategy,
this judgment framework should be implemented through a safe harbor or
policy statement. We leave to the SEC and its staff the resolution of
these difficult issues.
The Nature and Limitations of GAAP
Some have suggested that the standard in a potential professional
judgment framework 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 adoption of such standards in a professional judgment framework
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
suggested judgment framework 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.
[[Page 10926]]
III.B. Developed Proposals
We have developed the following proposal:
Developed Proposal 3.4: The SEC should adopt a judgment framework
for accounting judgments. The PCAOB should also adopt a similar
framework with respect to auditing judgments. Careful consideration
should be given in implementing any framework to ensure that the
framework does not limit the ability of auditors and regulators to ask
appropriate questions regarding judgments and take actions to require
correction of unreasonable judgments.
The proposed framework applicable to accounting-related judgments
would include the choice and application of accounting principles, as
well as the estimates and evaluation of evidence related to the
application of an accounting principle. We believe that a framework
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 important and would be
beneficial to investors, preparers, and auditors. Therefore, we propose
that the PCAOB develop a professional judgment framework for the
application and evaluations of judgments made based on PCAOB auditing
standards.
We propose that the framework for accounting judgments be
consistent with the following concepts:
Framework for Professional Judgment in Accounting
The Concept of Professional Judgment
Professional judgment, with respect to accounting matters, should
be the outcome of a process in which a person or persons with the
appropriate level of knowledge, experience, and objectivity form an
opinion based on the relevant facts and circumstances within the
context provided by applicable accounting standards. Professional
judgments could differ between knowledgeable, experienced, and
objective persons. Such differences between reasonable professional
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.
This framework would serve as the primary, though not exclusive,
approach to evaluating the process of making professional judgments.
While regulators would strongly support the principles of this
framework, the mere completion of the process outlined in the framework
in making a judgment would not prevent an auditor and/or regulator from
asking appropriate questions about the judgment or asking companies to
correct unreasonable judgments. A judgment framework would not
eliminate debate, nor should it attempt to do so. Rather, it organizes
analysis and focuses preparers and others on areas to be addressed
thereby improving the quality of the judgment and likelihood that
auditors \60\ and regulators will accept the judgment. Conversely, not
following the framework would not imply that the judgment is
unreasonable.
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\60\ It should be noted that, while auditors should be using the
framework to evaluate a client's judgments and should respect
reasonable judgments, they still have a requirement to follow PCAOB
auditing standards, which would include expressing an opinion
regarding whether the client's financial statements are fairly
presented, in all material respects, in accordance with GAAP.
Therefore, this framework would not require auditors to issue an
unqualified audit opinion when they disagree with a judgment.
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This framework reflects the fact that GAAP does not always reflect
the economic substance of a transaction and that it may be difficult to
determine how the accounting would meet the needs of investors. In
addition, this framework would be applicable to accounting matters only
to the extent that judgments were required in the choice or application
of accounting principles, in estimating the amount to record, or in
evaluating the sufficiency of the evidence.
In applying the components of the framework, it would be expected
that the amount of documentation, disclosure, input from professional
experts,\61\ and level of effort in making a professional judgment
would vary based on the complexity, nature (routine versus non-routine)
and materiality of a transaction or issue requiring judgment.
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\61\ In many cases, input from professional experts would
include consultation with a preparer's independent auditors.
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Components of a Framework
Critical and Good Faith Thought Process--Professional judgment
should be based on a critical and reasoned evaluation made in good
faith, prior to the exercise of the judgment, of an identified issue,
including the nature and scope of the issue based on:
1. An 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. A thorough review and analysis of relevant literature, including
the relevant underlying principles.
4. Alternative views or estimates, including pros and cons for
reasonable alternatives.
5. The 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. Known diversity in practice regarding the alternatives or
estimates.\62\
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\62\ If there is not diversity in practice, it would be
significantly harder to select a different alternative.
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8. The consistency of application of alternatives or estimates to
similar transactions.
9. The appropriateness and reliability of the assumptions and data
used.
The critical thought process should include input from personnel
with an appropriate level of professional expertise and should include
a sufficient amount of time and effort to properly consider the
judgment.
Material issues or transactions that were analyzed pursuant to the
application of the framework should be disclosed in accordance with
existing disclosure requirements. This disclosure should be transparent
so that the investor understands the transaction and assumptions that
were critical to the judgment. When evaluating professional judgment,
auditors, and/or regulators should take into account the disclosure
relevant to the judgment.
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.
IV. Future Considerations
We intend to examine the area of regulation and compliance for
issues that create avoidable complexity in financial reporting. Some of
the areas that we intend to focus on include: (1) The interaction
between companies and their auditors, the SEC, and the PCAOB, (2) the
interaction between audit firms and the SEC and PCAOB, and (3) the
levels of enforcement and regulation of standards in other developed
markets around the world.
[[Page 10927]]
Chapter 4: Delivering Financial Information
I. Introduction
We have been evaluating the information needs of investors, methods
by which financial information is provided to investors, and means to
improve delivery of financial information to all market constituencies.
In evaluating the information needs of investors, we have recognized
that the information needs of different types of investors are not
always the same. We have agreed that information must be delivered in a
manner that is efficient, reliable, and cost-effective for each of the
relevant investor groups and will not significantly increase burdens on
reporting companies.
We have determined that we will focus our efforts on financial
information provided by reporting companies in their periodic and
current reports under the Securities Exchange Act of 1934 (``Exchange
Act'') and other ongoing disclosures provided by reporting companies to
investors and the market.\63\ We believe that we can make some useful
proposals to enhance ongoing reporting that will enable investors to
better understand reporting companies.
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\63\ We have determined that we will not address information
delivery in registered offerings under the Securities Act of 1933
for two primary reasons. First, the SEC already has addressed
information delivery in registered securities offerings when it
adopted new communication rules in 2005 for registered offerings by
issuers other than registered investment companies. Second, we view
information delivery relating to ongoing company reporting by public
companies as the area needing greater focus.
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Based on the above, we have analyzed two ways to improve the
delivery of financial information to investors and the market. These
are:
Tagging of financial information (XBRL).
Improving corporate website use.
We also intend to look at the following in the future:
Use of executive summaries as an integral part of Exchange
Act periodic reports.
Disclosures of key performance indicators (KPIs) and other
metrics to enhance business reporting.
Improved quarterly press release disclosures and timing.
Continued need for improvements in the management
discussion and analysis (MD&A) and other public company financial
disclosures.
II. Tagging of Financial Information (XBRL)
II.A. Background
Description of XBRL
XBRL is an international information format standard designed to
help investors and analysts find, understand, and compare financial and
non-financial information by making this information machine-readable.
It enables companies to better control how their financial or non-
financial information is presented and disseminated and reduce
reporting costs by integrating their operating data with their
financial reporting disclosure. XBRL is a computer language which uses
standardized XML (eXtensible Markup Language) technology and permits
the automation of what are now largely manual steps for access,
validation, analysis, and reporting of disclosure. For example, an
investor or analyst who wants to compare the sales of all
pharmaceutical companies will be able to use software applications to
take the XBRL-tagged information, extract the sales numbers and
download them directly to a spreadsheet.
XBRL uses standardized definitions of terms, like a dictionary. The
standardized terms are then arranged in a logical structure called a
taxonomy. A GAAP financial statement itself, in that its underlying
details are summarized in the line items of a balance sheet or income
statement, is a kind of taxonomy. There are taxonomies for different
kinds of businesses. For example, the banking industry sector taxonomy
differs from that of a software industry sector company.
Status of XBRL-Tagged Financial Statements in SEC Reports
The SEC has adopted a voluntary pilot program for the use of XBRL
in which participants submit voluntarily supplemental tagged financial
information using the XBRL format as exhibits to specified EDGAR
filings.\64\ Voluntary pilot participants may use existing standard
XBRL taxonomies. Over four dozen companies are participating in the
pilot program and have agreed to voluntarily submit their annual,
quarterly and other reports with interactive data for a period of one
year. The SEC recently expanded the voluntary filing program to include
mutual funds which will file using a risk and return taxonomy developed
by the Investment Company Institute.
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\64\ The SEC's voluntary XBRL rules specify the form, content,
and format of XBRL submissions, description of XBRL data, timing of
XBRL submissions, and use of Taxonomies. For example, the rules
require the tagged data to be described either as ``unaudited'' or,
for quarterly financial statements, ``unreviewed.''
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On December 5, 2007, XBRL-US published a draft XBRL U.S. GAAP
Taxonomy and draft preparer's guide for public testing and comment. The
XBRL U.S. GAAP Taxonomy includes tags for a company's financial
statements and notes. Public review currently is scheduled to end April
5, 2008, and XBRL-US has stated that it anticipates that the final XBRL
U.S. GAAP Taxonomy and preparer guidance will be issued in spring 2008.
After the final XBRL U.S. GAAP Taxonomy and preparer guidance is
issued, the SEC EDGAR system must be modified to accept submissions
tagged using the XBRL U.S. GAAP Taxonomy.
