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Regulators Discuss Ways to Improve Financial Reporting

Rep. Barney Frank (D-MA), the ranking minority member on the House Financial Services Committee, noted that criticisms of the Sarbanes-Oxley Act persist, especially with respect to section 404 on internal controls. Frank said he hopes for appropriate adjustments rather than exceptions from the Act. If the SEC needs additional authority under the Act, he encouraged the agency to ask for it. Frank offered these views at the opening of yesterday's hearing by the Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises on transparency in financial reporting.

Frank also said that with the adoption of a standard for the expensing of stock options, he now hopes that all parties, including those who resisted its passage, will work to improve its implementation. With respect to executive compensation, Frank said criticisms of large pay packages are not simply a matter of envy. He believes that excessive executive pay can have significant negative implications for the economy and cited a study by Professor Lucian Bebchuk which found that pay by public companies to their top five executives, as a ratio to earnings, amounted to about 10% between 2001-2003. Frank called for a mechanism not only for shareholders to receive this information, but also to act on it.

Rep. Geoff Davis (R-KY) reported that he has introduced legislation to require annual testimony for the next five years by the chairs of the SEC, FASB and PCAOB regarding their efforts to reduce the complexity in financial reporting. The Act, entitled "Promoting Transparency in Financial Reporting," will remind those bodies that the promotion of transparency is a top priority, he explained. Davis said the efforts to improve transparency should include a reassessment of complex and outdated accounting standards, moving from rules-based to principles-based standards, promoting the use of plain English, and encouraging the use and acceptance of extensible business reporting language in financial information.

Acting PCAOB Chairman Bill Gradison said that a system of rules without principles is unworkable and the debate over the right balance between the two will be ongoing. Principles-based standards are likely to increase the variability of results, he said, even when applied by conscientious corporate managers and checked by competent independent auditors. As long as company managers challenge their auditors to show them where in the accounting literature it says that they cannot do something, he said the benefits of principles-based accounting standards will be limited.

Gradison said that another impediment to greater reliance on principles-based standards is the constant pressure on standard setters to provide exceptions to the principles, usually to suit the interests of a particular industry or group of companies, or from auditors seeking a safe harbor from exposure to liability. The more exceptions that are granted, the more rules-based the standards become. Gradison added that the PCAOB has received many requests for specificity and for exceptions. The Board is mindful of the risk of accommodating those requests, he said, knowing that the result may be auditing standards that are overly prescriptive rather than standards that provide a framework for the exercise of professional judgment. 

The Board has periodically issued implementation guidance, Gradison advised, but it is careful to avoid detailed, rules-based or exceptions-filled approaches. During inspections, the staff looks for sound judgment in auditing rather than a strict focus on technical compliance, he said.

Scott Taub, the SEC's acting chief accountant, cited the Commission's report on off-balance sheet arrangements which noted that achieving transparency in financial reporting will depend on the efforts of many parties. Preparers of financial information must be committed to issuing financial reports to communicate with investors, rather than focusing solely on compliance with rules and standards. The legal system must reward and encourage the use of unbiased, professional judgment. Investors and other users of financial information must try to understand the information that is presented without relying on a single figure, such as earnings per share, in making their investment decisions. Regulators must develop a regulatory regime that requires the disclosure of necessary and appropriate information without overburdening preparers and investors.

Taub said the complexity of accounting standards evolved over the years as groups including FASB, the Emerging Issues Task Force, the SEC and the AICPA all set standards with different missions in mind. The result is a set of standards that range from broad to specific, according to Taub, and include inconsistent methods of accounting for similar economic transactions. The proliferation of guidance is based on fears by market participants of being second-guessed by plaintiffs, regulators and other gatekeepers, he said. The resulting demand for detailed rules, bright lines and safe harbors has overwhelmed the basic principles that underlie many of the accounting standards, in Taub's view. The SEC has been encouraging a major national effort to find ways to simplify financial reporting.

Taub noted that complex standards make it difficult for auditors to determine the evidence necessary to support management's conclusions. The complexity also leads to high costs for training and the application of the rules and standards. However, a move to a more principles-based approach will require a different world view than currently exists, he said.

FASB Chairman Robert Herz said that the complexity that pervades the reporting system poses a major challenge to maintaining and enhancing the accuracy and transparency of financial information. FASB is concerned that the complexity has led to a form-over-substance approach to accounting, auditing and reporting that has diluted professionalism and created the need to involve technical experts in order to ensure compliance. FASB has been systematically readdressing specific accounting standards that are overly complex and rules-based, he advised, including the areas of revenue recognition and pensions and other post-employment benefits.

FASB is discussing the issues surrounding accounting complexity with the SEC and the PCAOB, as well as other interested parties, according to Herz. He said it will take the involvement of all key parties to bring about broad-based improvements in the U.S. financial reporting system. The effort will not be easy, but Herz said it is of national importance.

Rep. David Scott (D-GA) asked Gradison about the risk auditors face in being sued. Gradison said the question of liability hangs over auditors "every minute of the day." They must exercise their professional judgment and skepticism, but face a huge financial risk if they miss something. Gradison suggested that Congress might want to take a look at that issue separately. He said he has no answer right now for how to reduce auditor liability, but it is an extremely important question. When asked about Auditing Standard No. 2, Gradison said the standard was never intended to be a one-size-fits-all approach and he is open to revisiting the standard if necessary.