(The article featured
below is a selection from SEC
Today, which is available to subscribers of that publication.)
SEC Advisory Committee on Improvements to Financial
Reporting Issues Final Report
The SEC's Advisory Committee on Improvements to
Financial Reporting has issued its draft final report recommending major changes to regulation and standard-setting
involving financial statements and their independent audit. The committee was
formed by the SEC in July 2007 with a mandate to examine how to increase the
usefulness of financial reports to investors and reduce their complexity to
investors, preparers and auditors. The committee is chaired by Robert Pozen.
From the outset, the committee focused on areas in
which the SEC, FASB and the PCAOB could act within a reasonable time frame. The
committee avoided recommendations that would require legislation. The
overarching principle guiding the committee's recommendations is that the
primary purpose of financial statements must be to help investors make
well-informed decisions.
The committee also limited its scope on international
matters. While broadly supporting the move towards international financial
accounting standards, the committee did not focus on the ongoing convergence of
U.S. GAAP and IFRS. The committee believes that the principles underlying its
recommendations are relevant no matter how convergence develops.
The main themes of the recommendations are increasing
the usefulness of information in SEC reports and enhancing the standard setting
process. A number of recommendations deal with reforming the FASB
standard-setting process. For example, the committee urges the SEC to recommend
that FASB develop a framework to integrate existing disclosure requirements into
a cohesive whole to ensure meaningful communication and the logical presentation
of disclosures based on consistent objectives and principles. The recommendation
would eliminate redundancies and provide a single source of disclosure guidance
across all financial reporting standards.
The committee said that FASB should also disclose the
principal assumptions that may impact a company's business and provide a
qualitative discussion of the key risks and uncertainties that could
significantly change these amounts over time. The recommendation would encompass
transactions that are recognized and measured in the financial statements, as
well as events and uncertainties that are not recorded such as litigation and
regulatory developments.
The committee also urged the SEC to issue a statement
of policy articulating how it evaluates the reasonableness of accounting
judgments and including factors that it considers in making the evaluation. The
statement of policy should also address the choice and application of accounting
principles. The PCAOB should develop guidance on how the Board, including its
inspections and enforcement divisions, would evaluate the reasonableness of
judgments based on PCAOB auditing standards. The PCAOB's statement of policy
should acknowledge that the Board would look to the SEC's statement of policy to
the extent that the PCAOB would be evaluating the appropriateness of accounting
judgments as part of an auditor's compliance with PCAOB auditing standards.
The Pozen Committee seeks the creation of a formal
Financial Reporting Forum to include the SEC, FASB and the PCAOB, as well as
representatives from the preparer, auditor and investor communities, to make
recommendations for responding to immediate needs and longer-term priorities in
the financial reporting system. The recommendation may require the FASB to
reevaluate the roles and composition of other advisory groups or agenda
committees. One or more key decision-makers from the SEC, FASB and the PCAOB
should be members of the Forum, which would allow coordination of how and by
whom guidance should be issued and reduce the impetus for the SEC to issue
interpretive implementation guidance.
The committee urged the SEC to stop issuing broad
interpretive implementation guidance that would change U.S. GAAP. Instead such
matters should be referred to FASB through the Financial Reporting Forum. The
SEC staff should re-emphasize that its comment letter and pre-clearance
processes are registrant-specific and that other registrants should respond to
those comments by changing their accounting only after concluding that it is
appropriate to do so.
With regard to the materiality standard, the SEC or
FASB should supplement existing guidance to reinforce the concept that those who
evaluate the materiality of an error should make the decision based upon the
perspective of a reasonable investor. Materiality should be judged based on how
an error affects the total mix of information available to a reasonable
investor. Just as qualitative factors may lead to a conclusion that a small
error is material, qualitative factors also may lead to a conclusion that a
large error is not material. In this recommendation, the term "large"
refers to any error that is more than insignificant. The committee understands
that this is a broad definition and that the larger an error is the more likely
that it will be deemed material regardless of any qualitative factors.
The committee endorsed the U.S. Supreme Court's
definition of materiality in that a fact is material if 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 and TSC
Industries, Inc. v. Northway, Inc.). When looking at how an error affects
the total mix of information, the committee said that one must consider all of
the qualitative factors that would impact the evaluation of the error. Bright
lines or purely quantitative methods are not appropriate in determining the
materiality of an error to annual financial statements, according to the
committee report.
The committee believes that the current materiality
guidance in SAB Topic 1M is appropriate in making most materiality judgments,
but warned against making one-directional materiality judgments under which, for
example, a quantitative error would be considered material without regard to
qualitative factors. Such a one-directional judgment would be inconsistent with
the Supreme Court's materiality standard, which requires an assessment of the
total mix of information available to the investor.
The determination of how to correct a material error
should be based on the needs of investors making current investment decisions.
For example, a material error that is not important to a current investment
decision would not require the restatement of the financial statements in which
the error occurred, but would need to be promptly corrected and prominently
disclosed in the current period.
Regarding restatements, the committee is concerned
about the impact of the lack of information for investors during the dark period
between the initial notification to the SEC and the time when the restated
financials are filed with the SEC. This silence creates significant uncertainty
regarding the size and nature of the effects on the company of the issues
leading to the restatement, which often results in decreases in the company's
stock price. The current disclosure surrounding a restatement often is not
adequate to allow investors to evaluate the company's operations and the
likelihood that such errors could occur in the future. The committee urged the
SEC to issue guidance on the disclosure of financial information during the
period in which the restatement is being prepared. Companies should be
encouraged to provide any reasonably reliable financial information affecting
the restatement.
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