The SEC has stated that it will use the initial financial
statements prepared using the new XBRL U.S. GAAP Taxonomy to help it
further update its EDGAR system so that it will be able to ``seamlessly
accept and render the filings.'' We understand that currently, the
SEC's EDGAR system does not yet accept and render financial statements
with XBRL tags based on the newly-developed XBRL U.S. GAAP Taxonomy.
In addition, we understand that the software industry has been
engaged in developing tagging and rendering (turning the XBRL-tagged
information into a human readable format) software for XBRL-tagged
financial statements. Companies generally use two methods to tag their
financial statements using XBRL. The first method, called a ``bolt-on''
approach, involves developing the XBRL reports after the filed
financial statements are developed--a process known as ``mapping.''
Companies also may use XBRL as part of an integrated approach to
financial reporting. In an integrated approach, companies incorporate
XBRL into their internal company financial systems which allows
financial reports to be created from the XBRL-tagged financial systems,
without first preparing such financial statements in ``human readable
format.'' XBRL-tagging using a ``bolt-on'' approach may involve
somewhat more effort than using an integrated approach. Currently,
there is software that allows companies to XBRL-tag their financial
statements using the ``bolt-on'' approach.\65\ At this time it is
unknown how many companies have begun integrating XBRL-tagging into
their internal financial reporting systems and, therefore, it is not
clear when a significant number of companies would
[[Page 10928]]
move from a ``bolt-on'' to an integrated approach to XBRL-tagging of
their financial statements.
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\65\ Using the ``bolt-on'' method, companies can prepare their
financial statements (including notes) in a number of formats, such
as Adobe (pdf), Word, and HTML.
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Time and Costs Involved in XBRL-Tagging
We understand that while the XBRL U.S. GAAP Taxonomy has a
significant number of individual tags or elements, it contains all of
the terms or concepts commonly used in financial statements prepared in
accordance with GAAP. We understand that reporting companies would use
only a limited number of tags or elements. For example, one large
voluntary filer uses approximately 192 tags (it tags its notes as
blocks rather than at a granular level) to tag its Form 10-Q. We
understand that there may be the need for customized ``extensions'' if
the XBRL U.S. GAAP Taxonomy does not include a tag for the particular
item in the company's financial statements. Because the XBRL U.S. GAAP
Taxonomy currently out for public comment tracks GAAP, we believe that
there likely will be less need for customized extension elements. One
of the purposes of the comment period on the XBRL U.S. GAAP Taxonomy
and preparer guidance is to identify additional tags or elements that
should be added to the XBRL U.S. GAAP Taxonomy, reducing the need for
customized extensions. The draft preparer guidance out for public
comment also will be evaluated by preparers, investors, and others to
determine whether it provides adequate guidance for determining when an
extension should be used by preparers.
The type of information that is tagged also is relevant to
understanding XBRL-tagged financial statements. Companies participating
in the voluntary program have been tagging the face of their financial
statements using existing taxonomies and software. As to the notes to
the financial statements, additional effort may be involved. While the
notes to the financial statements may easily be tagged as a block of
text, unlike preparation of notes to the financial statements in a
paper-based format, tagging the individual information in each note
will involve additional tags and, therefore, more work than block-
tagging the text.
Certain preparers participating in the SEC's voluntary program have
indicated that the initial number of hours it took to tag the face of
their financial statements using existing standard taxonomies (not the
new XBRL U.S. GAAP Taxonomy) and a ``bolt-on'' approach ranged from 80-
100 hours and that the number of hours dropped significantly for
subsequent reports (due to the lack of a need to replicate the tagging
process for most items).\66\ For preparers also tagging the notes to
their financial statements using a ``block'' tag, the number of hours
increased slightly. The costs to tag the face of the financial
statements using standardized software were not significant. Additional
time and cost was spent by at least one preparer to validate the tags
that were used. In these cases, there was no auditor involvement in the
process.
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\66\ For example, one S&P 500 company participating in the
voluntary pilot spent 80 hours learning the tagging tool,
understanding SEC requirements, creating extensions for tags, and
creating a process for ongoing tagging and future submissions.
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Smaller Public Company Reactions to XBRL-Tagging
Smaller public company representatives recognize the benefits that
XBRL offers their companies over the long-term, but are concerned about
initial implementation costs, which could be alleviated with the
development of improved tagging and verification software. The
representatives strongly support a phase-in approach in which such
smaller public companies would be included at the end, once larger
public companies had worked through any significant implementation
issues, including use of company resources involved in tagging and
verification of XBRL tags.
Potential Benefits of XBRL
We see a number of potential benefits of XBRL for reporting
companies and investors of financial and non-financial information.
First, XBRL-tagging could benefit reporting companies by permitting
improved communications with analysts and investors. Released corporate
data could be instantaneously and immediately usable by analysts in
their models without the need for them to wait for third party
aggregators or staff to input the data into their own format. There
would be a reduction in search costs. Further, such reduced search
costs could potentially increase coverage of companies, especially mid-
size and smaller companies, by sell-side and buy-side analysts, and at
both major brokerage and independent research firms. XBRL-tagging also
would likely improve the quality of data \67\ and the ability of a
company to control the presentation of its financial information. The
elimination or reduction of the manual input would likely reduce error
rates in reporting and inputting of corporate data by aggregators.
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\67\ Although XBRL is frequently called ``interactive data,''
the use of the term ``data'' should not be deemed to imply numerical
data alone. XBRL also is useful for the tagging of narrative
information.
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Second, XBRL has the potential to improve the integration of
company operating and reporting data. Using XBRL, operating data can be
accessed in the internal enterprise applications where it is regularly
stored, and thus will be used for financial reporting purposes without
the necessity of downloading to paper or manual search. The same
electronically accessible data can be used for other purposes beyond
those of financial statements, including tax, industrial filings,
audit, benchmarking, performance reporting, internal management, and
sustainability. We believe that the full economic benefits of XBRL will
most likely come when companies incorporate XBRL into their internal
reporting, instead of using it as a ``bolt-on'' after their financial
reports are prepared.
Finally, XBRL-tagged financial statements can provide a number of
benefits to investors, including both retail investors and the ``model
builder/research analyst.'' Investors can benefit from, among other
things, a reduced cost of locating and inputting data into analytical
frameworks, elimination of manual input thereby reducing the likelihood
of input error by an investor or data aggregator, reduced investor
dependence on proprietary and inconsistent data sources, increased
likelihood of more investors utilizing primary data sources, and
reduced cost of and improved company comparisons. The XBRL-tagged
financial statements should enable investors and experienced analysts
at research organizations to spend more time analyzing data than data
gathering.
We recognize, however, that notwithstanding the potential benefits,
many company officers may not understand how XBRL works or what
improvements it could bring to both their financial reporting and their
costs of reporting. In addition, there currently is limited acceptance
of XBRL due, in part, to companies needing greater certainty that XBRL
will be adopted before they will expend the necessary resources to
understand it and its benefits. Companies may have other concerns about
potential start-up costs in adopting XBRL, including purchase of
software and personnel resources for data input and training. Further,
analysts and software developers generally are unaware or uninformed
about XBRL.
[[Page 10929]]
Implementation of XBRL-Tagging of Financial Statements
We believe that the SEC should, over the long-term, require all
public reporting companies (preparing their financial statements using
GAAP) to tag the financial statements (including footnotes) they are
required to file with the SEC as part of their Exchange Act reports
using XBRL. We believe that an implementation roadmap from the SEC is
needed to encourage the involved parties to move beyond a wait-and-see
approach and commit resources toward the necessary development of
software. That software would tag financial information and enable the
viewing and reading of the XBRL-tagged information, the use of XBRL-
tagged data by investors such as analysts and investors, and the
integration of XBRL by companies. We believe that full implementation
of mandated XBRL-tagged financial statements will require a phase-in
over a period of time, as discussed below, to enable preparers and
investors to understand XBRL by preparers and investors, to permit
successful use of the new XBRL U.S. GAAP Taxonomy, and to enable the
further development of tagging and rendering software. We believe that
such a phase-in should be sensitive to the concerns of smaller public
companies regarding mandated XBRL-tagged financial statements.
We believe that mandatory implementation of XBRL will involve a
number of steps leading to the ultimate goal of requiring public
reporting companies to tag their financial statements using XBRL.
Full mandatory implementation may not be possible until all the
following preconditions are met:
Taxonomy development.
[cir] Testing of the XBRL U.S. GAAP Taxonomy is completed. The
testing process for the new XBRL U.S. GAAP Taxonomy, which is to
determine whether disclosures are complete and relevant in the current
market environment, is now underway.
[cir] The final XBRL U.S. GAAP Taxonomy and preparer guide are
released following public review and comment.
[cir] Voluntary filers have successfully used the XBRL U.S. GAAP
Taxonomy and preparer guide for a period of time.
--Status: On December 5, 2007, XBRL published the draft of XBRL U.S.
GAAP Taxonomy and draft preparer guide for public testing and comment.
The XBRL U.S. GAAP Taxonomy includes tags for a company's financial
statements and footnotes. Public review currently is scheduled to end
April 5, 2008, and it is anticipated that the final XBRL U.S. GAAP
Taxonomy and preparer guide will be issued in spring 2008.
Ability of SEC EDGAR to ``seamlessly'' accept XBRL
submissions using the new XBRL U.S. GAAP Taxonomy and other XBRL-tagged
data and provide an accurate rendered version of all such tagged
information.
[cir] Status: The SEC has stated that it will use the initial
financial statements prepared using the new XBRL U.S. GAAP Taxonomy to
help it update EDGAR so that it will be able to ``seamlessly accept and
render the filings.'' Currently, the SEC's EDGAR system does not accept
financial statements with XBRL tags based on the newly-developed XBRL
U.S. GAAP Taxonomy.
We believe that, to achieve the desired acceptance of XBRL, after
the XBRL U.S. GAAP Taxonomy precondition is satisfied, on an interim
basis XBRL-tagged financial statements should be required to be
implemented on a phase-in basis as follows:
The largest 500 domestic public reporting companies based
on unaffiliated market capitalization (public float) should be required
to furnish to the SEC, as is the case in the voluntary program today, a
document prepared separately from the reporting companies' financial
statements that are filed as part of their periodic Exchange Act
reports. This document would contain the following:
[cir] XBRL-tagged face of the financial statements.\68\
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\68\ To allow this first phase, the SEC EDGAR system must permit
submissions using the new XBRL U.S. GAAP Taxonomy.
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[cir] Block-tagged footnotes to the financial statements.\69\
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\69\ We understand that tagging beyond the face of the financial
statements and block-tagging of footnotes, such as granular tagging
of footnotes and non-financial data, may require significant effort
and would involve a significant number of tags.
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Domestic large accelerated filers (as defined in SEC
rules, which would include the initial 500 domestic public reporting
companies) should be added to the category of companies, beginning one
year after the start of the first phase, required to furnish XBRL-
tagged financial statements to the SEC.
We believe that a phase-in would provide businesses, financial
planners, software developers, and investors with the impetus to move
forward in building systems based on XBRL. For example, in connection
with the mandatory implementation of XBRL, we are aware that, if
tagging were mandated for companies, they may use a ``bolt-on''
solution in-house or use a service provider in the early stages before
moving to a broader integrated interactive data approach. This ``bolt-
on'' approach, for many, could be used as a means to begin to climb the
learning curve in a cheap, easily managed manner. In this regard, we
believe that companies should have the capacity to compare XBRL-tagged
and rendered financial statements to avoid errors and the SEC should
take steps to assist in that regard. We believe that the SEC should
encourage or commission the development of free software to compare
rendered and filed statements.
During the phase-in period, the SEC and PCAOB should seek input
from companies, investors, and other market participants as to the
experience of such persons in preparing and using XBRL-tagged financial
statements using the XBRL U.S. GAAP Taxonomy, and related costs. The
SEC should consider conducting or commissioning a study of the rate of
errors by companies in using the appropriate XBRL tags in comparison to
the financial statement items, which should be done only after filers
use the final uniform Taxonomy and preparer guidance to tag their
financial statements.
As mentioned above, under the phase-in approach, the XBRL-tagged
financial statements would still be considered furnished to and not
filed with the SEC. As part of the mandatory implementation, we believe
that, as is the case in the voluntary program, the SEC should make
clear what liability provisions the XBRL-tagged financial statements
would be subject to under the federal securities laws.
Finally, at the end of the phase-in period described above, and as
promptly as practicable after all the preconditions to full
implementation discussed above are met, the SEC should evaluate the
results from the phase-in period to determine whether and when to move
from furnishing to the SEC to the official filing of XBRL-tagged
financial statements with the SEC by domestic large accelerated filers,
as well as whether and when to include all other reporting companies,
as part of a company's Exchange Act periodic reports.
II.B. Developed Proposals
We would like to make recommendations that increase the certainty
that XBRL will be a significant part of the reporting landscape so that
preparers, investors, auditors, software developers and regulators make
the needed investment in XBRL.
Based on the above considerations, we have developed the following
proposal:
[[Page 10930]]
Developed Proposal 4.1: The SEC should, over the long-term, mandate
the filing of XBRL-tagged financial statements after the satisfaction
of certain preconditions relating to: (1) Successful XBRL U.S. GAAP
Taxonomy testing, (2) capacity of reporting companies to file XBRL-
tagged financial statements using the new XBRL U.S. GAAP Taxonomy on
the SEC's EDGAR system, and (3) the ability of the EDGAR system to
provide an accurately rendered version of all such tagged information.
The SEC should phase-in XBRL-tagged financial statements as follows:
The largest 500 domestic public reporting companies based
on unaffiliated market capitalization (public float) should be required
to furnish to the SEC, as is the case in the voluntary program today, a
document prepared separately from the reporting companies' financial
statements that are filed as part of their periodic Exchange Act
reports. This document would contain the following:
[cir] XBRL-tagged face of the financial statements.\70\
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\70\ To allow this first phase, the SEC EDGAR system must permit
submissions using the new XBRL U.S. GAAP Taxonomy.
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[cir] Block-tagged footnotes to the financial statements.\71\
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\71\ We understand that tagging beyond the face of the financial
statements and block-tagging of footnotes, such as granular tagging
of footnotes and non-financial data, may require significant effort
and would involve a significant number of tags.
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Domestic large accelerated filers (as defined in SEC
rules, which would include the initial 500 domestic public reporting
companies) should be added to the category of companies, beginning one
year after the start of the first phase, required to furnish XBRL-
tagged financial statements to the SEC.
Once the preconditions noted above have been satisfied and
the second phase-in period has been implemented, the SEC should
evaluate whether and when to move from furnishing to the SEC to the
official filing of XBRL-tagged financial statements with the SEC for
the domestic large accelerated filers, as well as the inclusion of all
other reporting companies, as part of a company's Exchange Act periodic
reports.\72\
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\72\ A dissenting vote on developed proposal 4.1 was cast by
Peter Wallison.
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II.C. Assurance
An important issue related to tagging public company financial
statements using XBRL involves whether assurance should be provided by
a third party. We understand that among the primary benefits of
providing independent assurance of XBRL documents is that financial
statement investors could quickly build confidence in interactive data
and increase their use of such data. One primary reason for not
obtaining such independent assurance of XBRL documents is the concern
that the cost and time incurred to obtain such assurance may
significantly outweigh the benefits to preparers and investors.
As to assurance, we understand that questions arise as to whether
assurance should be provided as to matters such as:
1. The appropriate use of the proper XBRL U.S. GAAP Taxonomy and
accurate tagging of financial statements.
2. The reasonableness of any company extensions to the XBRL U.S.
GAAP Taxonomy.
3. The compliance of the XBRL-tagged document (also called the
``instance document'') with SEC content and format requirements.
4. The separate performance of validation checks over footings and
inter-checks (for example, whether inventory is reported more than once
throughout the document determine if amounts reported are consistent)
of the XBRL instance document.
5. Whether the information in the XBRL instance document is the
same as the information in the official filed financial statements
(applicable under a ``bolt-on'' state).
We note that there are ways in which companies may, inadvertently
or deliberately, create XBRL reports in a manner that will potentially
mislead investors. Accordingly, one of our members believes that
independent assurance of XBRL documents prepared by management should
be provided, as described in items (1) and (5) above (at a minimum),
provided that such assurance does not result in a significant increase
in costs. This member noted that accounting knowledge and professional
judgment would be required in providing that assurance, but believed
that the assurance process is relatively simple, should not take a
significant amount of time because many steps can be automated, and,
therefore, should not be an expensive or time-consuming activity.
The concept of obtaining assurance on the correct tags and matching
the XBRL rendered documents to the filed statements is predicated on
the belief that the incremental monetary and human resource costs to
provide the assurance will be very small. Reviewing the tags the first
time will involve significant effort, but subsequent reviews may be
limited to new or changed tags. Moreover, the costs and benefits of
assurance reviews may differ depending on whether companies are using
the ``bolt-on'' rather than the integrated tagging approach. Therefore,
our other members believe that it is appropriate to study the assurance
process during the phase-in period to assess the actual costs and
benefits of assurance that might be provided on the XBRL-tagged
financial statements.
The type, timing, and extent of assurance, if any, on a company's
XBRL-tagged financial statements and other tagged information required
to be furnished to the SEC should take into account the needs of
investors, and other market participants, along with the costs to
reporting companies. Until a group of reporting companies has been
required to furnish to the SEC XBRL-tagged financial statements and
notes using the new XBRL U.S. GAAP Taxonomy for a period of time that
will allow investors and other market participants to evaluate the
reliability of such XBRL-tagged financial statements and notes, it is
premature to make concrete suggestions regarding assurance.
Accordingly, our developed proposal does not include any assurance
proposal. During the interim phase-in period discussed above, the SEC
and PCAOB should seek input from companies, investors, and other market
participants as to the type, timing, and extent of desired or needed
assurance, if any. This input should include the experience of such
persons in preparing and using XBRL-tagged financial statements using
the newly-developed XBRL U.S. GAAP Taxonomy, and related costs.
Additionally, after public companies are required to tag their
financial statements using XBRL, whether in accordance with our
proposals or otherwise, the SEC should consider initiating a voluntary
pilot program in which companies obtain assurance on their XBRL-tagged
financial statements (whether using a ``bolt-on'' or integrated
approach) in order to evaluate fully potential costs and benefits
associated with such effort.
III. Improved Corporate Web site Use
Background
We have been examining the integral role that technology and
corporate Web sites play in informing the markets and investors about
important corporate information and developments, including Web site
disclosure presentations that are under development by software
vendors. A valuable element of many of such Web site presentations is
that they present the most important general information about a
company on the opening page,
[[Page 10931]]
with embedded links that enable the reader to drill down to more detail
by clicking on the links. In this way, viewers can follow a path into,
and thereby obtain increasingly greater details about the financial
statements, a company's strategy and products, its management and
corporate governance, and its many other areas in which investors and
others may have an interest.
Improving the use of corporate Web sites can enable shareholders
and investors to gather information about a company that is at a level
they believe is satisfactory for their purposes, without requiring them
to wade through large amounts of written material that may provide a
level of detail beyond their particular needs.
Corporate Web sites offer reporting companies a cost-effective,
efficient method to provide information to investors and the market.
Encouraging reporting companies to increase their use of their Web
sites, including developing a tiered approach to deliver such corporate
information on their Web sites, would benefit investors of all types,
retail and institutional. Enhanced corporate Web site usage could
decrease the complexity of information presentation and would enhance
its accessibility. In addition, through coordination by industry
participants, uniform best practices on uses of corporate Web sites
could be developed.
The SEC has issued a series of interpretive releases and rules
addressing the use of electronic media to deliver or transmit
information under the federal securities laws. The SEC issued its last
comprehensive interpretive release on the use of electronic media,
including corporate Web sites, in 2000. Since 2000, significant
technological advances have increased both the market's demand for more
timely corporate disclosure and the ability of investors to capture,
process, and disseminate this information. Recognizing this, the SEC
has adopted a large number of rules that mandate, permit, or require
disclosure of the use of corporate Web sites to provide important
corporate information and developments.
We have been informed, however, that there are continuing concerns
about the treatment of Web site disclosures under the federal
securities laws that some have argued may be impeding greater use of
corporate Web sites. These concerns include liability for information
presented in a summary format, the treatment of hyperlinked information
from within or outside a company's Web site, the disclosure of non-GAAP
measures and required reconciliations to GAAP, and the need for
clarification of the public availability of information disclosed on a
reporting company Web site. Consequently, we believe that the SEC
should issue a new comprehensive interpretive release regarding the use
of corporate Web sites for disclosures of corporate information. We
believe that SEC guidance would encourage further creative use of
corporate Web sites by reporting companies to provide information,
including Web site disclosure formats following industry developed best
practice guidelines.
Developed Proposal
Based on the above, we have developed the following proposal:
Developed Proposal 4.2: The SEC should issue a new comprehensive
interpretive release regarding the use of corporate Web sites for
disclosures of corporate information, which addresses issues such as
liability for information presented in a summary format, treatment of
hyperlinked information from within or outside a company's Web site,
treatment of non-GAAP disclosures and GAAP reconciliations, and
clarification of the public availability of information disclosed on a
reporting company's Web site.
Industry participants should coordinate among themselves to develop
uniform best practices on uses of corporate Web sites for delivering
corporate information to investors and the market.
IV. Future Considerations
Use of Executive Summaries in Exchange Act Periodic Reports
We have been exploring a requirement to include an executive
summary in reporting company annual and quarterly Exchange Act reports
(Forms 10-K and 10-Q). We understand that a summary report prepared on
a stand-alone basis would not necessarily provide investors with
information they need in a desired format. However, an executive
summary included in the forepart of an Exchange Act periodic report may
provide investors with an important roadmap to the company's
disclosures located in the body of such a report. 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 would include cross-references to the location of the
fuller discussion in the annual report.
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 included 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 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.'' \73\ The executive summary should
build on the MD&A overview disclosure and include the following:
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\73\ 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).
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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.
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.
The executive summary would 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
[[Page 10932]]
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.
We will continue to evaluate the concept of requiring an executive
summary in a public company's Exchange Act periodic reports such as the
annual report on Form 10-K and the quarterly report on Form 10-Q.
Disclosures of KPIs and Other Metrics To Enhance Business Reporting
Enhanced business reporting and KPIs are disclosures about the
aspects of a company's business that are the source of its value. The
Enhanced Business Reporting Consortium,\74\ 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.
KPIs are leading indicators of financial results and intangible assets
that are not encompassed on a company's balance sheet. 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
are said to 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.
---------------------------------------------------------------------------
\74\ 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.
---------------------------------------------------------------------------
The important issues for us to examine are what types of KPIs
should be made available, in what format and at what time, and whether
they are clearly and consistently defined over time. Currently,
companies are disclosing some company-specific KPIs in their periodic
reports filed with the SEC or in other public statements. Other people
in the market are working on developing industry-specific KPIs in order
to improve comparability of companies on an industry basis. We will
explore ways to encourage companies to disclose company and industry-
specific KPIs. In addition, we will examine who should develop the
disclosure standards for defining and measuring KPIs to assure
consistency among companies and through time, and whether XBRL should
be extended by industry sector to include KPIs and information on
intangible assets. Further, we will examine the interplay between the
use of non-GAAP measures and KPIs. We also will examine ways in which
consistent KPIs can be developed through industry coordination.
Improved Quarterly Press Release Disclosures and Timing
The quarterly press release, being 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.
We intend to review the earnings press release for its consistency,
understandability and its timeliness. We will consider the consistent
provision of income statement, balance sheet and cash flow tables in
the quarterly release. We also intend to consider 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. Ultimately, we view the goal
for an earnings release as a consistent, reliable communication form
that all investors can easily navigate.
In addition, we will evaluate 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. In this regard, we will review a survey of CFA
Institute members on a similar proposal, as well as the comments
received by the SEC when this idea was put forth in prior SEC rule
proposals. We will consider, among other things: (1) The savings in
time spent cross-referencing two separate but fairly identical reports
separated by a very short period of time, and (2) the elimination of
the concern that the two reports may not perfectly match.
We do not intend to deliberate the potential elimination of the
issuance of quarterly earnings results. The elimination of quarterly
reports would deprive investors of important sources of information
about a company's performance. However, we may discuss 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. Moreover, as
mentioned above, we will focus on efforts to encourage corporate
reporting of KPIs and other measures of sustainable business progress
over longer periods.
Continued Need for Improvements in the MD&A and Other Public Company
Financial Disclosures
Every public company is required to include a MD&A section in its
annual and quarterly reports filed with the SEC. The three principal
objectives of the MD&A are to:
Provide a narrative explanation of a company's financial
statements that enables investors to see the company through the eyes
of management
Enhance the overall financial disclosure and provide the
context within which financial information should be analyzed
Provide information about the quality of, and potential
variability of, a company's earnings and cash flow so that investors
can ascertain the likelihood that past performance is indicative of
future performance.
The SEC has made clear that the quality of the MD&A in public
company periodic reports is not as good as it should be. In 2003, the
SEC concluded, based in part on the Fortune 500 report issued by Corp
Fin, that additional guidance was useful in the following areas:
The overall presentation of the MD&A
The focus and content of the MD&A (including materiality,
analysis, key performance measures and known material trends and
uncertainties)
Disclosure regarding liquidity and capital resources
Disclosure regarding critical accounting estimates.
The SEC has stated that the MD&A should not be a recitation of
financial statements in narrative form or a series of technical
responses to the MD&A requirements.
We understand that 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 both in terms of additional
disclosures and elimination of what the SEC termed ``unnecessary detail
or duplicative or uninformative disclosure that obscures material
information.''
[[Page 10933]]
Under the Sarbanes-Oxley Act of 2002, the SEC is generally required
to review every public company's filings at least every three years. In
that regard, we believe that through the review process, the SEC will
gain important insight into whether there has been improvement in the
MD&A disclosures and the types of ongoing concerns regarding such
disclosures. We will be evaluating whether the SEC should periodically
issue a report on common types of comments issued on the MD&A and other
financial disclosures, similar to the Fortune 500 report, to provide
additional guidance on improving the MD&A in accordance with the SEC's
most recent interpretive guidance.\75\
---------------------------------------------------------------------------
\75\ We note that the SEC's comment letters on a reporting
company's filings are made publicly available on the SEC Web site
after completion of the SEC's review of such filings. We also note
that third parties prepare reports on the MD&A disclosures.
---------------------------------------------------------------------------
Appendices
Index of Appendices
A--Separate Statement of Mr. Wallison
B--Examples of Substantive Complexity
C--Committee Members, Official Observers, and Staff
Appendix A
Separate Statement of Mr. Wallison
Introduction
In its meeting on January 11, 2008, the Committee endorsed the use
of XBRL for financial reports with this statement: ``The Committee
believes that the SEC should eventually require all public companies
(preparing their financial statements using U.S. GAAP) to tag the
financial statements (including footnotes) they are required to file
with the SEC as part of their Exchange Act reports using XBRL. The
Committee believes such a mandate is necessary in order to encourage
the commitment of resources toward the necessary software development
for tagging, viewing and reading of XBRL tagged information * * *
''.\76\
---------------------------------------------------------------------------
\76\ Draft report, p. 81
---------------------------------------------------------------------------
Yet, despite the value the Committee saw in mandating the use of
XBRL by reporting companies, the Committee adopted an extended phase-in
that will delay the widespread use of XBRL for financial reporting well
into the next decade. I dissented from the Committee's vote--and am
filing this separate statement--because I believe the Committee's
proposed timetable is (i) based on an erroneous assessment of the
potential costs of auditor assurance, (ii) applies restrictions on
reporting that will be harmful to XBRL and to users, and (iii)
unnecessarily delays the date on which XBRL will be available to
investors and analysts.
In the Committee's timetable, the first phase begins with the 500
largest reporting companies. These companies would be required to
``file'' their regular audited financial statements, as they do today,
and at the same time to ``furnish'' a supplement consisting of the XBRL
tags that were applied to the filed statements (for purposes of this
memorandum, I will refer to this supplemental XBRL material as the
``XBRL financial statements''). In the Committee's recommendation, the
XBRL financial statements would include both the facing financials and
block-tagged footnotes (block-tagging means that one XBRL tag is
applied to the entire footnote, instead of applying individual tags to
each of the individual disclosures within the footnote).
The first phase would not begin until certain technical
preconditions have been resolved, the most significant of which is the
upgrading of the SEC's website to receive XBRL filings. John White, the
director of the SEC's Division of Corporation Finance, told the
Committee that he did not think the first phase would begin until the
fall of 2008. One year after the first phase begins, domestic large
accelerated filers (perhaps 1500 additional companies) would be
required to ``file'' their regulator audited financial statements, and
``furnish'' a set of XBRL financial statements. Some time after the
second phase has begun, the SEC is to decide ``whether and when to move
from furnishing to the official filing of XBRL financial statements for
the domestic large accelerated filers, as well as the inclusion of all
other reporting companies.''
The Delay
Assuming that the first phase begins in the fall of this year, it
seems unlikely that the companies involved will be required to begin
with their 10-K reports, which for the most part are due to be filed no
later than March 31, 2009. So in reality, the first phase 500 companies
will be filing reports and furnishing XBRL financial statements for the
quarters ended in 2009 and the 10-K due in March 2010. The second phase
will begin late in 2009 (one year after the beginning of the first
phase) and will include the financial statements that are due (for most
companies) in the first three quarters of 2010 and the 10-K due at the
end of the first quarter of 2011. We are already three years from
today, and only 2000 or so companies will have been required to prepare
XBRL financial statements.
Only after the second phase has begun in late 2009 or early 2010
will the SEC (in the Committee's recommendation) begin to consider
whether to require any companies to file (rather than furnish) their
XBRL-tagged financial statements. Since the second phase companies will
(in the Committee's recommendation) be permitted to furnish rather than
file their XBRL financial statements, that must mean they won't be
required to file their XBRL financial statements until after their 10-
Ks are filed in March 2011. That means no company, large or small, will
be required to file a 10-K with XBRL financial statements until March
of 2012. That's four years from now, and quite a generous phase-in,
considering we are talking about only 2000 or so of the largest and
most sophisticated companies in the U.S. When the remaining 13,000
reporting companies will be required to file XBRL financial statements
under this ``mandatory'' phase-in is anybody's guess.
The distinction between furnishing and filing is important. Under
the Securities Exchange Act of 1934, companies are absolutely liable
for false or misleading material filed with the SEC. However, in the
case of material that is merely furnished to the SEC, liability only
attaches if it can be shown that the material was intentionally false
or misleading. Accordingly, the Committee seems to have adopted the
idea of furnishing rather than filing XBRL financial statements because
of its concern about the possible cost of auditor assurance. It seems
to have reasoned that, if XBRL financial statements were furnished
rather than filed, the reduced liability would permit companies to
dispense with auditor assurance entirely, and thus to avoid these
potential costs. However, as I will discuss below, the concern about
assurance costs is misplaced and ultimately self-defeating. Not only
was there no need to require the furnishing of XBRL financial
statements, but allowing XBRL financial statements to be furnished
rather than filed will severely impair the value of XBRL for investors
and analysts and is an important source of what will be an enormous and
unnecessary delay in the adoption of XBRL in the United States.
Will auditor assurance as to the accuracy of XBRL-tagged financial
statements be costly?
As noted above, the Committee's phase-in recommendation, and its
distinction between filing and furnishing XBRL financial statements,
were apparently motivated by concern that auditor assurance as to the
accuracy
[[Page 10934]]
of the XBRL tagging will be costly. Some committee members, without any
supporting evidence, referred to the process of auditor assurance as
potentially as costly as Section 404 of Sarbanes-Oxley--erroneous
statements that were picked up in some media reports of the meeting.
However, as I will discuss below, concerns about the cost of assurance
are unfounded and should not have been a factor in the Committee's
deliberations.
Today, most companies that tag their financial statements use the
so-called bolt-on method. It is the simplest, although not potentially
the least costly, approach to tagging financial statements. In the
bolt-on method, financial statements are prepared and audited in the
usual way. When the audit is completed, the financial statements are
``mapped'' to the XBRL taxonomy. This means simply that the various
items in the company's financial statement are tagged with the
appropriate XBRL tag. The tagging can be done largely automatically,
with existing software that reads the financial statement and applies
the appropriate tag, or manually through a drag and drop method that
also uses available open source (zero cost) software.
Once the items in the financial statements have been tagged, the
question arises whether the tags have been correctly selected and
applied. It is at this point that the question of assurance becomes
significant. It is also important to note that there is no relationship
between the audit of the financial statements and the assurance process
on the application of the XBRL tags we are discussing here. The audit
of the financial statements has been completed when the bolt-on process
begins. The assurance process for the XBRL tags does not make the audit
in any way more complicated or costly. The only remaining question is
whether the tagging, after the audit, has been done properly. For
purposes of this memorandum, the key question is what it would cost for
the company's auditor, having completed the audit, to determine that
the company properly applied the XBRL tags after the audit's
completion.
There are only three significant questions that must be answered
for the auditors to assure themselves--and to provide assurance to
others--as to the accuracy of the tagging:
Did the company choose the correct XBRL taxonomy (there
are several different XBRL taxonomies, because the financial statements
of banks, for example, are different from the financial statements of
operating companies);
Did the company properly tag each disclosure in its
financial statements? (For example, is the ``revenue'' item in the
financial statements properly mapped to the correct ``revenue'' tag in
XBRL?)
Did the company add extensions to the tags that were not
appropriate in light of the company's business? (Adding extensions to
the tags already included in the XBRL taxonomy, although permissible,
could make it difficult to compare one company's financial statements
with another's.) \77\
---------------------------------------------------------------------------
\77\ In the brief discussion at the Committee meeting on January
11, one member suggested that more financial information was
included in XBRL material associated with a financial statement than
in the financial statement itself. This is not correct. XBRL does
not contain any more financial data than the company chooses to
disclose in its financial statements.
---------------------------------------------------------------------------
To put this in some perspective, one S&P 50 technology company told
Subcommittee 4 that its 10 Q report, including the financial
statements, block-tagged footnotes, and the MD&A, required only 192
tags. So the assurance process, had it been done for that company by
its auditors, would have required that the auditors answer the three
questions above for only 192 tags. In the end, the company performed
its own assurance, which required only 10 hours of work by one lower
level accountant.
Despite the seeming simplicity of the three principal questions,
and the relatively small number of tags likely to be involved, is it
possible that auditors would have to go through complex steps in order
to provide assurance as to the tagging? The answer is no. There is a
simple way for assurance to be done, and no reason why a company's
auditors would not follow it.
Today, most companies prepare their financial statements in Excel,
Word, or some other desktop publishing software; those companies that
are furnishing or will furnish XBRL financial statements will use the
bolt-on method to add the XBRL tags. Once the tagging has been
completed, all these desktop publishing applications can be used to
print out a set of financial statements, and when printed out these
statements should be an exact replica of the audited human-readable
statements. The two financial statements can then be compared either
manually, through a visual comparison, or through an automated
comparative analysis. If they match, the XBRL tagging must have been
accurate--otherwise the XBRL financial statements could not produce an
exact replica of the audited human-readable statements. If there are
discrepancies, errors in the tagging will be immediately apparent.
Any suggestion that this simple process will or could involve costs
remotely like section 404 of Sarbanes-Oxley is thus completely
fanciful. A better description of the costs involved in auditor
assurance would be one word: trivial.
Is assurance by auditors necessary?
Certainly. There are two reasons. First, without a third-party
review, companies will get careless in the rush to complete their XBRL
financial reports and file with the SEC. No matter how simple the
tagging process, mistakes will be made. Mistakes are especially likely
if the tagged financial statements are furnished rather than filed. In
that case, companies will believe that they don't have to be
particularly careful with the mapping to the XBRL taxonomy, since there
will be little likelihood of liability for mere negligence. If, as some
have suggested, the SEC will offer some kind of safe harbor for XBRL-
tagged financials that are furnished rather than filed, this problem
will be compounded; companies will have little incentive to take the
time to get the tagging right, and many incentives to get the tagging
wrong if they are hoping to avoid unfavorable comparisons with their
peers. Under these circumstances, errors in the tagging--and incorrect
information in the XBRL financial statements--will not be an infrequent
occurrence; the result will be to raise questions about the value and
usefulness of XBRL. In this way, a potentially valuable resource for
investors, which could have been introduced without flaws, will be
damaged and diminished. And all this because of an unfounded fear that
auditor assurance will be costly.
Second, and perhaps even more important, in the absence of any
consistent rules for tagging, imposed either by regulation or reporting
standards and monitored by auditors, many companies may add extensions
to their tags that will make it difficult or impossible to compare
their financial results from period to period or with others in their
industry. The XBRL taxonomy is a set of standardized categories for
typical financial reports. The designers have made efforts to include
all the tags that would be necessary to achieve some degree of
comparability between companies in the same business. However,
companies, on their own, can add extensions to the standard tags in the
XBRL taxonomy. In some cases, these extensions may more accurately
describe a company's specific unique disclosures (e.g., business
[[Page 10935]]
segments), but they can also make comparability more difficult.
In the development of XBRL, it was assumed that the tagging process
would be reviewed by the company's auditors--not only to assure that
the tagging was done properly, but also to impose some period-to-period
consistency on the process by which companies choose their tags or add
extensions to the standard tags in the XBRL taxonomy. The Committee's
proposal to allow XBRL financial statements to be furnished without
assurance will invite a chaotic outcome, in which it will be possible
for companies to add unnecessary or inappropriate extensions to the
XBRL tags. This will impair comparability, one of the principal
purposes of XBRL, and substantially reduce XBRL's value to investors
and analysts.
Is the furnished vs filed distinction sustainable?
No. The Committee's draft report conceives of the audited human-
readable financial statements and the XBRL financial statements as two
separate documents. This is certainly true as the bolt-on method is
used today. The result is two documents, with the XBRL materials
furnished, while the human readable (audited) financial statements are
filed. However, if companies follow the Committee's suggestion, they
will have to forego the use of a major advance in the formatting of
filed documents that will be available to companies around the world in
only a few months. This new document format is known as Microformat,
and should be available by this coming May. When it is available, it
will be usable through the bolt-on method as well as other more
efficient and less costly approaches. The technical specifications that
will make the Microformat standard possible will be published soon by
XBRL International--the umbrella group for the development and
worldwide promulgation of XBRL--and this will enable software
manufacturers to prepare updated plug-ins, so that existing report-
writer and desktop publishing applications will be able to create
Microformat documents. Using the XBRL Microformat standard, it will be
possible to both print out a human-readable financial statement, and
download an XBRL financial statement into a model, from a single XBRL
Microformat document.
In this case, of course, there can't be a separate filing of the
XBRL and human-readable financial statements; nor can the human
readable portion be filed while the XBRL portion is furnished; they
will both be included in the same document and rely on the same data.
If that data contains an error, both the human readable portion and the
XBRL disclosures will reflect that error, because both are derived from
the same underlying information. In other words, it will make no sense
to apply different liability standards to the human-readable document
and to the XBRL tagged disclosures, because both the human-readable
audited financial statement and the XBRL financial statement will come
out of the same data source.
Under these circumstances, one of two things will happen: either
the Committee's distinction between furnishing and filing will be
ignored by companies that decide to use the Microformat document, or--
more likely--the distinction between filing and furnishing that the
Committee (and perhaps the SEC) has offered will induce U.S. companies
to forego the Microformat option and continue to use older and less
efficient technology for their financial reporting. Accordingly, the
Committee's hope that a mandatory timetable for filing financial
statements in XBRL format will bring about the adoption of new
technology will have been thwarted by the Committee's own (unnecessary)
requirements. In addition, the huge efficiency benefits that would come
from the creation of a single Microformat document, which can produce
both a human-readable statement and be downloaded into a model, will be
lost.
Conclusion
Auditor assurance as to the accuracy of tagging is a simple
process, and cannot under any imaginable circumstances be costly for
companies--large or small--that are required to file XBRL financial
statements. There are many ways that assurance can be accomplished
through efficient automatic means, but one way that even non-technical
people can understand is that the XBRL financial statements can be used
to print out a set of human-readable financial statements, which can
then be compared visually with the audited statements. If they match,
the tagging must have been done correctly. Accordingly, there is no
need to distinguish between furnishing and filing XBRL financial
statements, and no need for more than a limited SEC inquiry to confirm
that the costs are trivial. After that, the SEC can determine how and
at what pace it should require companies to file their financial
statements in XBRL format.
In my view, therefore, the Committee should eliminate both the
distinction between filing and furnishing XBRL financial statements,
and the entire phase-in plan contained in its draft report of January
11. Instead, it should--for the reasons stated in the January 11
draft--endorse a requirement that all companies file their financial
statements in XBRL Microformat, and leave it to the SEC to determine on
what timetable this should occur.
Appendix B
Examples of Substantive Complexity
1. Industry-Specific Guidance
1. Below is a list of examples of industry-specific guidance in
GAAP. Note that this list does not reflect all industry-specific
guidance or all industries subject to its own guidance.
------------------------------------------------------------------------
Industry Sources
------------------------------------------------------------------------
Broadcasting Industry........ SFAS No. 63, 139; EITF 87-10; SOP 00-2.
Banking and Thrift Industries APB Opinion 23; SFAS No. 72, 91, 104,
109, 114, 115, 147; Technical Bulletin
85-1; FSP 85-24-1; SOPs 90-3, 03-3;
EITFs 97-3, 93-1, 92-5, 89-3, 88-25, 88-
19, 87-22, 86-21, 85-44, 85-42, 85-41,
85-31, 85-24, 85-8, 84-20, 84-9, 84-4, D-
Topics D-78, D-57, D-47, D-39, SEC
Regulation S-X--Article 9, SEC Industry
Guide; AICPA Auditing and Accounting
Guide.
Cable Television Industry.... SFAS No. 51.
Computer Software to be Sold, SFAS No. 2, 86.
Leased, or Otherwise
Marketed.
Contractor Accounting: ARB 43, Chapter 11, ARB 45, SFAS No. 111;
Construction-Type Contracts SOP 81-1.
& Government Contracts.
Development Stage Enterprises Opinion 18; SFAS No. 7, 95, 154;
Interpretation 7; SOP 98-5; AICPA
Auditing and Accounting Guides.
Finance Companies............ SFAS No. 91, 111, 115; SOP 01-6; AICPA
Auditing and Accounting Guide.
[[Page 10936]]
Franchising: Accounting by SFAS No. 45, 141.
Franchisors.
Insurance Industry........... SFAS No. 5, 60, 91, 97, 109, 113, 114,
115, 120, 124, 133, 135, 140, 144, 149,
156; Interpretation 40; FSP FAS 97-1;
AICPA Auditing and Accounting Guides;
EITFs 99-4, 93-6, 92-9; D-Topics D-54, D-
35. D-34, SEC Regulation S-X--Article 7,
SEC Industry guide.
Investment Companies......... SFAS No. 102; FSP AAG INV-1; SOPs 94-4-1,
93-1, 93-4, 95-2, 00-3, 01-1; AICPA
Auditing and Accounting Guide; D-Topics
D-76 D-74, D-11, SEC Regulation S-X--
Article 6.
Mortgage Banking Activities.. SFAS No. 65, 91, 114, 115, 124, 125, 133,
134, 140, 149, 156; Technical Bulletin
87-3; SOP 97-1, 03-3; EITF 95-5, 90-21,
87-34, 85-13, 84-19, D-Topics D-10, D-4,
D-2.
Motion Picture Industry...... SFAS No. 139, SOP 00-2.
Oil and Gas Producing SFAS No. 19, 25, 69, 95, 109, 131, 143,
Activities. 144, 145, 153; Interpretation 33, 36,
FSP FAS 19-1, 141/142-1, 142-2; AICPA
Auditing and Accounting Guide; SEC
Industry Guide, SEC Reg S-X Rule 4-10,
SAB Topic 12, FRR Section 406; EITFs 04-
6, 04-4, 04-3, 04-2, 90-22.
Pension Funds: Accounting and SFAS No. 35, 75, 102, 110, 135, 149; SOPs
Reporting by Defined Benefit 92-6, 94-4, 94-6, 95-1, 99-2, 99-3, 01-
Pension Plans. 2.
Real Estate: Sales & SFAS No. 13, 34, 66, 67, 91, 98, 114,
Accounting for Costs and 140, 144, 152; Interpretation 43; SOPs
Initial Rental Operations of 75-2, 78-9, 92-1, 97-1, 04-2; AICPA
Real Estate Projects. Auditing and Accounting Guide; EITF 06-
8, 05-3, 98-8, 97-11, 95-7, 95-6, 94-2,
94-1, 91-10, 91-2, 90-20, 89-14, 88-24,
88-12, 87-9, 86-7, 86-6, 85-27, 84-17,
SEC Regulation S-X--Rule 3-14, SEC SAB
Topic 5N, 5W.
Record and Music Industry.... SFAS No. 50.
Regulated Operations......... SFAS No. 71, 87, 90, 92, 98, 101, 106,
109, 135, 142, 144, Interpretation 40;
Technical Bulletin 87-2; EITFs 97-4, 92-
7; D Topics D-21, D-5; SAB Topic 10.
Title Plant.................. SFAS No. 61, 144.
------------------------------------------------------------------------
2. Industry-specific exceptions in GAAP, such as the scope
exception for registered investment companies and life insurance
entities in FIN 46R, Consolidation of Variable Interest Entities and
for U.S. savings and loan associations, other ``qualified'' thrift
lenders, and stock life insurance companies in SFAS No. 109, Accounting
for Income Taxes.
3. Industry practice such as accounting for certain types of
inventory at fair value.
2. Alternative Accounting Policies
Examples of alternative accounting policies are as follows:
SFAS No. 87, Employer's Accounting for Pensions and SFAS
No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions, which permits alternatives for amortizing delayed recognition
amounts and for measuring return on plan assets.
SFAS No. 95, Statement of Cash Flows, which permits
alternative presentations of the form and content of the statement.
SFAS No. 115, Accounting for Certain Investments in Debt
and Equity Securities (specifically Q&A 35 of the SFAS 115
Implementation Guide), which indicates that companies are not precluded
from classifying securities as trading, even if they have no intention
of selling them in the near-term.
SFAS No. 130, Reporting Comprehensive Income, permits a
choice in presenting comprehensive income. An entity may present other
comprehensive income below the total for net income in a single
statement, in a separate statement that begins with net income, or in a
statement of changes in equity.
SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, which permits, but does not require, the use of
hedge accounting, which, in certain circumstances, may mitigate
earnings volatility from marking derivative instruments to market.
SFAS No. 159, The Fair Value Option for Financial Assets
and Financial Liabilities, which permits, but does not require, the
measurement of certain financial assets and financial liabilities at
fair value.
EITF 88-1, Determination of Vested Benefit Obligation for
a Defined Benefit Plan, which permits vested benefit obligations to be
determined as the actuarial present value of the vested benefits to
which the employee is entitled if the employee separates immediately or
the actuarial present value of the vested benefits to which the
employee is currently entitled but based on the employee's expected
date of separation or retirement.
EITF 06-3, How Taxes Collected from Customers and Remitted
to Governmental Authorities Should Be Presented in the Income Statement
(That Is, Gross Versus Net Presentation), which permits that certain
taxes, such as sales, use, and value added taxes, may be presented
either on a gross or net basis.
EITF Topic D-98, Classification and Measurement of
Redeemable Securities, which permits a choice of methods of accreting
to the redemption value.
FIN 48, Accounting for Uncertainty in Income Taxes, which
permits an entity to classify interest and penalties as either interest
or taxes.
FSP AUG AIR-1, Accounting for Planned Major Maintenance
Activities, which prohibits the accrue in advance method, but allows
for continued use of one of three other alternatives: direct expense,
built-in overhaul, or deferral methods.
Oil & gas accounting: The two accounting methods followed
by oil and gas producers are the successful efforts method and the full
cost method. Successful efforts accounting essentially provides for
capitalizing only those costs directly related to proved properties;
the costs associated with exploratory dry holes are expensed as
incurred. Full cost accounting generally provides for capitalizing
(within a cost center) all costs incurred in exploring for, acquiring,
and developing oil and gas reserves-regardless of whether or not the
results of specific costs are successful.
SAB Topic 5H, Accounting for Sales of Stock by a
Subsidiary, which permits gains/losses on sales of stock by a
subsidiary to be recognized in income or equity.
[[Page 10937]]
3. Bright Lines
Examples of bright lines, rules of thumb, and pass/fail models
include the following:
A. Bright Lines
Lease Accounting
Current lease accounting is based on a principle: when a lease
transfers substantially all of the benefits and risks of ownership of
the property, it should be accounted for as an asset and a
corresponding liability by the lessee and the asset is derecognized by
the lessor (capital lease); otherwise, rental expense is recognized as
amounts become payable (operating lease). However, to apply this
principle, SFAS No. 13, Accounting for Leases, provides the following
bright lines for classifying leases as capital or operating. Meeting
any one of these criteria results in capital lease treatment.
[cir] The lease transfers ownership of the property to the lessee
by the end of the lease term.
[cir] The lease contains a bargain purchase option.
[cir] The lease term is equal to 75 percent or more of the
estimated economic life of the leased property.
[cir] The present value at the beginning of the lease term of the
minimum lease payments, excluding certain items, equals or exceeds 90
percent of the excess of the fair value of the leased property.
Consolidation
For those entities that are not subject to the FIN 46R model, ``the
usual condition for a controlling financial interest is ownership of a
majority voting interest, and therefore, as a general rule, ownership
by one company * * * of over 50% of the outstanding voting shares of
another company is a condition pointing toward consolidation.'' \78\
Further, there is a presumption that an investment of 20%-50% requires
equity method accounting. In addition, the equity method is required
for investments in limited partnerships unless the interest ``is so
minor that the limited partner may have virtually no influence over
partnership operating and financial policies'' (SoP 78-9, Accounting
for Investments in Real Estate Ventures). In this case, practice has
used a 3%-5% bright line to apply the ``more than minor'' provision.
This practice has been acknowledged by the SEC staff in EITF Topic No.
D-46, Accounting for Limited Partnership Investments.
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\78\ ARB No. 51, Consolidated Financial Statements, paragraph 2.
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Revenue Recognition
Bright lines may also be found in revenue recognition literature.
One example is SFAS No. 66, Accounting for Sales of Real Estate, which
provides bright lines for determining the buyer's minimum initial
investment requirements for real estate sales.
Business Combinations
When an SEC registrant undergoes a change in control, the company
must reflect the new basis of accounting arising from its acquisition
in its stand-alone financial statements (i.e., apply purchase
accounting to its own stand-alone financial statements) if the company
becomes substantially wholly-owned. ``Substantially wholly-owned'' is
defined such that this push down accounting is prohibited if less than
80% of the company is acquired, permitted if 80% to 95% of the company
is acquired, and required if 95% or more of the company is acquired.
In addition, SFAS No. 141, Business Combinations, requires that the
purchase price allocation period in a business combination usually not
exceed one year from the consummation date.\79\
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\79\ We note SFAS No. 141, Business Combinations, has been
superseded by a new FASB standard, SFAS No. 141 (revised 2007),
Business Combinations, which similarly states in paragraph 51, ``* *
* the measurement period shall not exceed one year from the
acquisition date.''
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Pension and Other Post-Retirement Employment Benefit
Accounting
SFAS No. 87, Employers' Accounting for Pensions, and SFAS No. 106,
Employers' Accounting for Postretirement Benefits Other Than Pensions,
permit the use of smoothing mechanisms that delay the recognition of
the effects of changes in actuarial assumptions and differences between
actual results and actuarial assumptions. However, these standards
contain a bright line as to when the delayed recognition amounts should
be recognized.
Hedge Accounting
SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, requires that derivative instruments be recognized at fair
value, with changes in fair value recognized in income. However, in an
effort to mitigate earnings volatility, SFAS No. 133 permits the use of
hedge accounting when a derivative is highly effective in achieving
offsetting changes in fair value or cash flows attributable to the risk
being hedged. GAAP, however, does not define ``highly effective.''
Instead, practice has defined ``highly effective'' as an offset ratio
of 80% to 125%.
Classification
Bright lines are also present in classification requirements. For
example, SFAS No. 95, Statement of Cash Flows, clarifies the definition
of ``cash equivalents'' by stating that ``generally, only investments
with original maturities of three months or less qualify under that
definition'' (paragraph 8). Despite use of the word ``generally,'' this
bright line is often interpreted stringently.
In addition, SEC Regulation S-X includes bright lines for separate
presentation of amounts that would otherwise be included in lines such
as revenue, other current assets and liabilities, and other assets and
liabilities.
Disclosure
Bright lines also exist with respect to the determination of
related parties for the purposes of disclosing related party
transactions and the identification of segments for the purposes of
determining which operating segments require separate presentation.
Further, SEC Regulation S-X includes a number of bright lines
regarding requirements to present stand-alone acquiree financial
statements, stand-alone equity method investee financial statements,
and pro forma financial information, among others. These bright-lines
are based on the results of certain significance tests, or
calculations, defined in Regulation S-X. These significance tests
compare the acquiree or investee to the registrant in the areas of
assets, investments, and income.
B. Rules of Thumb
Consolidation Accounting
The fall of Enron in late 2001 refocused attention on the effect of
bright lines as they relate to consolidation accounting. Enron, and
others, took advantage of bright lines related to the consolidation of
special purpose entities (SPEs) to avoid reporting assets and
liabilities, to defer reporting losses, and/or report gains. At the
time, the consolidation of SPEs hinged on an analogy to guidance that
required lessees to consolidate SPE lessors that lacked a substantive
investment at risk from an unrelated party. ``Substantive'' was defined
as 3%, at a minimum, with the caveat that a greater investment may be
necessary in certain facts and circumstances. Despite this caveat,
which would suggest the need for judgment, the presence of the 3%
bright line gave rise to numerous structured transactions to achieve a
specific accounting purpose.
In December 2003, the FASB issued FIN 46R, Consolidation of
Variable Interest Entities, which superseded the
[[Page 10938]]
3% rule. FIN 46R requires consolidation in certain circumstances by the
party that holds the majority of the risks and rewards of an entity,
rather than equity ownership and voting rights. This model has led some
to assert that FIN 46R is a principles-based standard. However, even
FIN 46R contains a rule of thumb--a presumption that if equity
investment at risk is less than 10% of the entity's total assets, the
entity is a variable interest entity subject to the FIN 46R model, with
similar caveats that require additional analysis, judgment and
consideration.
Contingencies
SFAS No. 5, Accounting for Contingencies, provides an example of
rules of thumb in interpretations of GAAP. SFAS No. 5 establishes
recognition and disclosure requirements based on the likelihood--
remote, possible, probable--that a liability has been incurred.
Although GAAP does not define these terms, audit firms have developed
rules of thumb for these terms.
C. Pass/Fail Tests
SFAS No. 48, Revenue Recognition When Right of Return
Exists, requires that where a right of return exists, revenue be
recognized at the time of sale only if certain criteria, such as the
amount of future returns can be reasonably estimated. Otherwise,
revenue recognition is deferred until the right expires or the criteria
are subsequently met.
SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities--if critical terms do not match or if documentation
does not comply with the rules, then companies are not eligible to
apply hedge accounting.
SFAS No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities contains
requirements, all of which must be satisfied, to achieve sale
accounting for a transfer of financial assets. Otherwise, the transfer
is treated as a secured borrowing with a pledge of collateral.
EITF 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock, identifies a number of criteria that must be met in order for an
instrument to be classified as an equity instrument. Failure to meet
any of these criteria results in classification as a liability, which
is marked to market through income. The criteria do not provide for
probability assessments or judgments based on the preponderance of
evidence.
SoP 97-2, Software Revenue Recognition, related
interpretations, and audit firm guidance contain the following pass/
fail tests:
[cir] If vendor specific objective evidence (VSOE) does not exist
for all of the undelivered elements of a software sales arrangement,
the recognition of all revenue from the arrangement must be deferred
until sufficient evidence exists, or until all elements have been
delivered, unless certain exceptions are met.
[cir] Extended payment terms usually result in a deferral of
revenue. Specifically, when extended payment terms are present, a
presumption exists that the vendor's fee is not fixed or determinable,
due to the possibility that the vendor may provide a refund or
concession to a customer. While there are factors to overcome this
presumption, interpretive guidance sets the hurdle to overcome this
presumption extremely high, generally resulting in the deferral of
revenue until payment is due.
Appendix C
Committee Members, Official Observers, and Staff
Members
Robert C. Pozen, Chairman, MFS Investment Management. (Ex Officio
Member of All Subcommittees)
Dennis R. Beresford, Ernst & Young Executive Professor of
Accounting, University of Georgia. (Standards-Setting Process
Subcommittee)
Susan S. Bies, Former Member, Board of Governors, Federal Reserve
System. (Chairperson, Substantive Complexity Subcommittee)
J. Michael Cook, Former Chairman and CEO, Deloitte & Touche LLP.
(Chairperson, Audit Process and Compliance Subcommittee)
Jeffrey J. Diermeier, CFA, President and CEO, CFA Institute.
(Chairperson, Delivering Financial Information Subcommittee)
Scott C. Evans, Executive Vice President, Asset Management, TIAA-
CREF. (Standards-Setting Process Subcommittee)
Linda L. Griggs, Partner, Morgan, Lewis & Bockius LLP. (Audit
Process and Compliance Subcommittee)
Joseph A. Grundfest, William A. Franke Professor of Law and
Business, Stanford Law School. (Substantive Complexity Subcommittee)
Gregory J. Jonas, Managing Director, Moody's Investors Service.
(Audit Process and Compliance Subcommittee)
Christopher Liddell, Chief Financial Officer, Microsoft Corp.
(Delivering Financial Information Subcommittee)
William H. Mann, III, Senior Analyst, The Motley Fool. (Delivering
Financial Information Subcommittee)
G. Edward McClammy, Senior Vice President, Chief Financial Officer
and Treasurer, Varian, Inc. (Substantive Complexity Subcommittee)
Edward E. Nusbaum, CEO and Executive Partner, Grant Thornton LLP.
(Audit Process and Compliance Subcommittee)
James H. Quigley, Chief Executive Officer, Deloitte Touche Tohmatsu.
(Standards-Setting Process Subcommittee)
David H. Sidwell, Former Chief Financial Officer, Morgan Stanley.
(Chairperson, Standards-Setting Process Subcommittee)
Peter J. Wallison, Arthur F. Burns Chair in Financial Market
Studies, American Enterprise Institute. (Delivering Financial
Information Subcommittee)
Thomas Weatherford, Former Executive Vice President and Chief
Financial Officer, Business Objects S.A. (Substantive Complexity
Subcommittee)
Official Observers
Robert Herz, Chairman, Financial Accounting Standards Board.
Assisted by: Thomas Linsmeier (Substantive Complexity
Subcommittee). Leslie Seidman (Standards-Setting Subcommittee).
Larry Smith (Audit Process and Compliance Subcommittee). Donald
Young (Delivering Financial Information Subcommittee).
Charles Holm, Associate Director and Chief Accountant, Banking
Supervision and Regulation, Federal Reserve Board.
Phil Laskawy, Chairman of the Trustees, International Accounting
Standards Committee Foundation.
Mark Olson, Chairman, Public Company Accounting Oversight Board.
Assisted by: Charles Niemeier (Substantive Complexity
Subcommittee). Dan Goelzer (Audit Process and Compliance
Subcommittee).
Kristen E. Jaconi, Senior Policy Advisor to the Under Secretary for
Domestic Finance, U.S. Department of the Treasury.
Committee Staff
Conrad Hewitt, Chief Accountant, Office of the Chief Accountant,
U.S. Securities and Exchange Commission.
James Kroeker, (Designated Federal Officer), Deputy Chief
Accountant, Office of the Chief Accountant, U.S. Securities and
Exchange Commission.
John W. White, Director, Division of Corporation Finance, U.S.
Securities and Exchange Commission.
Wayne Carnall, Chief Accountant, Division of Corporation Finance,
U.S. Securities and Exchange Commission.
James Daly, Associate Director, Division of Corporation Finance,
U.S. Securities and Exchange Commission.
Russell Golden (Senior Advisor to the Committee Chairman), Director
of Technical Application and Implementation Activities, Financial
Accounting Standards Board.
Holly Barker, Project Manager, Financial Accounting Standards Board.
Adam Brown, Professional Accounting Fellow, Office of the Chief
Accountant, U.S. Securities and Exchange Commission.
Bert Fox, Professional Accounting Fellow, Office of the Chief
Accountant, U.S. Securities and Exchange Commission.
[[Page 10939]]
Todd E. Hardiman, Associate Chief Accountant, Division of
Corporation Finance, U.S. Securities and Exchange Commission.
Stephanie Hunsaker, Associate Chief Accountant, Division of
Corporation Finance, U.S. Securities and Exchange Commission.
Shelly Luisi, Senior Associate Chief Accountant, Office of the Chief
Accountant, U.S. Securities and Exchange Commission.
Christopher Roberge, Project Manager, Financial Accounting Standards
Board.
Nili Shah, Assistant Chief Accountant, Office of the Chief
Accountant, U.S. Securities and Exchange Commission.
Amy Starr, Senior Special Counsel to the Director, Division of
Corporation Finance, U.S. Securities and Exchange Commission.
Sharon Virag, Director of Technical Policy Implementation, Public
Company Accounting Oversight Board.
Brett Williams, Professional Accounting Fellow, Office of the Chief
Accountant, U.S. Securities and Exchange Commission.
[FR Doc. E8-3544 Filed 2-27-08; 8:45 am]
BILLING CODE 8011-01-P